Bank of England fails to appreciate risks of creating asset bubble in gilts
by Dr. Ros Altmann
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All financial assets may be distorted and asset bubbles burst sooner or later
Policy assumes increasing asset prices will deal with debt but need money in real assets, not financial assets
Social risks if people enticed into rising asset markets as bubble inflates
The financial crisis stemmed from the belief that debts would always be affordable if asset prices keep rising and from a failure to understand investment risk.
QE promotes rising financial asset prices as a cure for over-indebtedness: Back in 2004, when consumer debt in the UK hit £1trillion, there were headlines about the dangers of households sitting on a ‘time-bomb’ and being unable to repay their borrowings. The Bank of England’s Chief Economist, Charles Bean, now on the MPC, said this was not a problem since the borrowing increase had been matched by an increase in financial assets. This belief, that rising asset prices can offset excessive debt, has been extended to extreme proportions with QE.
Gilt issuance has quadrupled: Since 2004, the issuance of gilts has quadrupled. It has doubled just since 2008. Normally, this increase in supply would mean lower prices and higher yields, but as the Bank of England has purchased a third of the market, gilt prices have actually risen (gilt yields have fallen) despite the extra supply. This is no longer a normal asset market.
Bank of England still trying to inflate asset prices to validate debt levels: Since 2004, UK consumer debt has actually risen a further 40% to £1.4trillion. At the same time, UK national debt has risen to £1.4trillion too. The Bank of England is still saying that the solution to this over-indebtedness revolves around trying to inflate asset prices to validate this debt, like the 2004 statement by Charles Bean. However, artificially inflating asset prices will not resolve a debt crisis if the underlying problems remain. The banking system and household sectors still have large, unsustainable debts which are not being resolved. Low rates help pretend they are affordable. This is just a temporary palliative, not a proper solution.
Sometimes, we lose sight of the scale of the central bank actions. The Bank of England now owns more gilts than all UK pension funds and insurance companies combined. Japan is being even more aggressive.
Long-term interest rates are too low relative to UK’s economic fundamentals – this usually marks an asset bubble. Given the massive increase in Government borrowing, if QE had not created £375bn to buy gilts, the price of these assets would have fallen and interest rates on long-term bonds would be much higher than they are now. Meanwhile, inflation remains above target so investors are accepting negative real rates of return. Yields seem divorced from the UKs economic fundamentals. Normally, such a situation would be called an asset price bubble.
All asset markets distorted but investors keep dancing: Monetary policy has relied on ‘rigging’ the government bond market – which is supposed to be the ‘risk-free’ base against which other asset classes are priced. QE reduces the liquidity premium of sovereign bonds which reduces the yield spread, and tries to force investors into other assets. This implies all financial asset markets have been distorted. A bubble in the gilt market is likely to lead to bubbles in other bonds, in property and in equities. Financial markets become a giant casino. Or, as Chuck Prince said, investors feel they have to keep dancing as long as they see others doing the same. However, sooner or later, all asset bubbles burst, but for the short-term they offer great returns.
Social risks – Households and small players will be hit when the bubble bursts: It should be of great concern that the environment being created is encouraging institutions and households to take on far more risk than they may be able to tolerate. If there are sudden market losses, that will leave many facing financial catastrophe. Smaller households or companies will not be baled out and there is a large social risk associated with this policy. As we have seen before, it is only the largest players who are considered important enough to save.
How will QE unwind? Not nearly enough attention is being given to the future, we are all being encouraged to just live for today. I do not believe the Bank of England has any idea how it will ‘unwind’ QE gilt purchases. Indeed, there must be a significant probability that they will not do so, which means that the whole of the sterling economy has been artificially ‘devalued’ by around one third in monetary terms. This ignores any consequences for inflation that may lie further down the line.
QE has already provided an underpin for the economy which will recover as other policies work through: There is plenty of money in the economy now, it is just not getting to the right places. QE should be abandoned. Rather than creating more new money, policymakers should try to ensure the existing funds work better. Large companies have been able to raise finance cheaply on the corporate bond markets, while pension funds and insurance companies have billions available to invest. This money needs to start flowing into creating real assets.
Initiatives to boost capital spending, infrastructure and housebuilding: The Government could provide special capital allowances for new corporate capital spending projects. These use it or lose it special allowances would last for, say 12 months, and apply to spending that begins during that time. Special arrangements to help pension funds and insurance companies finance infrastructure and housing projects are long overdue. House prices are clearly too high in many parts of the country, but that is partly driven by a shortage of supply. Building more homes will help boost growth and normalise house prices. High house prices, which have also driven up rents, have damaged younger people’s incomes and create further economic distortions.
QE doesn’t ensure the new money reaches the economy – just creates more asset bubbles: Pumping money into gilts does not create growth. Growth will come from investing in real assets, not financial assets. Waiting for money to trickle out of the banking system, or for firms to suddenly start investing as a result of buying gilts is not the most efficient policy. Although QE has created such huge amounts of new money, it does not ensure that money is reaching the parts of the economy that need it. Other policies can help growth, while further money creation will just add to asset bubbles that are so dangerous for the longer term.