An era is ending

A year which sees Britain vote to leave the EU and the US vote Donald Trump to be their President is clearly one which could be said to be the beginning of a new era. Perhaps of equal significance is the fact that an old era is ending, which may well have played a part in enabling this new era to begin.

Jim Callaghan’s remark to the BBC in 1976 that “We used to think that you could spend our way out of a recession … I tell you in all candour that that option no longer exists” marked the end of the post-war consensus on Keynesian demand management of the economy and the primacy of fiscal policy over monetary policy in economic policy-making. Since then monetary policy has been dominant, and changes in interest rates have taken the lead in adjusting the course of the economy. Central banks have become independent given the crucial (technocratic) role they are believed to play in the modern economy.

However, recent experience shows that at very low interest rates, further monetary easing has little and arguably, counterproductive, impact on the economy and the central bankers at the Fed, Bank of England, ECB and Bank of Japan have all made it plain that they cannot deliver the faster growth that governments are depending of them. At zero or even negative interest rates and substantial Quantitative Easing, we have reached the limits of effective monetary policy. Even if the next move is “helicopter money”, this is as much a fiscal policy as a monetary policy. The era of monetary policy primacy is ending.

The era of trade policy liberalisation that started in the mid-1980s is also ending (as discussed here) – no major new multilateral  trade deals have been struck for about a decade and the recent TTP and TPP deals look like they will not survive contact with Donald Trump. In addition, NAFTA looks unlikely to survive in its current form and whatever the outcome of the Brexit negotiations, trade between the UK and the EU will be less free than it is today. 2015 marked the first year in decades that the growth in world trade was slower than the growth of world GDP – trade has acted as an accelerator for the world economy, now it is acting as a brake. The message from the successes of both Brexit and Trump is that national borders will be subject to greater controls and it will be less easy for people and goods and services to cross them. The era of greater openness is ending.

The effects of these two major eras has been most clearly seen within financial markets in the 35-year bull market in government bond markets of Western nations. The eye-wateringly high interest rates required by monetarism in the early 1980s to combat inflation have given way to the “rigged” bond markets in which central banks have become some of the largest owners of their own bond markets. It is not yet clear that this bull market is over, but a world of fiscal policy primacy over monetary policy is likely to have higher interest rates and bond yields.

This bull market has supported and inflated the markets in all other financial assets as the risk-free rate of return has declined, creating large gains both for those invested in financial assets and for those firms that aid and service them. This “financialisation” of the economy, in which the financial sector has been growing faster than the rest of the economy over this period has been a major trend.

The big winners of this trend have been the asset managers – attractive market returns have attracted strong inflows of assets and substantial economies of scale have nearly all accrued to the fund managers rather than their investors. The recent report from the FCA on the asset management industry highlighted that it was one of the industry sectors with the highest profit margins. Asset managers now top the tables of highest-paying industries, having recently overtaken investment bankers, for whom profitability has been of increasing concern since 2008. The attention of the regulators has noticeably shifted in recent years from banks to investment managers. The asset management era, which began in the early 1980s, may also be peaking.

All these trends began between 30-40 years ago, and all have showed distinct signs of ageing in recent years. The dramatic events of 2016 may represent the “coup-de-grace” for them and the conclusion must be that the future will look increasingly different from the past.

Fiscal policy will become more important than monetary policy, international trade will come under increasing pressures, bond yields will not always fall, the financial sector will fall back as a proportion of the economy and the profit margins of the asset management industry will decline.

The Global Monetary Policy Kaleidoscope

In 2009, in the face of a global economic crisis, the major economies of the world came together and acted in concert to ease monetary policy aggressively.  Together with fiscal stimulus in the US and China, these policies helped to prevent the world from slipping into depression.  Four years on, the economic conditions around the world vary enormously, and the appropriate monetary policies are now very different (though for all countries fiscal restraint is deemed necessary).  These differing monetary policies are producing clear differences in how the local financial markets are performing, and in 2013 there has been a much greater dispersion of performance between equity markets around the world than in 2012.

The economy with the most aggressively easy monetary policy (relative to the size of its economy)  is currently Japan, where in response to the lead of the new Prime Minister, the new Bank of Japan Governor has begun a programme of doubling the country’s monetary base in just two years.  This is being done deliberately to raise the rate of inflation in Japan from the negative rates seen in recent years to the new target of 2%.  To bring Japan out of its 20 year deflation, policymakers have articulated that inflation, and inflation expectations, need to rise to boost the nominal growth rate of the economy.  Should the current policy settings not be sufficient to do this, it is expected that policymakers will move monetary policy to an even easier stance.  The weaker yen that is likely from this policy should be instrumental in helping to boost inflation.

Next is the US, where currently the QE programme is about $4bn of new money creation every day that the financial markets are open.  Before the latest Japanese policy move, this constituted the most aggressive monetary easing.  However, the recent furore following Bernanke’s comments about the tapering of the QE policy indicate the sensitivity of markets to changes in the direction of US monetary policy.  Bernanke tried to argue that tapering a policy of printing $4bn every day to one of printing $2bn or $3bn was still a very accommodative policy; the markets however appeared to interpret it as a tightening of policy.  The rise in US bond yields since May shows that a policy that is easy, but less easy than it was, creates different expectations in the minds of investors, and the Federal Reserve’s words have thus changed the thinking of investors.

Both the ECB and the Bank of England are at a similar phase in their monetary policy.  Both have pursued unconventional policies in the past, the ECB with their three year LTROs and the Bank of England with their own QE programme, but have done little recently to move policy easier.  However, the new Bank of England Governor has clearly been tasked with boosting economic growth in the lead-up to the next election, and the ECB is concerned about the continued poor performance of the Eurozone economy.   The recent rise in bond yields that began in the US and spread across the Atlantic has been unwelcome as it raises the cost of borrowing for business and so offsets the otherwise easy policy in both the UK and the Eurozone.  A further easing of monetary policy can therefore be expected from both Central Banks, and crucially, for markets, the direction of monetary policy is still moving easier, in contrast to the US.

In China, markets have been surprised by the actions of the People’s Bank of China in not providing sufficient liquidity for the interbank market to operate smoothly in the face of liquidity pressures.  This caused overnight interest rates briefly to move above 10%, and has been interpreted as a lesson to the banking system that they have been too carefree with their lending and need to cut back.  This is effectively an act of policy tightening, though it is unlikely that the Chinese will take such tightening too far and seriously damage the economy’s growth prospects.

Finally, there are a number of significant emerging markets such as Brazil, Turkey, Indonesia and India where Central Banks have actually raised interest rates or have indicated an intention to do.  For the most part, this has been due to currency weakness, which boosts inflationary pressures in these economies, and so a tightening of monetary policy is believed to be required, in contrast to most of the rest of the world.

The league table of the stance of monetary policy, which runs from Japan, the US, the UK, Europe, China and Asia and then other emerging markets correlates precisely with the league table of year-to-date equity market performance.  Those countries with the easiest stance of monetary policy are those whose stock markets have performed best, and those with the tightest policy stance have performed worst.  This highlights the increasing dependence of financial markets on the liquidity provided by Central Banks, rather than fundamental economic and earnings trends.

Looking forward, we would expect Japan to remain at the top of the easy monetary league, with the UK moving up and the US moving down in the next few months, and the Eurozone having little room to make any changes.  China’s slowing growth will eventually produce an easier monetary policy, but may not be imminent, while the other emerging markets appear to be the furthest away from easier policy.  Japan and Asia remain the most favoured markets in our portfolios with Europe and Emerging Markets the least favoured.

Q to reduce bonds

In the 1970s, the British comedian, Spike Milligan devised the Q series.  This was a surreal comedy show, which when any particular sketch had come to an end without a suitable punchline, the actors would then wander around saying “What are we going to do now?”  UK economic policy seems to have reached the “What are we going to do now?” stage.

 

On fiscal policy, the coalition government has been and remains totally committed to reducing the budget deficit by a planned, slow but steady austerity approach.  This initially involves an increase in taxes, followed by spending cuts throughout the life of this parliament and now extended well into the next parliament.  Unfortunately, for the UK economy, this well-planned and thoughtful approach has not delivered the budget deficit reductions that were predicted for two main reasons as follows:

 

  • the eurozone crisis meant that the domestic economy of our nearest and largest trading partner was much weaker than expected as even more severe austerity was introduced there than in the UK.
  • all the economists’ models of how an economy performs at a time of government spending cutbacks woefully underestimated the impact of austerity on the overall economy.  The result has been considerably weaker UK economic performance, and much higher budget deficits than forecast by the government.

 

None of the Chancellor’s choices on fiscal policy are politically appealing.  Should he choose:

 

  • to cut spending faster than planned, to try and meet the deficit targets in future years, then even more public sector workers will be put out of work in the run-up to the next Election.
  • to reverse the spending cuts, then he will be accused of admitting that the austerity policy was wrong all along.
  • to do nothing, then he will be accused of having no ideas to boost the economy.  Increasingly, with a little over two years to go until the election, these accusations are likely to come as much from his own MPs as from the Opposition.

 

With regard to monetary policy, Mervyn King, the current Governor of the Bank of England, has managed to thoroughly confuse everyone. For the last twelve months he has been saying that the policy of Quantitative Easing (in place since April 2009) is becoming progressively less effective and that monetary policy cannot solve all the UK’s economic problems.  This is somewhat at variance with his confidence in the policies when they were initially unveiled.  However, the latest minutes from the Monetary Policy Committee showed him in a minority of 3 (against 6), voting for more QE to stimulate the economy at a time when inflation is expected by the Bank to be above its target throughout the next two and a quarter years.

 

Further, the Chancellor, has asked the incoming governor to lead a debate to assess what the appropriate target of monetary policy should be.  Taken all together, one gets the distinct impression that those in charge of UK economic policy have run out of ideas.

 

The investment implications of this uncertainty and indecision have already begun to be seen.   Gilt yields have been rising, and sterling has been falling, evidence that international investors have been reducing holdings of UK government bonds.  A weaker pound is however positive for the profits (in sterling terms) of many of the UK’s largest companies, and so share prices have been rising.  The rise in government bond yields is likely to be mirrored by rising sterling corporate bond yields, and exposure to this asset class should be reduced.

Low growth; more jobs?

Over the ten complete quarters that the current UK government has been in power, economic growth has been minus 3%, but total employment has risen by 1%.  For the last calendar year, the data show the size of the economy as unchanged but total employment up by over 550,000 or about 1.6%.  In contrast to the jobless recoveries seen in many Western countries after the 2001 downturn, the UK is experiencing a job-creating recession that is the cause of great head-scratching amongst economists.

Productivity is defined as total output divided by the amount of labour used to produce that output.  It is increasing productivity that produces the increases in the standard of living within an economy.  Historically, productivity growth in the UK economy has averaged about 1.5% per annum, but over the last ten quarters, the UK’s productivity has been averaging minus 1.5% per annum – indicating that the overall standard of living in the UK is declining.

Two sectors in particular account for much of the fall in productivity.  First, North Sea oil output has been in decline for some time now, and requires more effort and resource to produce that declining output.  Secondly, the banking sector (which delivered dramatic productivity growth before 2008) has seen a dramatic fall in output, with little change in total employment.  Many highly-paid bankers have lost their jobs, but the banks have had to hire just as many people in the compliance, risk and legal areas to deal with the aftermath of the banking crisis.

It is also undeniably true that the UK labour market has become very flexible with many businesses making much more use of variable pay structures through bonus systems, meaning that labour costs can be initially lowered by reducing the variable element of compensation, rather than immediately reducing the size of the workforce.  There are also many examples of businesses where workers have agreed to lower wages and benefits, to maintain their jobs.  Average wage growth in the UK has been below inflation for the last four years, so real wages have been falling steadily.

The statistics of the numbers of people employed also show a steep increase in the numbers of self-employed.  However, many of these are actually working very few hours, and so the official data show them as employed but in fact with very little economic output.

Elsewhere, surveys indicate that there is a degree of labour hoarding going on within companies, who fear that by reducing their workforce, they may lose key skills that they might not be able to replace in an upturn.  This however becomes progressively more difficult to maintain as time passes.  It also acts as a potential overhang to the unemployment rate and restrains business and consumer confidence.

The paradox of a job-creating recession reinforces the views and sentiments that were set out in our 2013 investment outlook: 2013 – Limited Growth and New Monetary Policy Regimes .  The UK economy is likely to continue to struggle in 2013.  However, the combination of (i) a governing coalition in the second half of its life and needing some positive economic news, and (ii) the summer arrival of a newly-imported Governor of the Bank of England, who is generally regarded as being much softer on inflation than Lord King, could well lead to a new direction in economic policy, which would bring long-term inflationary consequences.  We continue to recommend positions in index-linked gilts and gold for most investors, to act as a portfolio insurance policy against these inflationary possibilities.

2013 – Limited growth and new monetary policy regimes

As 2012 draws to a close, three things about central banks and monetary policy are becoming more apparent. Firstly, central bankers are concerned that they are being expected to fix all the ills in their economies and they believe monetary policy cannot achieve such ambitious targets.  Messrs Bernanke and King have both recently expressed concerns about the limits of what monetary policy can deliver in the face of fiscal austerity.  Secondly, successive doses of Quantitative Easing (“QE”) are generating diminishing impacts on markets and on the real economies.  This is a problem that the Bank of England has recently been highlighting about QE in the UK.  In the US, the recent, and fourth, QE announcement from the Federal Reserve, which will mean over $1 trillion of money printed every year until further notice, saw the US stock market fall on the day, in contrast to all previous QE announcements.  Thirdly, Central Banks are exploring new policy targets: in the US tying policy change to the unemployment rate; in Japan seeking to increase the inflation target; and in the UK discussing the idea of a nominal GDP target in place of an inflation target.   As 2013 begins, investors need to take into account the above developments in their investment strategy.

There are two distinct scenarios for 2013.  In the first, economic recovery and job creation continue to disappoint, in which case it appears increasingly likely that governments will tell Central Banks to concern themselves much less about inflation and more about unemployment.  If so, they would be doing this just as the Central Banks are coming to the conclusion that their current policies to boost growth, are not working very effectively.  The results would be monetary policies that are far more inflationary in intent than has so far been the case since the crisis – this would be a significant regime shift for monetary policy.

Investors therefore will need to seek greater protection from the risk of such a regime change.  This requires heavy weighting to assets that would do well in the face of a generalised increase in investor inflation expectations.  These assets would be index-linked bonds and gold.  The performance of company shares in a scenario of rising inflation expectations is mixed – over the long term company profits would be expected to rise with higher nominal growth, but in the shorter term, rising inflation tends to lead to lower valuations.  Conventional bonds would suffer very badly in an environment of higher inflation.  Commercial real estate would, in the very long term, be expected to act as a form of protection against inflation (as rents rise with inflation).  However, a combination of high unemployment and the shift towards virtual retailing is acting as a significant dampener on demand for office and retail space.  Short term prospects for returns are limited to current rental incomes alone.

In the second scenario, where the global economy does improve enough for unemployment to fall at a rate that was satisfactory to policy-makers, the response from financial markets would also be likely to be higher yields on conventional bonds, together with higher company share prices.  Given these two scenarios (of which the first, disappointing growth, is more likely ), the preferred investment strategy is to be at least neutrally invested in shares, heavily under-invested in conventional bonds and heavily-invested in the “insurance policies” of index-linked bonds and gold.

Returns on cash will remain very low in 2013 and in fact are likely to decline further if further monetary easing takes place – the aim of the Central Banks being to over-supply liquidity to the financial system.  Given the exceptionally low yields available on government bonds, it is difficult to imagine a scenario in which they deliver strong returns.  Corporate bonds, which performed very well in 2012 as credit risk perceptions declined, still offer higher yields than government bonds.  However, they no longer have the potential for significant gains from a further narrowing of the yield premium (over government bonds).  Other areas of the bond markets where the yields are still attractive relative to their risks, are emerging market local currency bonds and short duration, high yield bonds in the US.

The Eurozone economy, the UK’s largest trading partner, looks most likely to continue to disappoint next year, and so create problems for policymakers. Its key economic issue (and Mrs Merkel’s favourite trio of statistics) is that it boasts 7% of the world’s population, 25% of the world’s GDP but 50% of the world’s social spending.  This is at the same time as its demographic patterns are about to deteriorate significantly in the face of a very weak birth-rate and a rapidly expanding population of pensioners.  The sense of existential crisis about the euro may have passed for now, following the ECB’s promise to be prepared to act as purchaser of last resort for sovereign government bonds, but the danger for the euro in 2013 is more likely to come from the streets of Greece or Spain, as continued austerity bears down even harder on the public.  The Italian election is also likely to see a strong performance from anti-austerity parties.  The Eurozone enters 2013 in recession, and its financial system woefully undercapitalised.  For Eurozone markets to perform well in 2013, the ECB will need to be seen to be actually printing money – this is still an unlikely prospect, given the deeply conservative approach to monetary policy of many of the ECB members.

The Japanese economy starts 2013 with a newly-elected Prime Minister who campaigned on a promise to stimulate the economy aggressively and have a higher inflation target.  A weaker yen would be enormously helpful to Japanese industry regaining competitiveness, and after a 23 year long bear market, the stock market may finally be in a position to move higher.

The US economy, still by some distance the largest and most important to the world economy, should continue to grow modestly, but not at a rate that is likely to bring down unemployment sharply.  The short term is clouded by fears over the “fiscal cliff” negotiations, the results of which are likely to produce some modest austerity, which, if European experience is any guide, will cause some damage to growth prospects.  Expect a mediocre year for returns from US assets.

The Chinese economy, the single largest contributor to global growth, appears to be seeing a pick-up in its growth rate after the below-target 7.4% report for third quarter GDP growth.  Growth is unlikely to return to the double-digit growth rates seen in the last decade, but should be of higher quality for stock market purposes.  Instead of relying on exports of low-cost labour manufactured goods and state-sponsored investment spending, Chinese growth in the future is more likely to come from satisfying the increasingly demanding Chinese consumer.  China is also in the fortunate position of having considerable scope to ease monetary policy in conventional ways should its growth prospects deteriorate.  These more conventional methods are generally more effective in the face of weak demand, than the unconventional methods that Western Central Banks are currently forced to use.  Asian equity markets are once again expected to be the best-performing region of the world in 2013.

The UK economy remains buffeted by the trends from the European, US and, to a lesser extent, the Chinese economies. The government’s fiscal austerity programme bites a little harder in 2013 than it did in 2012, but the change in Governor at the Bank of England is likely to lead to a wider discussion about monetary policy means and objectives, which may support the UK bond and equity markets better than those of the Eurozone.  Expect a modest year for returns from UK assets and a weaker Sterling following its surprising strength in 2012.

In conclusion, global economic risks are, in our opinion, biased to the downside for 2013. If these risks are realised, the clamour for a policy response will be very great.  The shift from the 2008 conventional policy responses of lower interest rates and higher government spending to the less conventional 2009-2012 policies of QE may well then develop into a shift to very unconventional policies.  These have not to date been openly discussed, but could include such ideas as (i) using QE to buy shares rather than government or mortgage bonds, (ii) using QE to buy foreign government bonds (equivalent to deliberately pushing down the exchange rate), or (iii) pushing new money more directly into the real economy by for example printing money to pay a “citizen’s dividend” in the hope that it would be spent.  These are all theoretical ideas that would normally strike inflationary fear into the hearts of Central Bankers, but may appear next year as the logical next steps in monetary policy.

 

Hello Governor

In choosing Mark Carney as the next Governor of the Bank of England, George Osborne appears to have adopted the strategy employed by Roman Abramovitch, the owner of Chelsea Football Club, when selecting managers.

Mr Osborne scoured the world for someone who (i) was respected as a monetary policy expert in order to be effective as Chairman of the Monetary Policy Committee, (ii) understood the global banking industry to maintain and develop the role of London as a major force in the world’s financial structure and (iii) was a very effective executive to deal with what has been identified as a very inflexible culture and hierarchical structure in the Bank of England.

In Mr Carney, he appears to have found the man that best meets those criteria.  However, he is not British, though he does have a British wife and he says he will take on British nationality, and he is expensive.  These concerns, which would have counted against him very strongly in previous times, are outweighed by his reputation in the global markets and the application of more money.  Mr Carney’s basic salary will be almost 60% higher than Lord King’s and with other elements could end up being more than double what the current incumbent earns.

Mr Carney’s time at the Bank of Canada is lauded.  He was at the helm when the Canadian economy went through the financial crisis and under him it returned to a reasonable level of growth, without a banking sector meltdown, and without resorting to zero per cent interest rates or Quantitative Easing.

However, it is also true to say that much of Mr Carney’s success at the Bank of Canada is down to the work of his predecessors.  The Canadian banking system was much more tightly controlled in the lead up to the global crisis (having gone through its own meltdown in the early 1990s), with the result that neither the banks nor the Canadian consumers became over-leveraged as was the case throughout most of the rest of the G7.  Mr Carney took over at the Bank of Canada a few months before the crisis occurred, so no blame could be attached to him, and the problems he faced were far less severe than those found in the UK or the US.  He did not need to take the aggressive easing measures required elsewhere, and when Obama embarked on the huge fiscal stimulus in the US in 2009 and 2010, the Canadian economy was a natural beneficiary of the extra demand this generated.

Napoleon famously remarked that he preferred lucky Generals over clever Generals, and Mr Osborne would doubtless agree with Napoleon. Mr Carney has, it could be argued, been a little lucky.  The Governor of the Bank of England’s newly expanded role is a huge job, requiring economic policy dexterity to deal with a weak economy dependent upon an over-sized banking system that is undergoing major structural change in an institution with an out-of-date culture.  He is the best man for the job, but it will be a hugely difficult one – perhaps like managing Chelsea?

 

This time IS different for equity markets

Observant investors over the last 30 years should be looking at the current markets and thinking that an opportunity to buy into equity markets may be at hand. Following some inflation fears in 2010 and 2011, inflation across the world has declined markedly in 2012 and looks set to decline further to levels below the targets that Central Banks have set. Further, economic growth is slowing markedly and has now become a greater economic and political risk than inflation. Policymakers’ focus has clearly shifted from concerns about inflation to concerns about growth. Historically this shift in focus (1982, 1988, 1992, 1998, 2002 and 2009 saw similar shifts) has been a clear BUY signal for equity markets – in today’s conditions this is further supported by very low valuations on equities.

In these previous cycles, the shift in policymaker focus led to substantial policy easing, principally via lower interest rates, which boosted consumer disposable income, boosted consumer confidence and encouraged demand for mortgages for house purchases.  This led consumer demand as a whole and thus an economic recovery. Equity markets rallied as they foresaw this pattern of events.

Sadly, however, this time is different. Policymakers certainly wish to boost demand by policy easing but the key differences this time around are (i) interest rates are essentially at zero and cannot be cut meaningfully, (ii) government deficit and debt levels have reached levels that terrify even the politicians and so fiscal policy has been neutered, (iii) the financial system is so badly damaged from its period of excess up until 2007 that it is no position to start lending again despite heavy political pressure, (iv) consumers now feel that in aggregate they allowed their debt levels to rise too sharply and wish to lower them and (v) consumer confidence in their economic future has been so badly damaged that many do not wish to borrow anyway.

The only policy stimulus open to governments and Central Banks is further Quantitative Easing (“QE”) or money printing. So far all the extra money that has been created has remained in the financial system and not found its way into the real economy – this is not to say that QE has been useless; it has not.  Indeed the financial system and the Western economies would be in a far worse state today if there had been no QE.  In addition, the long-running Euro saga has meant that the Eurozone has had to adopt very restrictive fiscal policies in an attempt for the weaker governments to maintain support from the markets and from the stronger Euro members, making the Eurozone economy much weaker than it needed to have been.

So this time, the usual cycle of policy easing leading to consumer recovery and thus economic recovery together with improving equity markets is unlikely to occur.  It is true that equity markets are cheap by historical comparison, and this should limit the downside potential for equity markets in the absence of a severe recession which would damage earnings. However, equities lack the usual reasons for investors to buy them, and so upside potential is also limited until some shock or crisis leads to a radically different policy approach.

 

Pro-growth policies at a time of fiscal austerity

In both the UK and Europe, commentators have become increasingly vocal about the need to combine the necessary fiscal austerity with policies designed to boost economic growth. They are correct to stress that the easiest method to reduce budget deficits is for private sector growth to boost tax receipts – the problem is how to combine demand growth in the private sector with the necessary control of demand in the public sector and the options are very restricted. Every pound or euro of public spending that is reduced as part of an austerity package is a pound or euro less of somebody’s income – this is why the savage austerity imposed on Greece, Ireland and Portugal (equivalent to 3% or more of GDP in a single year for several years) has led to recession as huge swathes of final demand were removed from the economy and business and consumer confidence collapsed. The UK is aiming to reduce its budget deficit only by about 1% pa, similar in fact to the pace of deficit reduction it achieved in the early 80s, and so far has avoided the severe recession seen in other European countries that had to make much sharper retrenchments of their government spending.

Monetary policy is the obvious starting point for pro-growth policies when fiscal policy has to be tightened. However interest rates have effectively already been cut as far as is meaningful, and the UK’s Quantitative Easing and the ECB’s trillion euro LTROs have meant a great deal of money has already been created in both the UK and Europe. The danger with these policies is that it is similar to filling a balloon with water – the balloon expands as water is added with no impact on its surroundings, until no more water can be contained and then the balloon bursts and drenches everything around it – there is very little impact on the economy from printing the extra money until it reaches a critical point and the money pours into the real economy creating inflation.

The IMF’s standard pro-growth policy used in conjunction with fiscal austerity for countries in need of support has always been a (large) devaluation. This provides a kick-start to the private sector which boosts export demand for its products at a time when the domestic market is struggling. Sadly for those countries inside the Eurozone, they voluntarily gave up the possibility of using this policy when they joined the single currency.

Politicians on the right of the political spectrum argue that lower tax rates increase the incentives to make money, and that this leads to growth and thus higher total tax revenues – and they point to point to the 1980s as evidence of this. It is true that there is an (unknown) optimum tax rate that yields the most tax; in the 80s marginal tax rates were very high (and probably above the optimum rate) and their reduction did spark more growth and higher revenues. However today’s marginal tax rates are much lower than then (and likely to be near or possibly already below the optimum rate), and it is not clear that it would have a very significant effect on growth today.

Increasing the efficiency of the economy by reducing bureaucracy and regulation is another policy often claimed to improve growth prospects. Certainly these impose costs and constrain the ability of business people to do more business. Reducing these requirements will boost growth in the long term but not necessarily in the short term. And in today’s society some degree of regulation is considered desirable (eg in healthcare and financial services) in order to protect consumers, so there is a need to distinguish between “good” and “bad” regulation and bureaucracy.

Infrastructure spending is generally viewed as a pro-growth policy since it creates jobs in the short term and boosts economic efficiency in the longer term. The problem for fiscally constrained economies is that the returns to this investment are very long term and so make the short term budget deficit even worse. There is however one option for the UK that would help to boost growth in the short term and that would be for the government to build directly or else to subsidise building a large number of new homes. The UK suffers from a shortage of housing, resulting in high rents and high house prices. Houses can be built and sold on for a profit reasonably quickly, leaving a small positive effect on public finances, providing jobs for thousands of construction workers and by boosting supply will tend to reduce the high rents and house prices which consume so much of the UK’s income.

Is Quantitative Easing reaching its sell-by date?

Nearly 3 years ago the Federal Reserve and the Bank of England, having taken interest rates to  just about zero but still believing that they needed to make policy even easier, announced a new policy of Quantitative Easing (QE) as their preferred route to help their economies recover. Recovery did followed, although in keeping with previous post banking crisis environments, this recovery has been weak and inconsistent. This unconventional policy was pursued because the conventional interest rate tool had reached its physical limits and with fiscal debt and deficits so high, so too had fiscal stimulus as a policy. The unconventional policy, QE, was the only thing left.

There are good grounds now for believing that the QE approach adopted to date is also approaching sensible limits. In the UK, the Bank of England will shortly own over a third of all UK government bonds outstanding – amazing as it might appear with a  trillion pound national debt which has doubled in just 4 years, there is potentially a shortage of government bonds. This is due to new, post-crisis rules on capital adequacy for both banks and insurance companies which drive these institutions towards holding many more government bonds. With many gilts also held as the underpinning of pensioner annuity payments, a continued steady reduction in the budget deficit could mean that there are simply not enough gilts available to be bought if the Bank judged that much more QE was necessary

In the US the enormous market in mortgage bonds issued by what are effectively government entities makes this less of a problem than in the UK, but it was very noticeable that the second round of QE in the US in 2010/11 resulted in a surge in commodity prices, including gold, which pushed up inflation in the US, reduced disposable income and contributed to a weakening economy, as opposed to the economic stimulus that was intended.

So if further Quantitative Easing of monetary may now be either not implementable or counterproductive, then what can the Central Banks do if they decide that their economies require further stimulus. Both the Bank of Japan and Bernanke have previously suggested that a further tool that could be deployed is for the Central Bank to buy equities in the secondary market and so push up equity prices. Terrific for shares and all those executives with share options, but it is not clear that this then leads onto companies raising new equity finance in order to invest which is the rationale for such a policy.

The problem for all monetary policy approaches post a banking crisis is that there are two economies, a financial economy which requires reliquefication, recapitalisation and write-offs of bad assets and a real economy which cannot gain finance from the financial economy and produce growth until the financial economy is cleansed and functioning again. In economic jargon, the monetary transmission mechanism from financial sector to real economy is broken and so QE although in theory a logical policy, in practice only gets adopted when things are so bad that it will not work.

The aggressive Quantitative Easing solution, which Central Banks have not yet adopted is “helicopter money”. This is where the government prints new money and drops it out of helicopters (or via tax cuts and higher welfare payments) into the real economy. This is very likely to work in boosting the economy in the short term (people have more money in their pockets and so go out and spend some of it), but it will not be long before there is an inflation problem. This is clearly an economic policy beset with risk and the reason that Central Banks prefer to work through the financial system, even though it does not function well – in Zimbabwe this policy led ultimately to the printing of Z$100 trillion notes.

Quantitative Easing is near its sell-by date – something different will be tried next, and whatever that policy is, it will mean more government interference in the economy and more (long term) inflation. Stay long of gold!