Stalling UK economy turns to its weakened central bank

The Bank of England has adopted an aggressive monetary stance to offset the government's fiscal tightening. But with the economy still stagnant the governor is contemplating extra measures.

The UK’s economy, unlike its inspirational Olympic team, has recently been unable to match the performance of most other developed countries. In the past two years, after allowing for the under-recording of growth in the official data, real gross domestic product has been little better than flat at a time when a strong recovery would normally have been expected. So what has gone wrong and what should be done about it?

The first issue is whether the growth shortfall has been due mainly to demand-side or supply-side factors. Sir Mervyn King, governor of the Bank of England, has pointed to the demand side, arguing that the crisis in the eurozone and the rise in commodity prices have depressed private sector demand, while the reduction in public spending has actually occurred slightly faster than the coalition government originally planned in 2010.

Aggregate demand has been far weaker than I expected this year and that has been primarily responsible for the absence of growth. Essentially, an aggressively easy monetary stance has not been sufficient to offset the impact of fiscal tightening, and the twin external shocks from oil and the euro crisis.

However, it is also clear that the supply side of the economy has deteriorated in ways that are not yet understood. Further evidence of this emerged this week with the downward revisions to the Bank’s medium-term GDP growth forecasts, while inflation projections were left broadly unchanged. The private sector is employing more workers than would have been expected.

While this has allowed the unemployment rate to remain lower than feared, it also means that the long-term path for productivity – and therefore for GDP – may be lower than a simple extrapolation of pre-2008 trends would suggest. This pessimistic conclusion has now been reached both by the BoE and by the Office for Budget Responsibility. Of course, one implication is that the path to fiscal consolidation could be even longer and more arduous than the chancellor predicted in 2010.

Can anything now be done to shock the economy on to a stronger growth path? Weakness in demand and supply are becoming inextricably linked. The dysfunctional nature of the banking system means that intermediation between lenders and borrowers has broken down. The rise in unemployment, if allowed to persist, could become permanent.

Many economists are arguing that monetary policy is running out of options and that the one remaining hope is to delay the path for fiscal tightening. Recent research by Nitika Bagaria, Dawn Holland and John Van Reenen argues that accelerated fiscal tightening has reduced real GDP in 2012 by about 2 per cent, and added about 1.5 percentage points to unemployment, compared to a delayed fiscal retrenchment.

This may well be true, but it would also have increased the hard-to-measure risk of a fiscal crisis. In an economy with its own central bank, such as the UK, a serious fiscal crisis probably would not have occurred, but it might have and could still do so. Any direct boost to fiscal spending therefore needs to be automatically time limited and aimed at the supply side, such as temporary tax cuts for investment.

This argues for additional action by the central bank. Sir Mervyn strongly maintains that further rounds of plain vanilla quantitative easing will add to the money supply and support the economy. However, with government bond yields now generally well below 2 per cent, the effectiveness of this route is becoming more dubious. The next steps could involve unconventional forms of QE, central bank purchases of private assets such as corporate or securitised credit, or the establishment of a direct lending institution funded by the BoE (as suggested by outgoing Monetary Policy Committee member Adam Posen in a speech last year).

With downside risks to the economy so prevalent, the governor now seems to have an open mind to some of these less conventional forms of QE, as long as the credit risk for these operations is taken by the government, and not the BoE.

He is right about this. The lines between the fiscal balance sheet and the central bank balance sheet are becoming increasingly blurred as the crisis deepens, and that remains a perilous path to go down.

Gavyn Davies writer is co-founder of Fulcrum Asset Management and Prisma Capital Partners, and former chief economist at Goldman Sachs.

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