Three levers pulled. Will they work?
So today the Bank of England starts using the money it has effectively printed to start buying up government debt. Will it work? In actual fact quantitative easing has already begun to work: the interest rate on a ten year IOU from the government (known as a "10-year gilt") has fallen to 2.95% - the lowest it's been for 40 years. It was just above 4% a couple of weeks ago.
When it was first tried out in America, on the advice of JM Keynes, QE worked within a month, and that was when buyers and sellers of government debt had to physically collect the paperwork. Gilt yields (aka interest rates) fell; the stock market bottomed. So if today's action continues to depress yields this is one of the first, tangible, positive signs that government policy is working.
The theory is that by driving interest rates on government debt down, this will drag down the cost of borrowing for companies - which at the risky end of the market has rocketed to 31%. But here's where the uncertainty creeps in.
Today, for example, Wrekin Construction - a business with £50m of orders reportedly on its books - went into administration. It told the press that RBS had refused to extend an overdraft: it needed £3m. Now 600 civil engineering and railway construction jobs are at risk - and we're supposed to be in the middle of a government-driven civil engineering boom.
This raises obvious questions about another part of the government's rescue policy, namely the bank bailouts: we'll come to that in a minute. But for now consider the risk events like this pose to the policy of QE. Construction firms can default on their debts: governments rarely do. So the risk of default has to be factored into the price of company borrowing. The danger is, as the economy worsens, this high risk of default keeps the cost of company borrowing high while the government's interest rates come down. This will defeat the purpose of quantitative easing.
For it to work it has to be joined up with other policies. Yet the central policy - the bank bailout plan - has a major question mark over it. It is one thing to expose the taxpayer to £625bn of potential bad debt. But to refuse at the same time to seize control of the banks is seen by many in the finance sector as inconsistent. It is not a question of nationalisation or otherwise: there is an obvious touchiness among Labour politicians about being seen to nationalise the banks. It is a question of control.
Publicly listed companies are run by managers for the benefit of shareholders. If shareholders dont like what managers are doing they get rid of them. Thus, in theory, the shareholders "control" the bank. As we know they did this badly, losing most of their own money in the process. If the government is the major shareholder - with 90% of RBS and 65% of HBOS - why does it not begin to exert control? The private sector shareholders exercised this function badly and now, reduced to a rump, are in no position to do so properly at all.
The government's opposition to nationalisation is always stated thus: "We have no desire to control a major bank; that's best done by the private sector". And the remit of UK Financial Investments, which holds the taxpayer shares, has been written to make this clear: they are to act purely as a commercial shareholder, one suspects - reading between the lines - the type of shareholder who turns up to the AGM, asks a few questions, and goes away for another year.
However real shareholding institutions exercise close and continuous supervision over major listed companies: their analysts are in and out of the finance department; they are actively engaged with the board. It is a legitimate question: if the major shareholder is not doing this, who is?
And here's why it matters. The government could have ordered RBS to bail out Wrekin Construction. It could even have bought some of Wrekin's debt on its own account, bypassing the banks completely, using the Bank of England's new powers. Quite simply, leaving all the ideological considerations aside, there is the danger that the refusal to actively manage the state-owned banks - relying instead on "agreements" to boost total lending in general and on normal commercial terms - starts to undermine the impact of quantitative easing.
If banks don't start pro-actively pumping money into companies that, on normal commerical terms, would not get the money, then the whole point of QE is lost.
One city bond trader last week suggested to me that the government could simply take operational control of the "fixed income" (ie bond) departments inside RBS and Lloyds and place, say, £50bn of the newly printed money at their disposal. He, like many in the City, was totally unsentimental about nationalising the banks. If you are stunned by that, don't be: high finance in a crisis is a game without a playbook. Only highly creative and audacious moves, which prompt people to say "I didn't know you could do that!" have a chance of putting things right.
And we are not talking here about some arcane side issue: Quantitative Easing and the nationalisation of bad banking debt are the last throw of the dice. They're both designed to pump spending power into the economy. They have to work - because the global economy is declining much faster and much further than anyone expected.
Two days ago IMF boss Dominique Strauss-Kahn labelled this the "Great Recession": the worst of our lifetimes. The IMF predicts world GDP growth will now shink to zero. In January the Fund's economists ran an modelling exercise showing Japan at high risk of deflation, closely followed by the USA, Taiwan, most of Europe and most of South East Asia at medium risk. Veteran UBS economist George Magnus warns that we are on the cusp of a deflationary spiral and even a depression, and that "even unorthodox monetary and fiscal policies" may not be enough to save us given the deep structural indebtedness of households, and the essentially bust situation of the banks.
This brings us to the third lever: fiscal stimulus. You will hear a lot in the run up to the G20 about "co-ordinated fiscal stimulus". Fiscal stimulus means cutting taxes or spending more taxpayers money to stimulate the economy. In Britain we've had one fiscal stimulus, in the form of the £12bn VAT cut, with a few billion more of public projects brought forward. The IMF poo-poohed this at the time but some close to government believe, though small, it is working: that we've had £12bn worth of bang for our bucks, pro-rata.
The point in the UK however is that there is very little room for a further fiscal stimulus. The government had to breach its own 40% ceiling, taking predicted debt towards 60% of GDP without factoring in what happens if much of that £600bn we have absorbed from RBS and Lloyds/HBOS goes bad. To launch a further fiscal stimulus in next month's budget would mean increasing the structural debt of the British government to unimagined levels.
There are two alternatives: one, as outlined by David Blanchflower of the MPC would involve injecting a further £90bn, Obama style, to create about 750,000 jobs. This would dwarf the fiscal stimulus of November and necessitate a rapid rewrite of the debt projections. Given this would saddle the next government - nay the next generation - with a massive tax burden, ripping up the present pattern of public spending for several decades, I cannot see how it can be done without either a) bipartisan support b) an early election.
The second alternative is to renounce fiscal stimulus and soldier on with the bank bailout plus quantitative easing. Until we hear otherwise we have to assume that's the default option. Which makes it vital that the policies - once opted for - are executed boldly, assertively and decisively. Hit the comments button as always.