Next: QE2 - and if that doesn't work it's a currency war
On both sides of the Atlantic we are now looking at what economists are calling QE2 - a second bout of "quantitative easing" in which the central bank prints money to sustain demand in the economy, which is faltering.
In the UK, the Bank of England's MPC minutes show the majority as minded to have a go at this sooner rather than later; here in the USA (I'm in Atlanta, GA) the Federal Reserve have already spelled out both the possibility and the limitations of a further bout of QE. It's worth revisiting the latter: first, Fed Chairman Bernanke warned, we don't know how to calibrate the effects of the existing QE; second there is a risk that the markets lose condidence in the central bank's ability to exit from QE. Bernanke concluded that further QE might not have much impact because the best time to use it is when everybody in the market is panicking.
The problem with QE as enacted in the UK is that much of the money printed has been taken by the banks and deposited back at the Bank of England. It has not flowed into circulation.
It's worth bearing in mind that when the central banks started to consider QE, nobody knew how to do it. Indeed, many of the economists inside the Bank of England warned their bosses it could not work, according to the accepted theories. On both sides of the Atlantic the bankers took a leap of faith and did it - but the fact they now have to consider doing more means either the policy did not work, or that other policies designed to back it up have failed.
QE purists, those who've studied Keynes in the 1930s and Japan in the early 2000s, always said it should be done as follows: you announce that interest rates will be zero for a fixed period (thereby abandoning inflation targeting); next you announce a target yield for 10 year government bonds (say 2%) - creating market knowledge that you will now intervene continually to achieve that target by printing money; next you take micro-economic powers to force the money through the banking system and into circulation.
Neither the Fed nor the BoE did this - though Bernanke is now considering both lifting the inflation target and announcing a long-term cap on interest rates.
The problem is that some 12% of GDP has been pumped into the economy but we're not sure how much that has translated into demand. If we are now looking at QE2, you would have to ask whether the stated aim - getting the banks to lend instead of hoarding money - could not have been achieved by some more hands on measure.
One option would be to accept the long-term state ownership of RBS and HBOS and to place their loan books in the hands of a state-directed investment commission (this was discussed but rejected under Alistair Darling in favour of a hands off approach to the nationalised banks). In the last Labour and first Coalition budget, both banks were set net lending targets - but this also happened in 2009 and they failed miserably to meet the targets.
Ultimately what policymakers are wrestling with is the fact that the economy is not responding to stimulus, and that's because both the UK and US economies are configured for consumer-driven growth. The Coalition has stated the aim to transform the UK economy so that private investment and exports fuel growth but that's a long-term and uphill task. The US policy debate on this remains at the position of rhetoric: the USA already has a good export and manufacturing base, but it is consumer demand that is ailing.
Both economies have one unstated monetary tool that will now come into focus: devaluation. Mervyn King is said by those who were on the inside to be privately proud of the fact he "talked down the pound" in 2008. The USA is gnashing its teeth about Japan's devaluation efforts and China's currency manipulation. (China's currency policy means the USA cannot devalue against its main trading partner). Meanwhile in Europe it's likely that the net impact of all the austerity measures will be cancelled out by the depreciation of the Euro. (UPDATE: See the FT, five hours after this post, for the basics)
The former boss of Intel, Andy Grove, called in July for a US trade war with China:
"If what I'm suggesting sounds protectionist, so be it. ... If the result is a trade war, treat it like other wars--fight to win."
I've heard this quoted approvingly by left-wing Democrat steel trade union men - and by people in the Teaparty movement. It's provoked outrage among the orthodox pro-globalisation lobby but it was Bernanke after all who educated us that, in the 1930s, it was countries who devalued first that recovered first.