The Bank of England’s latest announcement of quantitative easing, widely referred to as QE2, prompts as many questions as it does answers — particularly for investors and pension-holders. Under a QE regime, money printed out of thin air is used to purchase government bonds from banks and other private sector investors. The theory then has it that long-term interest rates will fall, and banks will have more money to lend to eager borrowers.
There’s just one problem with this cunning plan: it doesn’t work. It did not work in Japan, the first country to flirt with QE. Richard Koo, chief economist of the Nomura Research Institute, calls QE ‘the 21st century’s greatest monetary non-event’. The reason for his scepticism is that we are not in a normal business-cycle recession, in which the central bank reacts to a disorderly economic boom by hiking interest rates to suppress inflation. Businesses retrench, and as inflationary pressure subsides, interest rates are gradually reduced. Instead, we are in what Koo calls a ‘balance-sheet recession’: amid the economic uncertainty of the continuing financial crisis, businesses and households are more keen to pay down debt than to take on more, so it doesn’t really matter how low you make interest rates, because people aren’t really interested in borrowing.
The reason for reintroducing QE is that the Bank of England, like other central banks, is desperate to create economic stimulus, and to support ailing private-sector banks. Policy rates (i.e. the Bank’s base rate, which has been at 0.5 per cent since March 2009) cannot realistically go any lower, so QE is pretty much the last bullet in the monetary arsenal.
But in Koo’s words, QE with interest rates at zero is like a shopkeeper who cannot sell his store of 100 apples at 100 yen each, so he tries stocking his shelves with 1,000 apples, and when that has no effect, adds another thousand. ‘As long as the price remains the same, there is no reason consumer behaviour should change… This is essentially the story of quantitative easing, which not only failed to bring about economic recovery, but also failed to stop [Japanese] asset prices from falling.’
What else, if anything, could the Bank of England do? To some of us, it should simply get out of the way and allow the free market to act. There is a plausible economic argument in favour of laissez-faire — well made by the writer Murray Rothbard in his 1963 study, ‘America’s Great Depression’. In his view, the more government tries to intervene to delay the free market’s adjustment to the accumulated ‘malinvestments’ of a credit boom, the longer and more gruelling the depression. Unfortunately, government depression policy ‘has always aggravated the very evils it has loudly tried to cure’.
If you wanted to perpetuate a depression, suggests Rothbard, the very best way to do it would be to enact the policies the government is pursuing today: prevent widespread liquidation of financial assets by lending money to shaky businesses; deploy as much QE as you can, to ensure that bad banks remain in business like malodorous zombies; inflate further, which prevents a necessary fall in prices; keep wage rates up (thus ensuring permanent mass unemployment); keep prices up (which will create unsaleable surpluses); stimulate consumption and discourage saving — not least, by driving interest rates close to zero.
The Japan that gave the world QE also gave us another alien acronym: Zirp, or zero interest rate policy. This policy is now wreaking havoc on the assets of savers, especially pensioners on fixed incomes. With interest rates near zero, savers are forced either to eat into their own capital or to take risks they might prefer to avoid, namely jumping into the stock market during a period of acute volatility. The artificially low yields on offer from heavily manipulated government bonds are also destroying the value of pension funds, which are normally heavily invested in government debt. Rapidly falling gilt yields have, in turn, slashed the annuity rates on which they are based — the accountants PricewaterhouseCoopers suggest that a toxic combination of falling annuity rates and plunging stock markets has savaged the value of today’s private pensions by 30 per cent versus the pensions of those who retired just three years ago.
So what is a saver or investor to do? In the first instance, we should face facts. QE, as a fancy way of printing money, is inherently inflationary. That inflationary pressure may not be visible today (although the retail prices index already sits above the yield available from any British government bond), but give it time. Investors will probably be well served by diversifying into real assets that offer some form of inflation hedge: classic cars, top-end property, jewellery, fine wine, art. If our political and economic leaders eventually rediscover their senses, we may be lucky enough to avoid hyperinflation. If not, those who best navigated the infamous Weimar era hyperinflation put their assets into harder currencies, land, and gold.
Gold is probably the best refuge against the inflationist scoundrels that pass for our economic savants, in that it is the one currency that cannot be printed on a whim in the name of political expediency. Safe havens and higher-income assets are all difficult to find now, but for those who can stomach the price volatility, classic defensive equity investments such as utilities, pharmaceuticals, consumer staples and tobacco stocks all have their place in a balanced portfolio. There is probably an argument, too, in favour of borrowing at current market rates — for as long a fixed term as you can get — because we may not see their like again. We are stuck in an extraordinary and unprecedented financial landscape. Citigroup anticipate another two to three years of QE, along with the ultra-low interest rates the policy implies. But low rates will not be with us forever; future market crises are almost certain.
The great Austrian School economist Ludwig von Mises warned that there was no escape from an economic bust fuelled by a credit bubble. The only question was whether the crisis ended sooner as a result of the voluntary abandonment of further credit expansion, or later, in the form of a complete collapse of the currency system. Given that the Bank of England has voted to keep the credit bubble inflated, investors would be wise to start edging toward the exits.
Tim Price is Director of Investment at PFP Wealth Management.
This article first appeared in the print edition of The Spectator magazine, dated October 15, 2011