Confusion at the Bank of England

Alasdair Macleod – 25 September 2009
Last Thursday, the Daily Telegraph carried an article saying that the Bank of England had “summoned the City’s leading economists to an unprecedented meeting..…… the pound plunges amid growing confusion over its quantitative easing policy.”

It is enough to make one gasp. If the Bank of England can’t see it, what is the point of summoning economists? An economist is merely someone who doesn’t know what he is talking about, and makes you think it’s your fault. The mixed opinions of Keynesians and Monetarists will certainly leave the Bank no wiser and probably more confused. This article will answer the problem in language we can all understand.

The Bank through quantitative easing has issued about £175bn of raw money into the economy, by buying gilts both from existing holders and the government. It so happens that the budget deficit forecast for this financial year is £175bn. Ergo, the government has more or less funded its budget deficit by printing money. Now, Johnny Foreigner is no fool, and will have worked out what is going on, which explains why the pound is weak.

The Bank of England also cannot understand why a large portion of the money printed by quantitative easing has been redeposited by British banks on its own books; the rotters won’t lend it on to businesses.

There are two answers to this problem, one easy, and one the economists won’t understand. The easy answer is Lord Turner together with Alasdair Darling insists that banks should rebuild their balance sheets. You do not do this by lending your newly acquired cash. Furthermore, banks are still worried about all the toxic waste they own which they know may blow up on them sometime, so they are naturally cautious.

The second and more complex answer is that bank deposits are contracting. They are contracting because interest rates are rubbish, and people are paying off their mortgages and credit cards rather than being good little savers. A near-zero deposit interest rate is simply not attractive. However, if a bank sees its deposits contracting, it will simply stop lending. If the contraction of deposits is severe enough, banks will try to maintain some sort of balance in their affairs by reducing their loan book. This is actually what is happening at the moment. Those who think that banks simply take the view that lending is too risky only have part of the story.

Now here’s the bit beyond economists’ comprehension: if the Bank of England wants banks to lend, it will have to raise interest rates to attract depositors. But of course, if you do this, the impecunious, the businesses which should close because they are uneconomic, and others who rode the credit bubble will face reality in short order. No monetarist and no Keynesian will advocate this, they are not in the reality business. But the alternative is simple: keep interest rates at zero and the economy will stay on hold gradually sinking. All precedent is there: the 1930s and Japan.

And doubtless in six months time, more economists will be called in by the bank for their useless opinions.

The point they all miss is that deficit spending and monetary easing produces effects opposite to that intended. Government is financing its deficit through monetary inflation, which is a hidden tax on existing savings and on the medium of exchange. The transfer of money resources from the private sector to the public sector by whatever means is essentially a tax on production – a tax on the right production to subsidise the wrong production. Far from helping production and therefore the economy, deficit spending by governments makes things worse. Before Keynesianism and monetarism, we had no theory – only sound money – and no recession or slump lasted more than two years. The Keynesian fallacy about government intervention is plainly wrong, as is the monetarist view.

The monetarists in times of trouble always have one answer: print. They seek to do this by lowering interest rates to encourage borrowing, and if that doesn’t work, they print raw money and give it a fancy name like quantitative easing.

However, there are precedents for doing the opposite and raising interest rates in the middle of a recession. Such an act is in essence a return to sound money, since it prices the medium of exchange properly, and it supports the currency. The effect is to make savings available for the private sector to regenerate itself. This is what happened in America in 1921, when the Fed jacked rates up to 6%, and it is essentially what happened in Britain in 1821, when the money in circulation was reduced to restore the pre-Napoleonic War gold standard. In the former case, America embarked on a remarkable recovery and improvement in living standards fuelled by technological innovation. In the latter case, Britain commenced the economic expansion which lasted until the Great War ninety years later and made her the most powerful nation on earth. In both cases, rates were raised in the middle of a post-war slump, and both those slumps were very short.

But, unfortunately the Bank of England consults idiot economists who have no original thoughts, and have been taught all the wrong things. Like zombies, they are all dead from the neck up.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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