Have we dodged the bullet in the UK?
At one stage towards the end of 2008 prospects looked particularly bleak for the UK. Its prior growth and prosperity had relied, more heavily than in most other countries, on housing and financial services. But these were the two sectors most at risk from the crisis. Tax receipts, partly as a result, were dropping rapidly; and even with a relatively small, (and not well designed (VAT)), fiscal stimulus, the fiscal position was deteriorating rapidly down the tubes. Meanwhile a Scottish-led financial disaster (BOS and RBS) was leading British banks to delever and to cut back on new lending to the private sector, more so than elsewhere. So, unemployment would rise faster, house prices and bank lending fall further, and the economy and the fiscal position deteriorate more and quicker here than elsewhere.
It has not been as bad as that, even though it has been a painful year. The labour market has been stronger than expected; housing prices have stabilised; deflation has been averted, and the economy will soon be starting a slow recovery. The reason, for better than expected results, is that monetary policy, in the guise of Quantitative Easing (QE), has been brilliantly executed. In particular the public sector deficit has been largely monetised, with the vastly increased borrowing requirement almost exactly matched by the scale of QE, thereby offsetting banks’ delevering and putting no pressure on the gilts market. Although the resultant increase in liquidity, and surge in banks’ cash reserves, has not prevented the banks from continuing to run down their books, it has encouraged both the recovery in prices in capital markets, with strong surges in equity and bond prices, and the depreciation of sterling on the foreign exchange markets.
Overall the recovery in confidence, and the resurgence in asset markets, since the dark days of March 2009, (also the starting date for QE), has been little short of miraculous. But enough is as good as a feast, and/or you can have too much of a good thing. Neither the UK, nor the world, needs another asset price bubble, nor a continued slide in sterling. The UK has regained competitiveness; what is needed now is stability.
But if QE is set to pause this coming spring, what about the subsequent flood of new issues on the gilts market? Here there is another serendipitous development, the need to restore UK banks’ liquid assets. One reason why the collapse in wholesale financial markets caused such mayhem in 2007/8 was that banks had allowed their own, on balance sheet, liquid assets to fall to almost nothing, so, when push came to shove, they had nothing to sell off but illiquid (Mortgage Backed Securities) assets. This trend, which the regulators should never have allowed in the first place, is now being belatedly reversed.
Meanwhile the commercial banks have built up huge unused reserves at the Bank of England. It hardly takes a genius to recognise that there are three requirements that can be brought together and simultaneously realised:-
- Fund the public sector deficit in 2010/11;
- Return the Bank of England’s swollen balance sheet to normality;
- Rebuild the liquid assets ratio of UK banks.
And that all these can be done without placing severe deflationary or inflationary pressures on the economy.
There is just one more essential ingredient to dodging the bullet. This is that, immediately after the next General Election, whoever wins, a rapid and credible plan is put into place to restore the fiscal position of the UK to a sustainable level. If this can be done, then the UK may succeed in transforming itself from one of the worst positioned economies to one of the best within a couple of years. If it should happen, it should be acclaimed as a triumph of, largely monetary, policy in navigating through extremely adverse conditions.