QE inside out

Twitter can often be something of an intellectual cesspool in which people continue to shout across the cultural divide without ever hearing the views of the other side. It can, however, be a source of great enlightenment and I was very taken by a post (here) by Alfonso Peccatiello explaining why QE can never be inflationary. Having thought about it, there are many elements of this Twitter thread which are wrong. Nonetheless, it served a very useful purpose in forcing me to assess the nature of money and for that it is to be commended.

Inside versus outside money

At issue is the nature of “inside” versus “outside” money. Peccatiello argues that “inside money never reaches the real economy. Outside money does” and to the extent that he characterises QE as inside money, it cannot therefore impact on inflation. I suspect there is some confusion about definitions here and in order to get a better handle on this, we need to understand the concepts under discussion. The notion of inside versus outside money was introduced into economics by the seminal work of John Gurley and Edward Shaw, Money in a Theory of Finance, published in 1960. It was a very innovative work for its time and looked at the interaction between the real economy and monetary growth. As they put it, “real or “goods” aspects of development have been the center of attention in economic literature to the comparative neglect of financial aspects.”

Gurley and Shaw (G&S) define inside money as originating from within the private sector. Since one private agent’s liability is simultaneously another agent’s asset, inside money is in zero net supply within the private sector. Thus, funds held in bank accounts would be classed as inside money because they are an asset of private firms or households but a liability of private sector banks. Conversely, outside money derives from outside the private sector and is either fiat (unbacked) or backed by some asset that is not in zero net supply within the private sector. An increase in the stock of currency by the central bank would be classified as outside money, because although it is an asset of the private sector it is a liability of the public central bank.

The vexed question of money neutrality

Since outside and inside money represent different types of liquidity, they have differing effects on the wider economy. One implication of this is that the money stock is not homogenous – money is not just money as it is comprised of these two differing types. This calls into question the notion that money is neutral (i.e. it does not impact on real quantities in the long run and serves only to impact on prices). In light of the debate regarding the impact of liquidity creation by central banks and the recent surge in inflation, this may help us to shed some light on the monetary transmission process and the role of QE within it.

Without boring the reader with the details of the process, G&S demonstrate that in their general equilibrium framework inside money is neutral but outside money is not (the interested reader is referred here). How do we categorise QE?  In the sense that the central bank creates reserves to buy assets from the private sector (in this case, the non-bank private sector) but uses them to buy government bonds, they are merely swapping one type of outside money for another (cash for bonds). Consequently, the inside-outside composition of private sector assets remains unchanged. I thus agree with Peccatiello that QE can be categorised as inside money. If we accept the proposition of money neutrality, this implies that QE is unlikely to have any long-term impact on real activity. But this does not mean that it has no impact on prices. Indeed, classical monetary theory argues that if it does anything, QE will impact on price inflation.

Moreover, monetary neutrality relies on the absence of frictions but, as the work of Karl Brunner and Allan Meltzer has demonstrated, such frictions do exist and thereby allow monetary policy to have an impact on the real economy – perhaps only for a limited period of time. QE may not have had the impact on the economy that central banks hoped but there is in theory scope for it to boost activity. Analysis conducted by the BoE in 2011 suggested that the initial round of asset purchases boosted UK GDP by 1.5% to 2% compared to what would have happened in its absence.

Should central banks continue with asset purchases?

If we therefore accept that asset purchases do impact on inflation and prices, does it make sense for central banks to continue the programme, particularly in view of the surge in US inflation to 5.4% last month – the fastest rate since 2008? The short answer would appear to be no. Whilst it is true that the prices of used cars contributed a third of the monthly rise in the CPI in June, which is likely to be a temporary phenomenon, there is evidence that prices are rising rapidly across the board. Accordingly the Fed is widely expected to taper its asset purchases before too long with suggestions that the Fed will broach the subject at next month’s Jackson Hole symposium. Investors will recall the 2013 experience when the prospect of a slowdown in Fed asset purchases prompted the infamous taper tantrum which resulted in a spike in bond yields. However, with financial asset prices at red hot levels, taking some air out of the market may actually not be such a bad thing.

Last word

Whilst there is general agreement that QE has been the primary driver of asset prices in recent years, there remains much debate about its impact on the wider economy. Whilst I have never been persuaded of some of the claims made for it by policymakers, I have never accepted that it has zero impact. Even if the effects are small, such has been the magnitude of asset purchases that even small spillovers will show up in GDP and inflation data. This 2016 paper by Martin Weale and Tomasz Wieladek offers evidence that in contrast to the claim made by Peccatiello, “US (UK) QE had a similar (much larger) effect on inflation and (than) GDP.” If asset purchases have helped the economy to avoid a slow post-pandemic recovery, they have done their job. But having done their job, it may now be time to think about scaling back.

Open season

The announcement that the UK government intends to scrap almost all Covid-related restrictions in England on 19 July has led to significant concerns that it is yet again taking a risk with the pandemic that is not justified by the evidence. Covid cases are rising rapidly with latest figures showing a rise of 49% on a week ago (+383% over the last four weeks). Boris Johnson admitted in his speech to the nation that numbers could double to 50,000 per day by the time “Freedom Day” arrives. New health secretary Sajid Javid suggested in a radio interview that they could even rise to 100,000 per day. For the record, the previous record high was 68,053 on 8 January. For those who recall Boris Johnson’s promise that “data not dates” would determine the government’s policy actions, the latest announcement has raised more than a few eyebrows.

Is this a just policy?

There is no support for this strategy from the medical profession with the BMA calling for the continued use of face masks, arguing that even if the vaccination strategy has lowered mortality risks, the risk of infection has not disappeared which could have significant health impacts due to complications resulting from long Covid. However, the move appears to be a political response to the vocal and ill-informed anti-mask movement which somehow sees masks as an infringement on personal liberty. Indeed, this TV interview with a backbench Conservative MP spoke volumes when she called the wearing of masks on public transport “an infringement of civil liberties.” Ironically this concern for civil liberties was invoked on the day that parliament debated a policing bill which even many Conservative MPs find draconian. More seriously, as members of the medical profession pointed out, the wearing of masks gives people freedom to do things more safely that they may not otherwise be able to – such as travelling on public transport or visiting a restaurant.

One of the issues thrown up by this debate is the trade-off between personal and social responsibility. Anti-maskers argue that they should be allowed to exercise their own judgement as to when to wear them. Pro-maskers argue that since masks generate a positive externality by protecting others as much (if not more so) than the wearer, their use generates a wider social benefit. Welfare economics has attempted to build on the idea of Rawlsian justice as a way of assessing social choices, in which we have to balance the greatest possible amount of liberty being given to each member of society subject to the constraint that liberty of any one member does not adversely affect any other member.

To the extent that a person not wearing a mask impinges on the rights of those who wish to take precautions against Covid, the economist (not to mention the Rawlsian philosopher) would argue that simply doing away with masks flies in the face of social justice. After all, a public space belongs to everyone – not simply the group that makes the most noise. For the record, after Israel last month eliminated the requirement to wear a mask, 10 days later it was forced to backtrack.

Is there a herd immunity argument in favour of opening up now?

The proportion required to be vaccinated in order to achieve herd immunity differs according to the disease – for measles it is 95%, for polio 80%. Previous estimates suggest that such immunity for Covid would require between 60% and 70% of the population to be vaccinated (some estimates put the proportion even higher). For the UK alone, we are in the window, with around two-thirds of the adult population now having received two doses of the vaccine (though that figure drops to around 50% once we allow for children, who are not scheduled to receive the vaccine). But on a global basis we are nowhere near this. According to the respected website Our World in Data, only 24.4% of the world’s population has received one dose of the vaccine. So long as country borders remain open – even if only partially – the risk of cross-border transmission remains high.

A recent article in Nature suggested that herd immunity to Covid is now unlikely to be achieved and the epidemiology community is “moving away from the idea that we’ll hit the herd-immunity threshold and then the pandemic will go away for good.” As new variants emerge – much like the delta variant – and immunity begins to wane, the likelihood is that Covid will become an endemic disease in much the same way as flu. In this sense, at least, the UK government’s argument that we will have to live with Covid is consistent with scientific thinking. However, this is not an argument for ending all restrictions.

On the plus side, although cases are rising sharply, hospital admission and mortality rates have not. This provides strong support for the government’s argument that the vaccine programme has helped break the mortality link. Whether or not this remains the case cannot easily be predicted. The UK population is only partially vaccinated and virologists fear that ending restrictions in such an environment will create a breeding ground for new Covid variants. Even if the worst case does not arise, the medical evidence is clear: Avoid unnecessary exposure to Covid.

A recipe for economic chaos

It is perfectly understandable that parts of the hospitality industry want to get back to business as usual. But the wider economic costs of opening up are potentially significant. The government plans to scrap the working from home guidance and it will be up to employers to find an agreement with staff as to how the transition back to the workplace will be managed. However, the self-isolation rules requiring people to quarantine for 10 days in the event they come into contact with Covid will only be lifted on 16 August. On the basis that two people are forced to isolate for every recorded case, 100,000 cases per day as per Sajid Javid’s suggestion, would result in 1.4 million people having to self-isolate in the second half of July and first half of August.

Even if the number of cases is “only” 50,000 per day, it still implies that 2% of those in employment will be affected which will have significant implications for businesses. It is likely that many employers will continue to allow their employees to work from home but there are many jobs where this is simply impossible (e.g. retail). There will thus be some very heated conversations between employers and employees about the appropriate time to return to work.

Last word

In some respects the government’s insistence on setting a date to end restrictions is reminiscent of the approach to the Brexit deadline: Announce the date; implement the policy and deal with the fallout later. But given the government’s past approach to Covid which has seen it criticised for being too slow in applying lockdowns and closing borders, not to mention the policy towards old-age care homes, it is reasonable that people are concerned about the consequences of opening up at a time of rising Covid cases. The government knows that it cannot afford to get this policy wrong. Many people’s lives literally depend on it.

Telling it like it is

Andy Haldane, the Bank of England’s outgoing chief economist, is an eclectic thinker on matters of economic policy and his valedictory speech on his last day in the role was a tour de force of the issues facing central banks today. In recent months, Haldane has warned that inflationary pressures are building and in each of the last two MPC meetings he has voted to reduce the BoE’s asset purchase limit from the planned £895 billion to £845 billion (though I sometimes wonder whether an impending departure allows policymakers to throw off the shackles and vote against the consensus). Whilst this is not a huge change in the grand scheme of things it is a signal of intent and in his speech Haldane explained the reasoning behind his thinking.

In Haldane’s view the current conjuncture is rather different to that which prevailed in the wake of the GFC when the recovery was a rather slow and protracted affair. This supported the slow withdrawal of the post-2008 stimulus but with the economy apparently set to grow very strongly in 2021 “this time that policy script feels stretched.” The danger is that large and rapid balance sheet expansions (chart) but limited and slow withdrawals “puts a ratchet into central bank balance sheets” which raises concerns of fiscal dominance – the extent to which monetary policy becomes subservient to the needs of the fiscal authorities to manage deficits and debt rather than the primary goal of fighting inflation. Economists agree that large volumes of asset purchases do increase the risk of fiscal dominance but are less in agreement that recent actions will lead to such an outcome. There have been suggestions, particularly in Germany, that the ECB’s policies in recent years have been designed to support the heavily-indebted euro zone economies although we will only know if fiscal dominance has taken root if the ECB fails to act in the face of any inflation pressure. But as Haldane put it, “this is the most dangerous moment inflation-targeting has so far faced.”

He also pointed out that “a dependency culture around cheap money has emerged over the past decade.” I have a lot of sympathy with this view and argued strongly that central banks should have been quicker off the mark from 2013 onwards to withdraw some of the monetary stimulus put in place after the GFC. This is not to say that policy should have turned restrictive but it perhaps should have been less expansionary. After all, as I have consistently pointed out, the economy in 2012/13 may not have been in great shape but it was in far better condition than in 2008/09. The actions of central banks in the five years after the GFC were akin to performing life-saving surgery on a patient long after they had left the operating theatre and were resting on the ward.

As with all procedures there are side effects and one of those associated with lax monetary policy is extremely high asset values, both financial (equities) and real (housing). If investors do not expect central banks to take some air out of the balloon, they will continue inflating prices. This is more than just a financial market problem – there are social implications as well. For example, many young people who were leaving school in 2008 will now be thinking of starting families but find themselves priced out of the housing market. Moreover, rising asset values are fine for those sitting on a portfolio of stocks but serves to enhance the wealth disparity versus those who do not. And as I have been pointing out for some time, low interest rates penalise savers – particularly those nearing retirement. Expansionary monetary policy is undoubtedly the right policy in the right conditions but I am with Andy Haldane in hoping that central banks do not wait too long before cutting back on some of the support they are currently providing.

Haldane’s speech stood in contrast to the BoE Governor’s annual Mansion House Speech, given a day later, which was a rather more conservative take on the state of the economy. That said Andrew Bailey did highlight the upside risks to inflation, and I agree with him that they are likely “to be a temporary feature of the bounce-back.” Bailey’s speech carried the usual warning from policymakers that the central bank is prepared to tighten monetary policy if required to stave off an inflation threat but that this does not form part of the current baseline. Whilst inflation has not proven to be a problem in the wake of the GFC, so that this threat has never been put to the test, there may come a point where the BoE may have to follow up on its threat to take away the punchbowl.

There are some former BoE policymakers (notably Danny Blanchflower) who are completely opposed to the idea of raising interest rates any time soon, and who give no credence to the Haldane view of the world. But this is to assume that the conditions prevailing today are similar to those more than a decade ago. But this is not the case: As Bailey pointed out in his speech the degree of economic scarring following the recent output collapse has been far smaller than expected. Moreover, governments are adopting a much more active fiscal policy approach today, in contrast to a decade ago when monetary policy had to do all the heavy lifting.

A final argument as to why the zero (or negative) interest rate policy should have a limited shelf life is derived from the Japanese experience where more than 20 years of expansionary policy have done little to get the economy back on the path which the government desires. There is a general belief that monetary policy is neutral in the long-run i.e. it may impact on nominal quantities but does little to influence real growth rates or productivity. This has been borne out by the Japanese experience which demonstrates that monetary policy does nothing to impact on the supply side of the economy. This is hardly surprising: Monetary policy cannot boost the capital stock or improve education and training standards, implying that other policy prescriptions are required. The UK’s dire productivity performance over the past decade makes it clear just how much these alternatives are sorely needed.

As Andy Haldane goes off to face new challenges as Chief Executive of the Royal Society of Arts he will leave a gap at the BoE which will not easily be filled. He has not met with universal acclaim from within the economics profession but I have always found his willingness to cross-pollinate economic ideas with those from other disciplines has resulted in some illuminating insights. He will leave big shoes to fill.

Five years on

Five years ago today the world awoke to find that the British electorate had narrowly voted in favour of leaving the EU. The pre-2016 era feels like another world: in many ways it was, not least because Covid has had an even more transformative effect on the political and economic landscape. Looking back, the impact of the Brexit shock remains vivid and neither Leavers nor Remainers have since covered themselves in glory. Regular readers will know I regret the decision to leave the EU, largely on economic grounds but also because the UK is no longer part of a block which amplifies its voice on the world stage. However, it makes little sense to replay the debates of the past five years.

A quick retrospective

Nonetheless, this week marks a good time to assess the impact of Brexit, giving rise to a number of retrospectives in the British press. One of the best commentaries I have seen is this one by always excellent Fintan O’Toole, who points out that the Remainers never had a big idea which could overpower the simple narrative of taking back control espoused by the Leavers. As he put it, “Leave offered some kind of an answer [to the question of what defined British identity] – albeit a very bad one. Remain barely recognised the question.” He also argues that the project was not subsequently weakened by the “political discourse [which] ought to have doomed it … [because] uncertainty about what Brexit would mean in reality allowed it to sustain its character as a gesture.”

As a summary of what has happened over the last five years that just about nails it. As an economist, my mistake was to try and offer economic arguments against Brexit – not that they are wrong, but the simple but powerful notion of “controlling our own laws and our own borders” was a much more compelling vision. The fact that this was and is complete tosh is irrelevant – it is difficult to argue against a messianic vision with mere facts. The bigger concern is not so much the losing of the referendum but the way the process of departure was subsequently conducted, as the government tied itself in knots to reconcile many of the irreconcilable arguments made during the campaign.

A consultative (non-binding) referendum was treated as a winner-takes-all event with little attempt to engage with the near-half of voters which opposed the outcome. Three years of intense political debate eroded trust in the political process and far from lancing the boil of Euroscepticism which David Cameron feared would swamp his Conservative Party, the divisions opened up by the referendum have if anything grown deeper. This in turn has weakened the ties that bind the United Kingdom and given support to Eurosceptic movements in continental Europe. As the historian Timothy Garton Ash has pointed out, we find ourselves in a lose-lose position and it appears that the culture war which has largely been confined to the US for the last 25 years has now washed up on European shores.

A look at the economics

From an economic perspective there are no good arguments in favour of Brexit. Imposing barriers to trade with our biggest trading partner has no merit. The government has been telling us since 2016 that the UK will be able to strike better trade deals with third countries than those drawn up by the EU. There is little evidence so far that this is bearing fruit. Most of the agreements that have been struck so far represent a rolling over of existing EU trade arrangements. The first trade agreement to be drawn up from scratch was the recently-announced deal with Australia. However the government’s own figures suggest that this will increase UK GDP by just 0.02% over the next 15 years which is, to all intents and purposes, zero. On the basis that “the additional trade barriers associated with leaving the EU” will subtract around 4% from UK GDP over that period, Britain needs 200 Australia-type trade agreements merely to offset what has already been lost. To the extent that distance is one of the biggest obstacles to goods trade, the Australia trade deal is a largely meaningless exercise.

That said, most people have not really noticed the economic impact of Brexit (though in fairness, most people have not travelled abroad since the Covid crisis hit). But many exporters have highlighted the difficulties resulting from the erection of trade barriers and although year-on-year comparisons are distorted by Covid effects, a pattern is emerging whereby trade with the EU has fallen by far more than with the rest of the world. A recent report by the Food and Drink Federation noted that UK food and drink exports to the EU in Q1 2021 were 28% lower than a year ago whilst remaining unchanged to non-EU markets. On a more positive note, ONS aggregate data suggest that trade flows are slowly normalising but there is no doubt that UK-EU trade has taken a hit.

A synthetic control assessment

To obtain a handle on the joint impact of Brexit and Covid I have attempted a synthetic control exercise which constructs a synthetic (or “Doppelgänger”) GDP index for the UK based on trends in a panel of 23 other countries. The rationale behind the analysis is to use GDP outcomes in the control group to approximate what might otherwise have happened in the UK. When I conducted the analysis two years ago, I concluded that UK GDP was around 2.5% below what might otherwise have been expected which I attributed to Brexit-related uncertainty. Latest estimates suggest that GDP in 2021 Q1 was almost 10% below the synthetic indicator.

As can be seen from the chart, the UK began to underperform during 2017 as Brexit-related uncertainty kicked in and by Q1 2020 GDP was 4% below the synthetic control index which is in line with estimates made in 2016. However this pales into insignificance compared to the impact at the start of 2021. It is likely (but not certain) that the Covid-related output collapse contributed most to this underperformance and we will only be able to assess the impact of Brexit once the Covid shock dissipates.

Markets giving the benefit of the doubt

Despite this poor performance, markets have given the UK the benefit of the doubt with sterling trading at around 1.39 against the USD versus 1.36 at the start of the year (a gain of around 2%). In a similar vein, GBP is up around 5% versus the EUR whist the BoE’s broad effective exchange rate has appreciated by 4.1% since the start of the year. Sterling is still a long way short of where it was on 23 June 2016 (6.3% down on an effective basis) but it does seem to be moving in the right direction. UK stocks also continue to look cheap on an international comparative basis and there has been much discussion in recent months that the relative post-Brexit stability represents a good time to buy into the UK market.

To the extent that Brexit has not represented a seismic shock, there are good reasons why international investors might want to dip their toe in a market they have shunned in recent years. To the extent that much of the recent underperformance was the result of self-inflicted policy errors, so long as the government can avoid the mistakes of the last three years there may be some scope for catch-up. But the truth is we do not know how Brexit will pan out nor what the final balance of costs and benefits will be. Whilst Brexit has not proven to be a seismic economic event it may well prove to be a boiled frog problem with the cumulative effects building up over time. As it fades from the forefront of our consciousness and ceases to be the headline-grabbing event that has shaped the news agenda over recent years the devil will continue to make its presence felt in the economic detail.