WE SAW very different monetary policy responses in the UK and Japan yesterday. The Bank of Japan has embarked on a massive programme of quantitative easing (QE). In the UK, the Bank of England sat on its hands. Who is right?
QE has become a standard policy response for central banks that have already reduced interest rates to zero, or near-zero levels. When the central bank is unable to provide stimulus by cutting interest rates further, it creates new money (electronically) which is used to buy financial assets – normally government bonds. The theory is that the money will work its way through the financial system and ultimately raise spending by households and firms – helping the process of recovery. Eventually, when economic growth has become self-sustaining, the money creation programme can be unwound and normal policies can resume.
In 2009, QE appeared to work. In the UK and the US, it was used aggressively once interest rates had fallen to extremely low levels, and both economies stabilised and started to recover. But the results since then have been disappointing. The Bank of England has had two further rounds of QE – in late 2011 and 2012 – but growth has not picked up. And the UK economy has experienced persistently high inflation and a weak currency.
The recent results of QE look more promising in the US, where growth has been around 2 per cent over the course of the recovery. But this is disappointing by the standards of previous US recoveries. And unemployment remains high – nearly 8 per cent compared to the 5 to 6 per cent norm.
There are three key lessons we should take from this experience. First, in 2009, QE was effective because it was introduced alongside a range of policies that were deployed worldwide to counter the effects of the financial crisis – including bank rescues, record low interest rates, temporary tax cuts and extra government spending. When governments around the world pull out all the levers to support growth, it is difficult to work out what is really making a difference. QE certainly helped as part of the mix, but it is not a “magic bullet” which can support the economy single-handedly.
Japan's slow growth is largely structural - if QE delays reform it will be bad in the long term.
Second, while QE can provide temporary support for the economy, it is not a substitute for the measures needed to sustain growth in the longer term. Economies prosper because they have the skills, innovation, enterprise and infrastructure to support sustained growth. They also need effective market mechanisms which create flexibility so resources are reallocated when the economy is hit by large shocks. QE does not address these issues directly. It can only buy a limited amount of time to put the right policies in place.
Third, QE can have negatives as well as positives for economic growth. In the case of the UK, repeated bouts of QE reinforced the weakness of sterling – squeezing consumer spending by pushing up import prices. Another negative impact has been the effect on longer-term interest rates, which cut the income available to savers and pension funds. If QE is a short-term policy, we can ride-out these adverse effects. But the longer it is pursued, the more likely it is that they will become a drag on economic growth.
In the UK, the Monetary Policy Committee (MPC) seems to have become more realistic about the ability of QE to deliver. Despite disappointing growth, the MPC has not reached for the money creation lever in the last few months – even though the government appears to have changed its remit to make it easier to do so.
In Japan, they are taking a different view. But Japan has been here before. In the early 2000s, the Bank of Japan pioneered QE and the results were disappointing. Will it be different this time?
I fear not. The slow growth of the Japanese economy is largely structural, reflecting a shrinking workforce, strong competition from low-cost Asian economies in manufacturing, and weak productivity growth in the services sector. These problems could be addressed by making the labour market more flexible (in particular encouraging more women to participate in the workforce), and deregulating business so it can restructure and become more efficient – particularly in retail and other service sector activities.
The danger for Japan is that this latest round of QE is another reason to delay these important structural reforms. If that is the case, it will be bad for growth over the longer term.
Andrew Sentance is senior economic adviser to PwC and a former member of the Bank of England’s Monetary Policy Committee.