When monetary policy stops working

Growth forecasts for the UK economy have been downgraded in recent months. There seems very little prospect of a return to normal growth until the middle of next year.

What is the standard response to this state of affairs? Economic stimulus packages.

There are problems here. As I pointed out in yesterdays blog the government are cutting expenditure and raising taxes to cut the budget deficit. Some argue this is too much, too soon and that the lost Aggregate Demand will push the economy back into recession, or at the very least inflict avoidable pain on the population. The counter argument is that the level of debt is unsustainable already.

Whatever the merits of the opposing views a fiscal boost to the economy isn't going to happen.

So that leaves monetary policy or supplyside policy. Supplyside policy promotes longterm growth, but will do nothing to aid shortterm growth. So monetary policy is all that is left.

The MPC reduced interest rates to 0.5% and kept them there. There is no more they can do to encourage consumers and firms to borrow and so boost Aggregate Deamnd on that front. Monetary policy in this sense has hit its lower limit.

So the other possibility is to print money. The newly created money will find its way into the pockets of consumers and the level of AD will rise. This is done by 'Quantitative Easing' with the Bank of England buying up financial assets (almost always Government Bonds, but not necessarily) with money they simply create.

Some scream this will be inflationary, but that isn't the case if real output can rise to meet the increased demand. At least one member of the MPC, Adam Posen, thinks more Quantitative Easing is needed and more people are coming around to this view.

The prospect of a stimulus to the British economy may improve consumer and business confidence and get them borrowing at the historically low interest rates on offer. Frankly more 'QE' is unlikely to do any harm.

The Guardian reports Posen's views here

Consumer confidence a worry

The level of consumer confidence is a key determinant of Aggregate Demand. Although consumption primarily depends upon income levels households have the choice of how much of that income they put into savings.

When consumers are uncertain they are cautious. Cautious people save 'just in case'. This has the effect of reducing consumption, Aggregate Deamnd falls and there is slower growth, or worse still a recession. The slow growth alone is enough to convince households they were right to be cautious and recovery becomes difficult.

There are two problems that compound this problem at present.

1. Governments are cutting back on expenditure in order to reduce their debt. Government spending is another component of Aggregate Demand and also has a multiplier effect making the cuts here even more effective in reducing real GDP.

2. The banks are being forced to recapitlise their balance sheets. This is because they have had to write off bad debts and the new rules (Basel Accords) that demand a higher proportion of capital to liabilities. This means the banks take the extra savings they receive in deposits and keep them to raise their capital reserves rather than lend it to firms or consumers.

While many welcome the strenghtening of the banks and the reduction in household debt it is not good for the short term.

It is now clear that consumer confidence is falling in Europe. This is a problem as 60% of UK trade is with other EU memebrs and exports are another compnent of AD.

While the double dip recession remains unlikely rapid growth still seems quite a way off.

The Guardian reports on EU consumer confidence here