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2011-06-07 Mitsubishi UFJ Britains Lessons in Monetary Failure - Devaluation and QE Procude Starkly Negative Results

2011-06-07 Mitsubishi UFJ Britains Lessons in Monetary Failure - Devaluation and QE Procude Starkly Negative Results

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Economic Viewpoint
Brendan Brown
 
Tuesday, June 7, 2011
British lessons in monetary failure
Key messages:
 
The IMF in its latestreport gives thumbs upfor further doses of QEshould the economicrecovery weaken further.Yet they (IMF) offer nocritical assessment of howthe UK version of Bernanke-ism – QE plusaggressive currencydepreciation – hasactually fared.
 
In fact the experience of UK monetary andeconomic outcomesduring the past decadeprovides a basket case of what is wrong withBernanke-ism!
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This publication should not beviewed as a ‘personalrecommendation’ as defined by therules of The Financial ServicesAuthority.
Contact: Brendan BrownTel: +44 20 7577 2712Economic ResearchMitsubishi UFJ SecuritiesInternational plc
DEVALUATION AND QE PRODUCE STARKLY NEGATIVE RESULTS
In many respects the UK is a basket case as to what is wrong with Bernanke-ism. All the elements – inflation targeting, repudiation of automatic monetarycontrol mechanisms which would have the central bank targeting monetary basewhilst leaving interest rates market-determined, non-comprehension of wideraspects of monetary stability than just goods and services inflation, deflationphobia, principle of central bank infallibility, and legitimization of currency war(competitive devaluations) - had all come together in the conduct of UK monetaryaffairs even before President Bush invited Professor Bernanke to pack up his bagsand move from the Princeton Economics Department to the Federal Reserve.And what is the visible consequence of Bernanke-ism as applied in the UK?Well, first there was the bubble economy of the last decade, featuring a giganticcredit bubble alongside a consumer boom and commercial/residential real estatemarket boom and bust (except for the special case of London prime residential).And so deep was the mal-investment during the bubble years that even now thelevel of output in the UK economy remains some 3% below its 2007 peak. Thatshortfall is all the more remarkable given the aggressive policies of QE andcurrency devaluation (the two are opposite sides of the same coin) which weremeant to powerfully stimulate a UK recovery.Instead, the main recovery story in the UK has been the return of inflation,expected to peak this year at above 5%, and then sink back towards 2% p.a. bylate 2012 or into 2013. At least, you might think, if there were going to be such agigantesque bubble and bust the UK could at least extract the benefit of long-runprice level stability from its woes. But no, the QE policies and aggressivedevaluation (under-written by the QE) have left the UK economy with an inbuiltinflation momentum significantly higher than in other medium-sized advancedeconomies around the globe.And yet despite this fairly self-evident catalogue of failure the UK monetarypolicy makers can take pride in the fact they are still getting good marks from theIMF! In its latest survey of the UK economy (published yesterday) the IMF laudsthe conduct of policy by the UK monetary authorities and – wait for it! – exhortsthem to turn to a further dose of QE should the present recovery continue tostutter. Well, the UK may be a bigger case of what University of ChicagoProfessor Robert Aliber recently observed in connection with Iceland. He raisesthe question “How did the IMF and OECD completely miss the implications of themassive imbalances in Iceland (even as late as early 2008): staff from bothinstitutions visited Iceland once or twice a year”. And Professor Aliber continues,“one of my economist banker friends commented – Darwin had to visit theGalapagos to see phenomena that he might have observed in his backyard inEngland if they had not been obscured by a lot of clutter. And you had to go toIceland in your hunt for a bubble and to identify its origin”.The IMF scores such big misses in part because it purveys the same monetarydoctrines as the flawed ones practised in the countries it visits. A journalistrecently questioned whether Adam Smith or von Hayek would get a job today in aUS university given the dominance of econometrics and mathematics (tools whichthey did not espouse). Well in similar vein, it is certain that a leading economistpreaching a story of monetary stability and the role of monetary disequilibrium in
 
 creating cycles of asset inflation and deflation would not want to join the IMF and would notbe offered a job there. Indeed if somehow he or she got into that institution and then startedderiding “deflation phobia” and “inflation targeting”, the experience would not last very long!And so returning to the IMF establishment as it is, let’s look at its contention thatSterling depreciation as promoted by UK monetary policy (at least they call a spade a spadehere as against UK monetary officials who deny there is any connection between QE andSterling’s cheapness – and QE has not ended, all the vast purchases of gilts and the basemoney created in the process are still out there) has helped to “re-balance” the UK economy.It seems the IMF’s UK team have in mind here the transfer of resources from the oncebubble sectors to new sectors of the economy. Does it not occur to these IMF officials (letalone the UK monetary officials) that “re-balancing” is a process best accomplished by privatemarket forces and depends on Schumpeterian “creative destruction”.If the UK officials were serious about promoting the inevitably slow process of newinvestment opportunities emerging and entrepreneurs/equity stake-holders becoming ready toassume the risks, by far the most important consideration is the promise of long-run monetarystability and low taxation and lack of regulatory interference? Short-term brilliance of tacticsin a Bernanke-ite currency war cannot produce meaningful medium-term results. And indeedaccording the record so far the upturn of business investment – crucial to the re-building of aneconomy after the disaster of credit bubble and bust – has been particularly feeble in the UKrelative to elsewhere in the OECD area.Let’s turn finally to the trump card sometimes put on the table by UK monetary officialsand wider economic policy makers when all else is failing – “well, at least we kept outsideEMU”. In closer examination, this is no trump card, but at least it has been a stroke of luckthat the UK economy, borne down by such monetary woes of its own policy establishment’smaking, does not face the same scale of bills related to the insolvency of the periphery zonecountries as EMU members.The trump card is no such thing. The really poignant question is how did the UK outsideEMU with none of the additional problems of building a framework for stability in a newmonetary union suffer even worse monetary instability?And as a matter of historical record, the UK policy-makers did contribute to the flaws inthe EMU framework. So long as the UK kept the door open to EMU membership it negotiatedas a full partner in the run-up to EMU’s start. It has been well documented how the UK’sinsistence of low reserve requirements (in contradiction of Bundesbank practice) was adecisive factor in the eschewing of monetary base control founded on high reserverequirements in the new union. Under such a system, the extent of monetary instability(reflected in credit bubble and real estate bubbles) during the first decade of EMU might havebeen notably less than what in fact occurred.Finally from the viewpoint of the EMU countries, there can be no luckier fact than theUK not having joined. Just imagine the fall-out from a UK bubble and bust within the contextof EMU. Commentators now debate whether a run on Spain will eventually bring broad EMU toan end. A run on a bubble-bursting UK inside EMU would certainly have done so and at a costto French, German and Dutch taxpayers which would transcend the giant bills they alreadyface over the long-run for the “rescue of the periphery” in its fullest sense (to include the re-capitalization of their own failing banks).
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