UK Economy Needs More Than Quantitative Easing To Recover

Britain's cycle of rising debt and dependence on consumption to drive growth make it unlikely to bounce back any time soon.












Britain has just been through what is now officially the deepest slump since the Great Depression – pictured, the unemployed marching in London in 1930.

Britain has just been through what is now officially the deepest slump since the Great Depression. Economic data from the pre-war era is not 100% reliable, but the drop in output after the sub-prime mortgage crisis appears to have been almost on a par with the contraction following the Wall Street crash. What's more, the recovery – such as it is – has been even slower than in the 1930s.

Talk of a lost decade is not misplaced. The economy is likely to grow by barely 1% this year and will struggle to do much better than that in 2012. At this rate of progress, it will be 2016 before output returns to its level when the recession started in early 2008.

This performance looks all the more miserable when you consider the amount of stimulus that has been thrown at the economy. Interest rates were cut to 0.5% in early 2009 and have remained there. The government has borrowed £390bn in total in the last three fiscal years. After printing £200bn of electronic money, the Bank has decided that is not enough and has announced plans to do a further £75bn of quantitative easing. The image that springs to mind is of John Cleese's response when Michael Palin's pet shop owner insists that were the Norwegian Blue not nailed to its perch "it would nuzzle up to those bars and 'voom'".

"Voom?! Listen mate, this bird wouldn't voom if you put 4 million volts through it. 'E's bleedin' demised."

This is not the view of George Osborne or Sir Mervyn King, although both admit it is taking a while for the dead parrot to awake. King said last week that the UK was in the grip of a financial crisis at least as severe as that in the 1930s and perhaps the worst ever. The chancellor has repeatedly warned that it will take a long time to recover from the debt binge of the last decade. Most post-war recessions were caused by a tightening of economic policy in response to inflation, but that of 2008-09 was the result of individuals and banks borrowing too much.

Still, the mainstream view is that sooner or later things will get back to normal. Over the past two centuries, western economies have always bounced back from economic traumas, no matter how severe. It is taken as read that industrial capitalism is inherently robust and adaptable. It is perhaps time to challenge this assumption.

The first piece of evidence comes from the Office for Budget Responsibility, the independent fiscal watchdog created by Osborne when he became chancellor. Forec asting has been outsourced to the OBR, which expects growth to be quite perky in the years ahead, leading to a fall in the UK's budget deficit. Crucially, though, this is only because the OBR expects household debt to rise in the years ahead, from £1.6tn in 2011 to £2.1tn in 2015.

Alert readers will spot the circular argument here. Britain has a personal debt bubble that goes pop. Government steps in to clear up the mess and ends up with record peacetime debts itself. The cure for this is to get individuals borrowing again. Well, maybe. All the signs are that this will prove harder than the OBR imagines, resulting in weaker growth and a higher budget deficit.

This leads on to a second point, which is whether the UK variant of modern industrial capitalism is really as robust and adaptable as our policymakers would have us believe. The story of the past 25 years and more has not been of a new model of sustainable growth emerging from the old. Not since the mid 1990s has there been a period where the motor of growth has been production rather than consumption. For the rest of the time it has been the tale of asset-price booms, the withering of the productive base and the onward march of big finance. Following the bubble to end all bubbles, the taxpayer had to dig deep to bail out the banks and prevent an even deeper recession, pauperising the state in the process. A model that relies on excessive personal indebtedness and ends with the innocent suffering from extreme austerity seems neither robust nor adaptable, just bankrupt.

Britain has not been alone in its long march down this dreary road, but it has travelled further down it than any other developed western country. King and Osborne agree something has to change. The upbeat vision of the future goes something like this: Britain, despite everything, has a sizeable manufacturing base and can enjoy the benefits of a 25% drop in sterling since 2007. The UK has top-notch scientists who will deliver a new wave of innovation. It has an independent central bank that knows what it is doing and a Treasury determined to keep interest rates low. The banking system is being repaired. Credit will eventually start to flow again, taxes will at some point come down, consumers will pay off their debts and firms will start investing.

The dystopian vision of the future sees Britain displaying many of the traits of a developing country. Here's what a typical developing country looks like. It is governed by an elite and there is a gulf between rich and poor. The elite extracts economic rents from the rest of the population, then salts them away in tax havens. Developing economies often rely heavily on one commodity, which crowds out activity in other sectors. To the extent that they have an industrial base, it is as an assembly plant for foreign-owned transnational corporations. The country tends to be deficient in physical infrastructure and human capital. All too often the best brains leave the country.Now consider Britain. The country is dominated by the City, which exerts an extraordinary amount of political power. There is a widening gap between rich and poor. The rich find ingenious ways to avoid paying taxes. Large parts of the country are dependent on the public sector, while the private sector is increasingly dominated by financial services. Industry makes up a smaller and smaller part of the economy and not one world-class manufacturing firm has been developed from scratch since the second world war. Firms complain they can't find skilled labour. The infrastructure is a joke – witness the lack of snowploughs to keep Heathrow open during last winter's snow. This is not an economy that is going places: it is going south.

Economic Crisis: What Is The End Game?

The cycle of woe and uncertainty surrounding the economic crisis continues, with gloomy surveys predicting a double dip, and even fears of a ‘Great Depression'. Sir Mervyn King, Governor of the Bank of England, believes this could be the worst financial crisis ever - even beating the 1930s for gloom - and the economy is in breakdown, so what we want to know is:



















How grim are things going to get?

Yesterday various reports told us the UK was bottom of the global confidence league, 43% of finance directors were preparing for a second recession while companies had delayed or cancelled £4.7bn of spending, reports the Daily Telegraph. "Today we report the OECD's leading indicator falling for the seventh month in a row, pointing to a slowdown, and the British Chambers of Commerce warning on stagflation."

Mindful Money asks commentators what they think will happen:

While we don't know if the recent injection of more QE will do any good, we do know that it automatically invites stagflation into our economy by pushing the pound down, say commentators.

According to Mindful Money economist blogger Shaun Richards, the most likely outcome if both politicians and central banks continue with the policies that they have now is, indeed, stagflation.

But he adds: "Those who look at the past I think miss an important point which is that it doesn't have to be 10% inflation to hurt people. A continuation of 5% a year combined with wages only rising say 2% will gradually turn the screw. Let's face it this has been happening already for the last couple of years so in general people are poorer."

Investors Chronicle says that Andrew Sentence, a former member of the BofE MPC believes that inflation is a bigger concern for the UK economy than a recession."High inflation and slow growth are inextricably linked."

What happens if stagflation hit?

Stagflation is a term which is formed by joining the words stagnation and inflation. It is used in modern macroeconomics to give a description of a period of uncontrollable price inflation combined with sluggish output growth. Stagflation raises unemployment.

The last time stagflation held the western world in a seemingly lethal grip was 30 years ago in the 70s and 80s, and it is threatening to emerge from the shadows again. Such fears are dismissed as irrelevant by those in favour of pumping money into the economy through quantative easing (QE), which they think will stimulate growth and avoid the dreaded ‘double-dip' recession. But so far, this policy has failed to prompt the necessary growth.

Thursday's announcement of another £75billion worth of QE played well with the stock market, but it is unlikely to cause much cheer for long. On the contrary it threatens to stoke inflation even higher, and meanwhile, there is the threat that growth stagnates.

"Stagflation" remains a word not uttered in the polite company of the financial world.

"But there remain only a few more tumblers to fall into place for a return to that awful word that conjures up images of the "malaise days" of the late 1970's and early ‘80s, where rising inflation and slumping employment tramped down economic growth," says CNBC,

However, some economists believe stagflation isn't something to fear at present.

Azad Zangana, European economist at Schroders, says: "While the current environment feels like a typical stagflationary environment, this is set to be temporary. The outlook is more positive as we expect inflation to fall from its current level back down to below 3%, mainly due to the passing of the VAT effect from the start of 2011.

"Meanwhile, we forecast growth to improve in the second half of 2012, and so the balance between real and nominal growth will improve. To conclude that we are entering a fully fledged stagflationary period, we would need to see significantly stronger inflation and wage inflation, and a continuation of weaker growth as seen in the 1970's. In our view, this is unlikely to occur."

What other threats may there be?

Another danger, however, is the rising threat of hyper-inflation. Shaun Richards says: "Whilst the self proclaimed "financial geniuses" persist in buying every gilt they can find there is a danger of this. Also it is the nature of things that when problems happen these days with the speed of trading it happens so fast that it is better not to run the risk at all. But I see this as rising but still low.

"So for now the danger is the silent drip drip of inflation and this is the enemy. The biggest problem of all is that as I keep pointing out it should not be a problem at this stage of the economic cycle and furthermore is being inflicted on us by individuals whose own contracts protect them against it.."

And if we're being warned that this crisis beats the 1930s, what happened then?

What happened in the 1930s, given the governor believes the gloom beats this decade? This was the ‘Great Depression', where in America millions were genuinely destitute, and unemployment hit a staggering 25%. Two million Americans tramped the country, sleeping rough as they looked for nonexistent work, and malnutrition was widespread.

Southern England escaped reasonably lightly, but in the North there were pockets of extreme hardship. On Tyneside the collapse of shipbuilding left unemployment standing at 70%, prompting the famous Jarrow march.

There were soup kitchens on the streets and millions of families were subsisting on bread and margarine. In Germany, economic misery that had begun with hyperinflation in 1923 helped another world leader to power in 1933: Adolf Hitler.

So is there any cause for hope with growth and falling inflation?

Henderson's chief economist Simon Ward gives his opinion: "Assuming that an EMU break-up is avoided, the global economy may start to regain momentum from early 2012. Such a scenario depends on the US economy doing better next year, as suggested by recent money supply strength...

"Another reason for thinking global growth could revive from early next year is a fall in headline inflation due to recent weakness in food and energy commodity prices. Rising inflation has been a major contributor to the recent economic slowdown by squeezing consumer spending power and forcing monetary policy restriction in emerging economies."

And anyway, nobody knows.

Mindful Money's resident psychologist Kim Stephenson says: "Let's assume that Shaun's right..

"Afterwards, lots of people who said that we wouldn't get stagflation but something else (hyperinflation or whatever) will say - "ah, well, it depends on how you define stagflation (or hyperinflation, or whatever)", they'll twist it round to show that they were right when they were actually wrong. Or they will point to some action or event - from the Bank of England, IMF, German Government, something, and say "if that hadn't happened, it would have gone the way I predicted". Human beings don't like being wrong and they will selectively remember what they want to remember to avoid having to admit they were wrong.

"Similarly, human beings like being able to predict and control their world . The economy isn't just out of our personal control, it's clearly out of control (or even prediction) of anybody like the Chancellor, the EU etc. that are supposed to be able to control it. That is very scary. It's like when you're a child and you realise for the first time that your parents don't know everything, can't solve every problem, can't ease the pain, stop the bully or get you on the team every time. It hurts and it makes us afraid, so we desperately cling to the belief that somebody can predict it (if not control it) and that we can have some measure of understanding of what is going on. To contemplate the fact that actually nobody controls it, nobody really understands it or can predict it and that most of our predictions are going to be wrong is simply too much to take."