EEF blog

David Smith's column from the The Sunday Times (£) asks whether economists and policymakers are barking up the wrong tree.

"Some would say there was too much credit pouring in before the crisis, and that is true. But there is plainly too little now.

The Bank used to think M4 growth of 9% a year was consistent with economic growth of 2.5%-3% and hitting the inflation target. That may have changed as a result of a shift in the velocity of money but not that much. 1.5% M4 growth is inconsistent with sustained recovery and chronically weak credit growth will hold back growth.

Responding by boosting government spending or cutting taxes is at best oblique, at worst irrelevant, like trying to fix a leak in the roof by replacing the windows. What the economy needs is s sustained private sector-led recovery, and what that needs is an adequate supply of credit.

David's point is that if we're going to have a 'Plan B', then supply and demand side fiscal measures may be 'barking up the wrong tree' because we've got a credit problem.

And more to the point, he says QE hasn't worked because the MPC has chosen the wrong type of QE - buying government bonds rathr than lending to the private sector.

So, while the International Monetary Fund suggested last week more QE (and temporary tax cuts) might be needed if growth grinds to a halt, that would be a bad idea. It does not solve the problem of dangerously weak credit growth.

The only person who has said much publicly on this is Adam Posen, the monetary policy committee’s Japan expert. Though I do not agree with him in his regular vote for more QE, which would be a futile gesture, he was early on to 'the likely failure of lenders to support recovery'. He, like others, would have preferred it if QE had not been conducted overwhelmingly by the purchase of government bonds. Policy has failed to get credit flowing."

And because a picture is worth a thousand words, David demonstrates this policy failure in the chart below, which shows the meagre growth in M4 money (the broadest measure of the amount of notes, coins and deposits floating around in the economy) since the crisis set in.

It does make you wonder.

Stephanie Flanders breaks down the IMF statement, noting that some of the risks and caveats to the IMF's support for the Chancellor's deficit reduction plan:

"...the IMF's own research, for last year's autumn World Economic Outlook...suggested that Mr Osborne's plans were likely to have a significant effect on growth in the short-term.

The risk - spelled out in today's report - has always been that this short term cost will turn out to be permanent, because capacity gets lost forever.

To repeat, the IMF does not think that this has happened yet.

Today's report says that the government's policies are broadly right. It explicitly rejects the advice offered by some economists in Sunday's Observer [calling for a Plan B].

But the Fund does clearly believe that the chancellor should have a wider range of back-up plans than he has so far been willing to own up to."

Martin Wolf believes the government's Spending Review plans are like going climbing without a rope:

If businesses are to invest so strongly, they need to believe that demand will remain robust, come what may. In sum, a credible Plan B is not an optional extra. It is a necessary condition for a successful Plan A

Yet it remains depressing that investment spending was slashed at a time of slack demand, when the government can borrow so easily. That is classic Britis short-termism.

The decision to leave its “Plan B” to the Bank of England is another gamble. When the long-term interest rate on government bonds is down to 3 per cent, the impact of more “quantitative easing” is likely to be minimal.

This government has, in essence, decided to go political rock climbing without ropes.

We agree with his two key points: that business investment has to be part of a credible 'Plan A' on the economy, and that the benefits of additional QE are likely to be minimal.

All this week, we've been setting out our 'Plan A' for the economy - simple, targeted ways the government could help ensure we see a boost to [rivate sector investment in the coming years (see the links below).

But the QE point bears discussion.

Essentially we have two concerns about additional QE. The first £200 billion didn't have a great impact on the wider economy or money growth (in psuedo-eco speak, the transmission mechanism wasn't operating properly), so what makes either the Bank or the government confident that a ride on the QE2 be anymore successful?

And while the benefits of further QE are likely limited, the risks may not be. More QE could help push up asset prices, either here in the UK or abroad via carry trades. And this would just store up problems for the future.

So our view isn't to rule out QE altogether, but to pursue a proper 'Plan A' that will help boost investment and rebalance the economy.

Going for growth in the UK  

Monday: A 'Plan A' for growth 

Tuesday: The UK is OK (for now): Putting growth into context

Wendesday: Growth Plan Part I - A better partner to business

Thursday: Growth Plan Part II - A stable and predictable business environment

Friday: Growth Plan Part III - Investing in the future of growth