Michael J Oliver: You were a keen advocate of Quantitative Easing (QE) back in 2009, as
a short-term measure. It now appears that markets have become hooked on QE for something other than the short term.
Gordon Pepper: Let’s go back to why we recommended QE.
When Mervyn King announced QE in March 2009, he was quite clear. He wanted to bypass the banking system and inject money directly into the economy. Now that was successful: the market was in disarray when he announced QE and it stopped the fall in the market. The bears were caught on the wrong foot, and the market bounced back. Now, there’s a lot of nonsense talked about QE because some people thought it was designed to boost bank reserves, and they’re worried about hyperinflation because of the size of the central bank’s balance sheet. That was complete nonsense – the money supply is the thing that matters as far as inflation is concerned and throughout the period, monetary growth was not excessive.
MJO: But QE was pursued for 10 years, which seems like an awfully long time for a short-
term measure.
GP: There’s no doubt at all that the time lag between savings becoming expenditure was longer than usual with QE from 2009. One of the main reasons for that was the lack of confidence at the time because of the banking crisis. People are reluctant to spend, they tend to save, and therefore the time lag tends to be much longer than usual. There are other technical issues which we won’t go into, whereby, for example, companies, because long-term interest rates were so low, had bond issues and repaid bank overdrafts, which led to slow monetary growth. So by and large the time lags were longer than usual after the monetary expansion from 2009.
MJO: You’ve been very concerned about what has been happening in the government bond market over the last year. Are central banks destabilizing the bond markets rather than stabilizing them?
GP: QE went on far longer than we thought was necessary, and I think it was very wrong when the Bank of England announced another dose of QE when the Brexit referendum took place in 2016.
But it hasn’t just been the Bank doing QE: the European Central Bank (ECB) did it; the US Federal Reserve did it and it’s a worldwide movement. Now, under QE, what happens is that the central bank, in our case the Bank, bought gilt edged stock mainly off the life insurance company and pension funds. They receive money in exchange for that stock. What on earth were they going to do with that money? The answer was they wanted to reinvest it. So, supposing they reinvested some of the balances in equities, that merely transferred the balance to the person who sold the equities who wanted to reinvest it. Every single time it is reinvested, prices tend to go up. A huge amount of QE was created, so much so that investment managers became desperate, trying to find an attractive home for investments. There was therefore a worldwide boom in asset prices, and this created a financial bubble. Bubbles in due course burst. And that was a danger. QE went on for much longer than it should have done.
MJO: But in March 2020, markets fell off a cliff again and that started another round of QE. Has the policy been wrong since last March or do you think central banks have undertaken the right amount of QE?
GP: Well, it was quite remarkable. What I just explained was that QE was advocated when the money supply was undershooting. In March 2020, monetary growth was already excessive. The massive new dose of QE since then has been taken in utterly different circumstances than 2009. The reason for this new dose was that that financial bubble was bursting. We now know what happened in March 2020.
The Debt Management Office had a large issue of gilt-edged stock, and it was undersubscribed and in the words of its chief executive, there would have been a huge rise in yields (that’s a fall in gilt-edged prices) if the Bank hadn’t stepped in. The Bank stepped in and bought the entire issue. There is a danger of a financial crisis, because of the behavior of non banks. The IMF had warned about this earlier on, and the Bank injected the money to bail out, basically, the non banks and speculators in the market. Now, if you want me to be really naughty, the Chancellor (who is an ex-hedge fund manager) agreed to the Bank spending £15 billion or so to bail out hedge fund managers who got it wrong! And what historians will say about that in due course will be very interesting indeed. But the QE in March 2020 was done to stabilize the government bond market.
Now, the danger is in fact worldwide. In early March 2021, the ECB announced that one of its aims is to peg long-term bond yields. This is going right back to the way the Bank behaved in the 1960s and 1970s!
MJO: This brings us onto the past. The current amount of UK government debt is akin to that of the late 1940s, and then the post-1950 period was characterized by financial repression. How do you see financial repression playing out in the 2020s and 2030s?
GP: You’ve got to go back and look at the way the Second World War was financed. The current pandemic is a war: a war against the virus. And when you’re fighting a war, all your focus of attention is on winning the war. Once you’ve won it, you’ve got to go back and sorting out the mess of this huge amount of borrowing is very similar to sorting the mess out that the government had borrowed after the Second World War. At the end of the war, by far the largest British government bond issue was three and a half per cent War Loan. It was priced at 100. 25 years later its price had fallen to below 30. People had lost 70% of their value of War Loan. Now that was in nominal terms. Meanwhile, inflation has gone up. So, with inflation, the whole value was actually written off.
And inflation is a very efficient way of reducing the national debt and national debt to GDP ratio and we are likely to do the same thing this time.
MJO: But Gordon, you of all people should know, that if you are trying for a ‘modest’ inflation of five or six per cent, it can rapidly become double digit inflation.
GP: Well, you come back again to what the fundamental cause of inflation is. Inflation is caused by too much money chasing too few goods. Notice the two sides of it. Too much money causes inflation and too few goods cause inflation. So, producing more goods is one of the ways of reducing inflation. But what’s happening at the moment is the government is pegging yields in the gilt-edged market and that has become the main aim of debt management. This means that they will sell too few gilts.
Let’s go back again. There is no question at all that the government can always borrow whatever it needs. The key question is who does it borrow from? If it borrows from non banks there are no problems. If it borrows from banks, that increases the money supply. So, the danger basically is because the government is pegging yields in the gilt-edged market at too low a level it won’t borrow as much as it wants in the government bond market and it will borrow from banks. And banks create money, the increase in money will create inflation and in due course the gilt-edged market will have an even bigger fall. We’ve been through all of this in the 1960s and 1970s and we have spent a long time trying to educate the Bank that trying to preserve an orderly gilt-edged market creates an even bigger fall in due course. This is a classic example of policy in the short-run having precisely the opposite effect to that intended in the longer run. And the same is likely to happen this time.
MJO: Economics is often referred to as a dismal science and perhaps in part this is because economists’ forecasts are often too bearish. They’re often proved wrong. Would you care to comment?
GP: Economics is a dismal science because it neither art nor science; in other words, it can be a soft science. Now, one of the fascinating things about economics is the outturn is often precisely the opposite of consensus forecasts. This has happened again and again. Let’s go back to the situation in the late 1970s. Inflation had got up to over 25% under Ted Heath. Under Jim Callaghan we had the ‘winter of discontent’ in 1979. We had unemployment rising, everything was going wrong. And there were serious concerns that UK was in absolute decline, not just relative decline. And then what happened? The Conservatives were elected. The economy was heading downwards into recession and in 1981, Geoffrey Howe increased taxes. The whole of the economic profession, clubbed together and in the famous letter to The Times 365 economists said this would drive the UK economy into outright depression. It almost coincided to the day with the start of the economic recovery. Now, this is a classic example of the whole of the conventional economics profession getting it completely wrong. Now, what we need is the sorts of policies that Margaret Thatcher introduced when she came to power. The trouble is, the opposite appears to be happening.
