Thursday, 7 May 2009

Guest blogging at missmarketcrash

I'm guesting at missmarketcrash this week, so half my postings will be over there. But my loyal readers needn't miss out, because I'll come up with some slightly more theoretical musings here. Then again, if you prefer what I write on her blog, please say so, as it will be a bit more whimsical (if you don't count my Apprentice postings) and a bit less rigorous than here.

Today's posting over there is about Michael Savage - kind of - but more about the uniqueness of names and whether that's an economic commodity. I think the £50 billion intervention of the Bank of England today deserves note, so that's what I'll discuss at home.

It wasn't expected, and indeed the BBC reported it at face value: "Bank of England provides £50 billion boost to economy" evidently before letting their economics editors loose on it. Once Stephanie Flanders had her say, it was translated into "a QE surprise". Quantitative easing, as it's called, was instituted last month and the policy did not have to be extended until June - but they have announced it a month early.

The plan itself is straightforward - exactly the same as last month's £75 billion purchase, but more so. Some people are taking heart from the signalling value of the decision to spend £50bn instead of the full £75bn allowed by the Bank's agreement with the Treasury. Does this mean they see recovery coming? In conjunction with the other data emerging over the last three weeks, it's plausible.

The pound dropped a third of a cent against the dollar and two thirds against the euro, but this is well within the bounds of an ordinary daily fluctuation. That validates the idea that this was a fairly conventional move (which would have been an incredible thing to say six months ago, but let's put that aside). So does this tell us anything substantial about the economy?

The first thing to understand is what this quantitative easing means. It's referred to as "printing money" but modern economies don't need their central bank's permission to print money. Indeed, money is just an IOU from the government - which they promise to accept in lieu of taxes, and therefore has value. If you're willing to believe in the credit of a private party, their IOU will do just as well. And that's what most money is these days. If you have a bank account, you're trusting the bank to cough up when you use your debit card or pay your mortgage. If you take out a loan, the bank doesn't go and borrow any money to back up its loan - it just adjusts its computer systems, so your bank balance has £10000 more and your personal loan account has £10000 less.

About 95% of money in our economy is bank credit of exactly this kind. The Bank of England has printed about £53 billion of notes and coin which is in circulation; and holds about £41 billion of "real" money in reserves (which is money owned by banks, held at the Bank of England and backing up their external deposits). But the total supply of sterling "money", tradable as if it were real currency, is around £2 trillion.

So the Bank of England's money-printing programme is a little less significant than it might seem. Like many aspects of policy, it plays around the margins. A 5% increase in total money in the economy is significant but no revolution. Just as £180 billion of deficits is significant, at 12% of the economy, but there's no way it's keeping things going on its own.

Why then do we make such a fuss about small variations in total activity? This is a minor mystery, but it's not too hard to figure out. The phenomenon of loss aversion means that nobody wants to lose 5% of their salary. Think about it this way. How much difference would it make to you to get a 5% pay raise? Nice but it wouldn't change your life, right? What if you had a 5% pay cut? Would you toss a coin if heads would get you the 5% raise and tails would lose you 5%? Hardly anyone would.

So what does this mean in a recession? A 5% contraction in economic activity means that instead of everyone going back to their 2006 income - which didn't seem so bad, then - 5% of people lose their jobs instead. That's over a million people on the street. Pick nineteen friends. One of them's almost certain to be unemployed by the end of the year. And if it's none of them, it will be you.

Pick one of them in particular. Imagine they're the one. Focus on their face. Think of their house. They'll probably lose it within six months. Think of their children. What would it feel like if your parent - whichever was the breadwinner in your household - was at home all day earning no money? If you couldn't get new clothes any more. Frozen smoked cod loins from Iceland instead of that fresh tuna from Waitrose you're used to. Maybe you had to change school. Perhaps your friends just sensed there was something different about you now. Maybe some of them didn't hang out with you any more. That's what their children are going through as the new school term starts in the autumn.

Does that make it more real? I used to be very blase about recessions - who cares if the economy's a few percent smaller, really? But that's a lot of real people's lives being transformed. So is it, after all, worth the QE? Worth the fiscal stimulus? Worth whatever the government can do to stop it happening?

It might seem like electioneering, but there's a reason that they think this stuff wins votes - because it really matters to people. Would you pay that 4% increase in your taxes to insure against the possibility of losing your job? Not such a terrible deal, I think.

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