My Lords, the adage that one should never drive a car simply by observing the rear-view mirror applies equally, if not more so, to the stewardship of the economy. The Chancellor’s room for manoeuvre in his 2018 Budget benefited significantly from the hard decisions taken over the past eight years, especially the buoyancy of current and projected tax receipts. It has also been underpinned by a relatively resilient UK economy, supported by continued global expansion, fuelled by the sugar rush from US tax cuts.
However, it is all too easy to fall victim to lazy economics by using models based on extrapolating past trends—something which even the OBR has previously experienced. Witness the way in which it badly overestimated the recovery in UK productivity. During the late stages of a business cycle the disclaimer that the past is not a reliable guide to the future applies more than ever.
Despite our 43-year record low unemployment levels, and accelerating real wage growth, the economy is showing signs of softening. One of the most reliable lead indicators, the PMI, is already on a declining trajectory and business investment is anaemic. It is possible that lifting the Brexit uncertainty could produce what the Chancellor describes as a “deal dividend” but it is equally possible that the perpetuation of uncertainty through a fudged Brexit deal could tip the economy into a more aggressive down cycle as businesses and consumers lose patience and confidence.
The world economy is undoubtedly more vulnerable to shocks as the interest rate cycle turns, trade disputes intensify and the oil price advances. Our own Brexit-related issues could amplify the domestic impact yet further. The most likely source of economic shocks will come from the global tightening of monetary policy now under way. The effect of cheap money is like morphine—the pain comes back when it is no longer there.
As we mark a full decade since the financial crisis, the biggest piece of unfinished business is how central banks should unwind their use of unconventional monetary policy, as referenced by my noble friend Lord Macpherson. Quantitative easing, or QE, in the form of large-scale asset purchases by major central banks, has swelled their combined balance sheets almost fourfold to $16 trillion. In the UK, the Bank of England has purchased £445 billion of assets, predominantly gilts, from the private sector, with the aim of stimulating the economy at a time when interest rates were already low. It created a breathing space for macroeconomic adjustment during a period when fiscal policy was severely constrained by high deficits and debt. It is welcome that the deficit is now comfortably below 2% and debt is falling.
Although the path to recovery for western economies has been slow and erratic, the original purpose of QE has been accomplished and it is now facing diminishing returns. The Bank of England has gradually tightened monetary policy, with two interest rate rises in the past year and more on the horizon as the Financial Policy Committee seeks to bring inflation back to the 2% target. However, there has been very little public discussion about how and when QE will be unwound. The Bank of England’s own website simply says: “If inflation looks like it is becoming too high, we can sell the assets we have purchased to reduce the amount of money and spending in the economy”. In effect, this is a straightforward reversal through quantitative tightening, or QT.
Behind the scenes, the Bank of England will undoubtedly have developed more detailed plans for QT. In the near term, the official position is that interest rates will remain the primary instrument of policy. Unwinding the holding in gilts, which represents 25% of all government debt, through market sales, is not a straightforward process. If executed poorly, the disposals could create a significant dislocation for financial markets with unintended real economy effects. It is also plausible that we will never completely unwind QE and there will be a permanent increase in the monetary base. That is why the Government cannot just sit back and hide behind Bank of England independence.
Rising interest rates and the implementation of QT will arguably be more important than the Budget in determining our economic prospects and the Government’s political fortunes. I have therefore suggested a more radical option for unwinding QE through transferring some of the assets—say, £100 billion—into a UK sovereign fund, mandated to liquidate the gilts gradually, over time, and reinvest into real assets, focused on infrastructure. This would expand the productive capacity of the economy in a non-inflationary way. It might also provide a more permanent structure for the national productivity investment fund—first announced by the Chancellor in his 2016 Autumn Statement and expanded further at successive fiscal events—now standing at over £38 billion. The first national infrastructure assessment, published in July, recommends the creation of a dedicated UK infrastructure finance institution, particularly if we cannot retain access to the European Investment Bank after Brexit. Coupled with the Chancellor’s block on any new PFI projects, we urgently need a coherent alternative strategy for funding UK infrastructure.
However, my proposal would blur the distinction between monetary and fiscal policy, which is seen as heresy by most central bankers, who fear the inflationary consequences. Increasingly, though, economists are revisiting this orthodoxy. Researchers at UCL have highlighted several cases where fiscal-monetary co-ordination proved useful, such as the Reconstruction Finance Corporation used to implement President Roosevelt’s New Deal after the great depression, and Canada’s Industrial Development Bank, which was created to support SMEs. QE is openly described as unconventional monetary policy. In unwinding this unprecedented intervention, it is equally appropriate that the Government and Bank of England should consider alternatives that run against convention. The idea of a UK sovereign fund is not new, but the circumstances for its creation might now be ripe as policymakers grapple with the dilemma of how to unwind QE in the most orderly way and find a sustainable vehicle for funding long-term infrastructure.
If the chain of events triggered by the collapse of Lehman Brothers 10 years ago ultimately leads to the creation of a UK sovereign fund, mandated to invest in our country’s long-term productivity and prosperity, that would be an altogether more positive legacy from the turmoil of the financial crisis, and something that I hope the Government will consider seriously.