Page last updated at 12:39 GMT, Thursday, 5 March 2009

Bank steps into unknown territory

By Kabir Chibber
Business reporter, BBC News

We are facing unconventional problems. So, the argument goes, we need unconventional solutions.

BOJ employee with Japanese money
The UK is following Japan, but hopes to avoid the same results

The Bank of England's latest plan is, in effect, to underwrite the risks of the whole financial system. The series of measures, known as quantitative easing, are more than Plan B. They are Plans C to Z.

The new idea is for the Bank to buy government debt, bringing down the cost of borrowing over the long term and also providing extra money for banks to lend on to consumers and stimulate economic growth.

We are in new territory because as it approaches zero, the interest rate that the Bank normally uses to control monetary policy becomes useless.


The Bank said in its statement it would initially be allowed to buy £75bn of government debt. Estimates had put the amount at as much as £100bn, or as low as £25bn.

Simply, no-one has any idea exactly what the Bank and the Treasury will do and how much it will eventually cost, because it has never been done before.

The massive difference between the two amounts reflects the unprecedented nature of quantitative easing. The UK becomes only the second country to try this in modern times, and in radically different circumstances.

"It's not knowable," says Goldman Sachs economist Ben Broadbent. "For it to work, at least very effectively, you need banks to lend the money on. And that's not assured."

Another Iceland?

The other country to try this was Japan, between 2001 and 2006. With the interest rate just above zero, the Bank of Japan (BOJ) attempted to end its "lost decade" by providing money to banks that were crippled with bad loans. Sound familiar?

Icesave website
Iceland's high returns attracted massive investment from abroad

"The lesson from Japan is that the danger is if you don't separate good assets and bad, then QE is much less effective," says Mr Broadbent, meaning that the additional money is not passed on as anticipated.

He suggests the financial authorities in the UK will eventually have to accept the additional creation of a "bad bank" where commercial banks can store their toxic debt, an idea executed successfully in Sweden in the 1990s.

One issue is that Japan was attempting to end 10 years of deflation and stagnant growth, whereas Britain is facing very different circumstances. The UK still isn't seeing falling consumer prices, and the effects of pouring new money into an economy that is contracting sharply are unknown.

The Japanese experience of quantitative easing also created new problems. Japanese consumers, still distrustful of the banks, invested their money in real estate and directly in US and Japanese government debt, creating new bubbles in bonds and land prices.

The zero-rate policy also fuelled a phenomenon known as the carry trade, where investors borrowed money in yen and put it in countries with higher rates of return, such as Iceland. And we know how that turned out.

More art than science

The main concern, though, is that High Street and commercial banks will not lend on the Bank's extra money and instead hoard it to prop up their depleted balance sheets. It has been suggested that the "other securities" mentioned in the letter to Mr Darling might also include bank securities, another way to remove bad debts from the banks.

That means more risk being taken on by the Bank and, ultimately, the taxpayer.

From March onwards, the Bank's monthly meetings will probably involve the Monetary Policy Committee voting on the size of its reserves or the amount of debt it will buy in the next month, as the BOJ did for five years, rather than on interest rates.

"With so little experience of such a policy, and little to go on about its potential effects, the operation of QE will be more of an art than a science," Mr Broadbent adds.

The Japanese experiment in quantitative easing ended in July 2006, with not that much evidence that it worked. The subsequent pattern of inflation and interest-rate rises may have had more to do with record energy prices than the central bank's policies.

The BOJ has since been forced to cut rates back down to near zero as it now faces its worst recession since World War II, and has ruled out bringing back quantitative easing for the time being.

Mr King would hope the Bank's experiences with its new toy will be much more fruitful.

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