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We need more than QE2 even if the latter is the right call.

By David Bailey on Oct 8, 11 09:17 PM in Economics


No messing around this time. The Bank of England didn't even bother to wait for its next economic update. Having already cut interest rates to virtually zero and injected a big dollop of money into the economy a few years back, more Quantitative Easing (QE) is the last line of defence. The Bank is about to fire off its last round of bullets and my guess is that £75 billion is just the opening salvo. Expect more QE beyond this.

While QE is thought to have worked last time, raising real GDP by an estimated 1.5 to 2% and boosting confidence, one wonders if it will have the same effect this time round when long term interest rates are already so low. Maybe it's a big confidence trick. Whatever, let's hope it works.

And why now? After all, the Bank has known for some time that the economy was flatlining. Well firstly it's now clear that economic growth was even slower than previously thought, as many of us have felt. Secondly, the Eurozone's deepening economic woes threaten a repeat of the 2008 banking crisis. As Mervyn King put it this week, we may be facing the worst financial crisis in history, or at least since the 1930s.

If anything the Bank should have acted much sooner, and is now taking a gamble that inflation (now running at 4.5%) will come down next year. The risk that inflation won't is now over-ridden by the more serious risk that the economy will flip back into double dip recession without prompt action.

But while QE1 helped, it didn't get through to as many small firms as was hoped, mainly because the monolithic banking system was so constipated. The fear is that another round of QE will actually just improve banks' liquidity and not the wider UK economy.

Rather, QE2 (no, not the Titanic) needs to be the 'Heineken' of quantitative easing, reaching the parts that others didn't. And while QE2 is probably the right thing to do, on its own is not enough.

Firstly, a looser monetary policy (which is what QE is) would work better if it was working alongside and not counter to fiscal policy. Sadly, the latter is exactly what's happening because of the government's misguided austerity measures.

Secondly, action is needed to get credit to those small firms which can make use of it. That is not currently happening: in the first half of this year net lending to small firms fell on average by £330 million a month. Put another way, Project Merlin has been a flop.

And that's where Osborne's 'credit easing' comes in, and means the Bank - or the Treasury if the Bank doesn't want to do it - effectively buying corporate debt. Credit Easing is essentially QE+, in the form of extra lending to the private sector, effectively by-passing the banks.

But Osborne's conference announcement this week was pretty sketchy to say the least and leading coalition ministers were left scrambling around after the speech trying to explain what it meant. Credit easing could take a number of forms - the Bank buying corporate debt, or the government guaranteeing bank loans to small firms, or buying syndicated packages of small firm debt from banks, or even lending to investors in corporate debt.

But rather than waiting for the Treasury or the Bank to think up some complex wheeze which no doubt the banks will charge us through the nose for, we could do things so much more quickly. We could take real control of RBS and/or Lloyds (we own a big chunk of them anyway) and get them lending to small firms. Forget the pathetic Project Merlin - just order them to do it.

Or we could channel much more money via the mutual lenders like BCRS here in the Midlands, which already work with small firms and have the expertise to make judgements calls on which firms to lend to - unlike, it has to be said, the High Street banks that we bailed out.

Either way would effectively mean a small business investment bank being set up, which would inject some real competition into the moribund banking system. It's something we've been calling for over the last few years. And it's a cause which Monetary Policy Committee member Adam Posen recently joined in calling for exactly such a bank to be set up .

Interestingly, a second new institution called for by Posen would "bundle and securitise loans made to SMEs". This would be a "good" version of Fannie Mae and Freddie Mac in the US, and could ensure that the market has sufficient liquidity.

It's an interesting idea in that simultaneous to small firms struggling to access finance, big firms are reluctant to invest given low confidence about the future and are sitting on significant cash piles.

For example, at the end of last year, Vodafone was sitting on $14.3bn, BP $12.8bn and AstraZeneca some $10bn. Some of these firms might be tempted to buy such securities, thereby recycling their cash piles back via the new institutions to smaller firms which currently find it so difficult to get finance. This could tap into what is in effect a giant (private sector) growth fund currently sitting idle.

This issue is a key problem for many small firms in manufacturing; even if they win orders from bigger firms, they then face an uphill struggle in accessing the finance on acceptable terms to tool up for production. The danger here is that the desire of the manufacturing sector to invest, expand and export will be derailed by a dysfunctional financial system unless action is taken, and quickly..

If he's really serious about credit easing then Mr Osborne need to show us the plan. Or put another way, what's in your wallet Mr Osborne?

Professor David Bailey works at Coventry University Business School.

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