When the Bank of England launched its programme of quantitative easing (QE), it was accompanied by dire warnings that it would spark a round of massive price rises. Before we knew it, we'd be wheeling cash by the barrow load to our local branch of Tesco Express.
Yet three years into the policy, and with the Bank having printed the equivalent of more than a quarter of GDP, inflation has carried on much as it has over the last two decades at a moderate and persistent rate of 2%-4%, but without the escalating wages and prices cycle that we saw in the 1970s.
But the critics have been looking in the wrong place. It is sterling that is going to get hammered as a result of QE. That will make us all a lot poorer and could even spark a run on the pound.
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Britain's trade deficit keeps getting larger, despite the weakness of the economy. The latest set of trade figures for November were dire. The deficit came in at £9bn for the month, higher than forecast. The trade gap in goods was £27bn, only reduced by Britain's ability to keep selling high-end services around the world. The deficit is now 3.5% of GDP.
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While other countries in Europe are reducing their deficits (Spain, for example), or racking up big surpluses like Germany, Britain continues to run up big shortfalls in its trade balance.
Yet conventional wisdom tells us that Britain's deficit should be narrowing. There was a 25% devaluation of sterling right after the financial crisis. The economy has been through a double-dip recession and may be about to go into a third dip. Usually you'd expect that to narrow the deficit, as British goods get cheaper around the world, and depressed demand means we import less.
Through 2009 there were plenty of predictions about how we'd see a rebalancing of the British economy away from debt and consumption and towards making and exporting things. It hasn't happened. And the real reason for that is QE.
It is a simple matter of accounting. Say the Bank of England prints £100 billion a year to buy gilts. If the government was trying to borrow that money in the market, it would have to be matched by savings elsewhere. Some people decided not to buy stuff, and saved the money instead and that saved money was invested in gilts. So for every pound the government borrowed, a pound of consumption was foregone. It might have been in the UK, or elsewhere if the gilts were sold abroad. But the money represented some genuine economic activity.
Now, however, that £100bn is simply printed out of thin air, and effectively handed over to the government. It doesn't represent any saving anywhere, and it doesn't represent any consumption given up. It is completely fresh money. Over the course of the year, the government spends the money, and the cash slowly works its way into the real economy via government expenditure. Eventually it gets spent on real things.
Fast forward to today. That £100bn is simply printed out of thin air and handed over to the government. It doesn't represent any saving anywhere, and it doesn't represent any consumption given up. It is completely fresh money. Over the course of the year, the government spends the money and the cash works its way into the real economy via government expenditure. Eventually it gets spent on real things.
In a Keynesian fantasy world where Britain had excess capacity, that additional demand might boost production. But there's little evidence that Britain has any spare capacity. Employment is high, perhaps surprisingly so given the state of the economy. There aren't lots of factories sitting idle waiting for that extra demand to start making more things. What we do buy we largely import.
So the extra spending created by QE just sends the deficit higher. Most critics of QE argue that printing money will create hyper-inflation. That was true in closed economies, such as Weimar Germany. But in open economies that are highly integrated into the world economy, it creates trade deficits instead.
It is not just happening in Britain. In Japan, which pioneered QE, the same script is being played out. Japan started from a different position: it had a big surplus. But the trend is the same. Japan now runs a deficit and as the new government prints even more money, it will grow.
In the short term that may not matter much. The markets stopped paying any attention to deficits two decades ago. So long as currencies are allowed to float freely, it is assumed that a country will be able to finance its trade gap in the capital markets and if it can't, the currency will keep on falling in value until its factories finally become competitive again.
By widening the deficit, QE makes it certain that over time sterling will start to weaken significantly and carry on weakening so long as fresh billions keep being minted every year. Investors can protect themselves against that by shifting more of their portfolios overseas. But it still makes the country poorer.
The cost of everything we import will keep on rising. Energy and food will eat up an ever larger proportion of people's incomes. By comparison with other countries, Britain will slip further down the league table of global living standards. It may even result in a full-blown sterling crisis, if foreign investors lose faith in British assets and pull out of the market wholesale.
QE might have made sense as a one-off emergency response to the financial crisis of 2008 and 2009. As a permanent way of financing a government deficit that has grown out of control, it will impoverish the country. It looks more likely to happen via a sterling crisis than hyper-inflation but either way we will all end up worse off.
