Interest rates are at their lowest since 1951. The government is presiding over the biggest financial support package in British history. The banks are part nationalised.
But still unemployment is at its highest for a decade; the pound is subject to unprecedented overnight falls; company insolvencies are on the rise. Clearly, the medicine administered by the government and the Bank of England is not having the desired effect. So what options remain?
A significant number of commentators are now suggesting that interest rates will hit 0%. This would be completely new territory for Britain; while interest rates were low throughout the '30s and '40s, for example, 0% is simply unheard of in this country. Japan, however, has been in precisely this position - in order to stave off economic collapse, the Bank of Japan slashed interest rates. Over the course of the 1990s the country slipped into negative inflation, with a complete drying up of consumer spending.
Credit relianceThe recent cuts in the Bank of England base rate have been part of a concerted effort to kick-start the economy. It is thought that lower interest rates will encourage borrowing, which will encourage spending. This may seem a strange thing to encourage, given that unsustainable debt is one of the reasons that we are in this situation to begin with. However, the scale of the problem requires that the Bank and government encourage consumers and businesses to forget about the future for the time being, and just spend.
The part-nationalisation of the banks was seen as a potential solution to the consumer credit crisis. The bailout was intended, in part, to free up some extra cash that banks would then be able to lend, and consumers would be able to spend. Similarly, the interest rate reduction was intended to make borrowing more affordable for the consumer, particularly for those with tracker mortgages.
IneffectiveIt now appears that neither of these measures has been successful. Business overdrafts are still being cancelled, mortgage rates are still high, and new credit is virtually impossible to come by. Clearly, this is affecting small businesses most acutely, as they rely particularly heavily on overdraft facilities for their working capital.
These measures have failed for one major reason - they do very little to encourage banks to lend. The cost of lending is determined not by the base rate, but by the London Interbank Offered Rate (Libor); the latter figure describes the price that banks charge to lend to each other. This determines the amount of credit that will ultimately be extended to businesses and consumers. Libor currently sits at 3.38% - a full 1.38% above base.
Capital RequirementsAnother important aspect determining bank lending is the ratio between capital and loans. The Basel II Accord, which provides a regulatory framework for banks, requires that lenders have a set amount of capital for each loan that they give, in order to insure against the risk of default. The capital required is commensurate with the perceived risk of the loan; for example, a mortgage with a loan-to-value-ratio (LTV) of 90% will require the bank to have more capital per loan than a mortgage with a 70% LTV.
As part of the part-nationalisation of the banks, the government are pressuring the banks to curb their lending in relation to their capital. In this way, the amount that will be offered in credit is constrained not only by the price and availability of money on the wholesale markets (as determined by Libor), but also by the amount that each bank can attract in deposits.
There is a growing sense that the government and the Bank are running out of ammunition. However, there is one very large weapon left in the monetary arsenal, and it is known as 'quantitative easing'.
Basic principlesUnder normal circumstances, the central bank of each country sets a target interest rate. They then inject or remove money from the financial system in order to keep interest rates at this level. Under quantitative easing, the central bank provides the financial system with more money than is needed, thus providing excess liquidity. The hope is that this will prompt the banks to start lending again.
The only example of quantitative easing in recent history is the project embarked upon by the Bank of Japan (BoJ) in the 1990s. During this period the BoJ purchased huge amounts of government bonds, as well as various other forms of securities. However, there are a number of other flavours of solution that have been tabled in the last few days. One potential answer is for the Bank of England to buy up debt from the commercial banks. This has two advantages: firstly it provides the banks with some cash, which they would then (hopefully) lend. Importantly, though, it may also offer banks the opportunity to get rid of some of their 'toxic' debt. This would free up interbank lending, which is currently stalled in part because of the perception that this toxic debt will render banks unable to pay each other back.
Potential dangersQuantitative easing, however, is not without its dangers. In highly simplified terms, the process ultimately requires the Bank to print more money. Clearly, this brings with it the risk of inflation. Some of the more shrill commentators have drawn parallels with the fate of Germany in the 1930s, where money became virtually worthless.
Measures like those detailed above are becoming more possible by the day. Indeed, the government seems keen to keep all options on the table - one apparently unremarkable paragraph in the Banking Bill, announced in last week's Queen's Speech, apparently removes the necessity for the Bank of England to publish figures stating how many bank notes it issues.
Quantitative easing would be an unpopular proposal in some quarters. As such, it is likely that it would be conducted with little fanfare. There is a tell-tale sign, however; the Bank tends to print more notes in the few months before Christmas anyway, with circulation dropping after January. If the Bank is still publishing figures in January, and the number of notes being printed continues to rise, then it is a fair bet that elements of quantitative easing will have been adopted.