But David Owen, of Jefferies Fixed Income, on Wednesday, has a nice exploration of a deflationary-doom scenario:
Here’s the thrust of his argument:
One of the advantages of the UK’s monetary data is that it is very detailed. The chart below shows the public sector’s contribution to the broad measure of money supply M4 in the UK. Basically, by buying in gilts the public sector has massively been underfunding the budget deficit. This has been boosting M4 by over 10% annualized a month, an unprecedented figure. Students of UK economic history may remember the early 1980s as a period when the government overfunded the budget deficit in order to rein in monetary growth and so hit an inflation target, the so-called Medium Term Financial Stability (or MTFS). However, this was much smaller in size and had to be abandoned; in de-regulating the financial system and abolishing foreign exchange controls the government’s other policies caused an explosion in monetary growth. But at no point did overfunding the budget deficit in the early 1980s reduce the money supply by approaching 10% annualized a month.
That bit needs a bit of explanation, and David Owen was kind enough to do it for us.
If a government is running a budget deficit it is adding to money in circulation in the private sector by spending more than it receives in stuff like tax receipts. In normal times it effectively sterilises this by selling gilts (mostly) to pension funds, insurance companies, etc.
When these institutions buy a gilt from the government they write a cheque which draws down the deposits in M4 money supply. Normally the government *perfectly* funds the budget deficit through its actions, so looking at the BoE’s publication of bank stats, as above, there is no impact of the public sector on the so-called counterparts to the money supply. There is virtually no impact of the government on the amount of deposits/M4 in UK. Gilt sales etc. simply equals the budget deficit.
Now consider QE. The government is still selling gilts to fund the deficit but then BoE buys an equivalent figure back. Pension funds, insurance companies etc. sell gilts to the BoE, receive a cheque in return and deposit the proceeds in a bank — so money supply is higher than would otherwise have been. Without QE, the deleveraging of the financial system could have been very very painful worsening the downturn, Owens says. The budget deficit has been underfunded.
The question which everyone has been asking is; is it inflationary?
Here’s Owen’s answer:
No, because the money created is not being lent on to wider real economy, banks need liquidity etc reserves held at BoE rise, although asset prices rise and spreads narrow (partly because pension funds etc have more cash). What happens though when QE stops (and long before BoE sells the things back to the market – arguably it will hold most to maturity). Well assume underfunding has boosted M4 by 10% annualised and then stops. Everything being equal M4 falls by an equivalent amount unless banks can attract deposits from elsewhere.
Which brings us back to the bank funding gap.
UK banks have evolved to rely heavily on wholesale funding rather than customer deposits, which means, they now have something of an asset-liability mismatch problem. Banks have simply lent more than they have in customer deposits. That’s not a problem per se, but the extent of it is dramatic:
That’s a funding gap (customer deposits minus customer loans) equivalent to nearly half of GDP.
No wonder then, that BoE governor Mervyn King reportedly made quite a mention of the thing in his Tuesday testimony to the Treasury Select Committee.
Full Jefferies note in the Long Room.