**Michael J Oliver:** You were a keen advocate of Quantitative Easing (QE) back in 2009 as a short-term measure. It now appears that markets have become hooked on QE for something other than the short term.
**Gordon Pepper:** Let’s go back to why we recommended QE.
When Mervyn King announced QE in March 2009, he was quite clear about its purpose. He wanted to bypass the banking system and inject money directly into the economy. That was successful. The market was in disarray when QE was announced, and it stopped the fall. The bears were caught on the wrong foot and the market bounced back.
There has been a lot of nonsense talked about QE because some people thought it was designed to boost bank reserves and became worried about hyperinflation due to the size of central bank balance sheets. That was complete nonsense. The money supply is what matters for inflation, and throughout that period monetary growth was not excessive.
**MJO:** But QE was pursued for ten years, which seems like an awfully long time for a short-term measure.
**GP:** There is no doubt that the time lag between savings becoming expenditure was longer than usual following QE from 2009. One of the main reasons was the lack of confidence caused by the banking crisis. People were reluctant to spend and tended to save, which lengthened the time lag.
There were also technical issues. For example, because long-term interest rates were so low, companies issued bonds and repaid bank overdrafts, which slowed monetary growth. By and large, the time lags after the monetary expansion from 2009 were much longer than usual.
**MJO:** You’ve been very concerned about developments in the government bond market over the past year. Are central banks destabilising bond markets rather than stabilising them?
**GP:** QE went on far longer than we thought necessary, and I believe it was a serious mistake when the Bank of England announced another round of QE after the Brexit referendum in 2016.
It wasn’t just the Bank of England. The European Central Bank did it, the US Federal Reserve did it — it became a worldwide movement. Under QE, central banks bought government bonds, mainly from life insurance companies and pension funds, which then received cash in exchange. The obvious question was: what would they do with that money? The answer was reinvest it.
If they reinvested in equities, the cash simply passed to the seller of those equities, who then wanted to reinvest in turn. Each reinvestment pushed prices higher. The scale of QE was so large that investment managers became desperate to find attractive homes for capital. This created a worldwide boom in asset prices and ultimately a financial bubble. And bubbles, in due course, burst.
QE went on far longer than it should have done.
**MJO:** But in March 2020 markets fell off a cliff again, triggering another round of QE. Has policy been wrong since then, or have central banks undertaken the right amount of QE?
**GP:** It was quite remarkable. QE in 2009 was advocated because the money supply was undershooting. By March 2020, monetary growth was already excessive. The new round of QE was undertaken in completely different circumstances.
The reason for it was that the financial bubble was bursting. We now know what happened. The Debt Management Office issued a large amount of gilts, which were undersubscribed. In the words of its chief executive, there would have been a huge rise in yields — that is, a fall in gilt prices — if the Bank had not stepped in. The Bank bought the entire issue.
There was a danger of a financial crisis driven by non-bank behaviour. The IMF had warned about this, and the Bank injected money to bail out non-banks and speculators. If I’m being particularly naughty, the Chancellor — an ex-hedge fund manager — agreed to the Bank spending around £15 billion to bail out hedge funds that got it wrong. What historians will make of that remains to be seen.
QE in March 2020 was done to stabilise the government bond market.
The danger is now global. In early March 2021, the ECB announced that one of its objectives is to peg long-term bond yields. This takes us right back to policies of the 1960s and 1970s.
**MJO:** This brings us to the past. UK government debt is now comparable to that of the late 1940s, followed by a period of financial repression. How do you see this playing out in the 2020s and 2030s?
**GP:** You have to look at how the Second World War was financed. The pandemic is effectively a war — a war against a virus. During a war, all focus is on winning. Once it’s over, attention turns to cleaning up the borrowing mess.
After the war, the largest British government bond issue was the 3.5% War Loan, priced at 100. Twenty-five years later it was trading below 30. Investors lost 70% of its value in nominal terms. Meanwhile, inflation rose, effectively wiping out the debt in real terms.
Inflation is a very efficient way of reducing the national debt and the debt-to-GDP ratio. We are likely to see something similar again.
**MJO:** But Gordon, if you aim for ‘modest’ inflation of five or six per cent, it can quickly turn into double-digit inflation.
**GP:** You must always return to fundamentals. Inflation is caused by too much money chasing too few goods. There are two sides to it. Producing more goods reduces inflation, but at present the government is pegging gilt yields and selling too few gilts.
The government can always borrow what it needs. The critical issue is who it borrows from. Borrowing from non-banks is safe. Borrowing from banks increases the money supply. Pegging yields too low means the government borrows less from the bond market and more from banks, which creates inflation.
We went through this in the 1960s and 1970s. Attempts to preserve an orderly gilt market ultimately caused larger collapses. This is a classic example of short-term policy producing the opposite effect in the long run.
**MJO:** Economics is often called the dismal science. Is that because economists are too pessimistic?
**GP:** Economics is dismal because it is neither art nor science — it is a soft science. One of its fascinations is that outcomes are often the opposite of consensus forecasts.
Look at the late 1970s. Inflation exceeded 25% under Ted Heath. Under Jim Callaghan we had the Winter of Discontent. Unemployment was rising and there were fears of absolute decline. Then the Conservatives were elected. In 1981, Geoffrey Howe raised taxes. Three hundred and sixty-five economists wrote to _The Times_ predicting depression. That moment almost coincided exactly with the start of recovery.
It was a classic case of the entire profession getting it wrong. What we need now are the kinds of policies introduced under Margaret Thatcher. Unfortunately, the opposite seems to be happening.
