Category Archives: Bank of England

Stop expecting central bankers to grow the economy: They can’t

masthead

Your humble narrator is in City AM today explaining why central bankers can’t grow real GDP so we shouldn’t expect them to.

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Central Bankers Are All ‘Corbynistas’ Now

 

papers

Your humble narrator is in the Wall Street Journal Europe again today. I’m arguing that increasingly popular and respectable monetary policies, in this instance ‘helicopter money’, are little different to the People’s Quantitative Easing announced by British Labour Party leader Jeremy Corbyn just less than a year ago, and widely mocked.  “They’re not laughing now”, as the great economist Bob Monkhouse used to joke.

Wages and immigration in the short run

The Bank of England has a new paper out titled The impact of immigration on occupational wages: evidence from Britain. Its key finding is that “the immigrant to native ratio has a small negative impact on average British wages…Our results also reveal that the biggest impact of immigration on wages is within the semi/unskilled services occupational group.”

Why, then, does the Bank of England correctly state that “There seems to be a broad consensus among academics that the share of immigrants in the workforce has little or no effect on native wages”? The reason is that “These studies typically have not refined their analysis by breaking it down into different occupational groups”, which the Bank’s paper does.

To de-jargon this, studies which find no effect of immigration on wages make no distinction between the wages and workers they are examining; they lump the falling wages of nine road sweepers in with the rising wage of one City banker and say that, on averages, the ten workers wages haven’t fallen. A paper from Oxford University which also dug down into the averages found similar results to the Bank of England; immigration disproportionately reduces wages at the bottom end of the labour market.

In the short run at least, this is what economic theory would lead you to expect. If you increase the supply of anything relative to the demand for it, ceteris paribus, the price of that thing, whether it is shoes or labour, will fall.

But that, too, is to fall into the trap of looking at ‘the average’. There is no labour market in which we are all willing sellers of homogeneous labour. I am not offering the same skills on the job market as Sergio Aguero or Stephen Hawking. The market for the labour of economists and the market for the labour of footballers are different markets, they are not part of ‘the’ labour market. Labour, like capital, is heterogeneous.

To simplify, consider an economy with two types of worker, highly skilled and lower skilled. The markets for each are shown below, for highly skilled labour in chart a and lower skilled labour in chart b.

wages

Immigration of  lower skilled workers increases the supply of lower skilled labour – the rightward shift of the supply curve on chart b from S1 to S2. Ceteris paribus, this pushes wages for lower skilled workers down from P1 to P2. But, and this is the point the Bank of England paper makes empirically, this has no effect on the wages of highly skilled workers, as shown on chart a.

If the immigrants were skilled then the opposite would be the case. The wages of highly skilled workers would fall and those of lower skilled workers would be unaffected. It is doubtful, however, that this is currently the case, at least in Britain.

This debate over the effects of immigration on wages, in the short run it should be stressed, is another example of the difficulties economists can find themselves in when thinking of lumpy, homogeneous aggregates. Lumping all labour together for anayltical purposes makes no more sense than, for example, lumping all capital goods together. The Bank of England’s new paper is a welcome step towards greater acknowledgment of the heterogeneity of economic variables.

Has monetary policy been ‘loose’ or ‘tight’ in recent years?

One of the policy responses to the economic crisis of 2008 and comparatively subdued economic recovery, was the use of monetary policy.

Central bank policy rates were slashed to the point where the European Central Bank got a reputation for monetary rectitude for having a policy rate higher higher than 0.5%. On top of this, and less conventionally, there was Quantitative Easing, in which central banks printed up new money and used it to buy assets from the financial sector.

Despite this apparent monetary activism, there are some who think that monetary policy was too ‘tight’ – that central bankers were not getting newly printed money out of the door fast enough. Many economists, probably most in fact, think that monetary policy over the period has, by complete contrast, been unprecedentedly loose, for better or worse.

Where does the truth lie? A first step would be to determine what we mean by ‘loose’ or ‘tight’ monetary policy.

I asked this question a while ago. An economist I know told me that monetary looseness could be defined as a situation where MS > MD (money supply, MS, is greater than money demand, MD). It follows from this that monetary tightness would be where MS < MD, and the sweet spot of equilibrium would be where MS = MD. This seems a good place to start.

Well, how do you know whether MS > MD? How do we know when the S of anything is > than the D for it? By a fall in its price.

So what is the price of money? It is the inverse of the price level. To clarify that bit of jargon, think of a DVD that costs £10. That is its price. The inverse of that is that £10 costs one DVD. The DVD buyer gives up £10 to get a DVD, the DVD seller gives up a DVD to get £10.

So, a fall in the price of money would mean that more money could be bought with one DVD. Lets say that the price of money falls so that now the DVD seller only has to give up half of a DVD to get £10. For the buyer, the price of the DVD has risen to £20. In other words, a fall in price of money is better known as inflation.

The same works in reverse. If a DVD seller has to give up two DVDs to get £10, the price of money has risen, in other words, then each DVD will now only cost the buyer £5. As generally understood, prices have fallen and we have deflation.

So if we see inflation we are seeing monetary looseness and if we see deflation we are seeing monetary tightness. What have we seen in recent years?

Consumer Price Indices – RPI indices: 2008 to 2015: September 2008=100

Picture1

Source: Office for National Statistics

The chart above shows a dip from the September 2008 pre-crash peak on an index of prices of 3.8% until January 2009. In the nearly six years since then, the index has risen to 23% above that trough and 19% above the pre-crash peak. This steady, but by historic standards modest, inflation, which equals a fall in the price of money, suggests a degree of monetary looseness, which equals MS > MD.

In short, by analysing money as thought it was like any other good or service, monetary policy in recent years has been loose, but not very.

Money derivative creation in the modern economy

The money derviatives Bulls turn Bearish

It isn’t often that a Bank of England Quarterly Bulletin starts “A revolution in how we understand economic policy” but, according to some, that is just what Money creation in the modern economy, a much discussed article in the most recent bulletin, has done.

In the article Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate seek to debunk the allegedly commonplace, textbook understanding of money creation. These unnamed textbooks, they claim, describe how the central bank conducts monetary policy by varying the amount of narrow or base money (M0). This monetary base is then multiplied out by banks, via loans, in some multiple into broader monetary measures (e.g. M4).

Not so, say the authors. They begin by noting that most of what we think of as money is actually composed of bank deposits. These deposits are created by banks when they make loans. Banks then borrow the amount of narrow or base money they require to support these deposits from the central bank at the base rate, and the quantity of the monetary base is determined that way. In short, the textbook argument that central bank narrow or base money creation leads to broad money creation is the wrong way round; bank broad money creation leads to central bank narrow money creation. The supposedly revolutionary connotations are that monetary policy is useless, even that there is no limit to the amount of money banks can create.

In fact there is much less to this ‘revolution’ than meets the eye. Economists and their textbooks have long believed that broad money is created and destroyed by banks and borrowers(1). None that I am aware of actually thinks that bank lending is solely or even largely based on the savings deposited with it. Likewise, no one thinks the money multiplier is a fixed ratio. It might be of interest as a descriptive datum, but it is of no use as a prescriptive tool of policy. All the Bank of England economists have really done is to describe fractional reserve banking which is the way that, these days, pretty much every bank works everywhere.

But there’s an important point which the Bank’s article misses; banks do not create money, they create money derivatives. The narrow or base money issued by central banks comprises coins, notes, and reserves which the holder can exchange for coins and notes at the central bank. The economist George Reisman calls this standard money; “money that is not a claim to anything beyond itself…which, when received, constitutes payment”.

This is not the case with the broad money created by banks. If a bank makes a loan and creates deposits of £X in the process, it is creating a claim to £X of standard money. If the borrower makes a cheque payment of £Y they are handing over their claim on £Y of reserve money. The economist Ludwig von Mises called this fiduciary media, as Reisman describes it, “transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists”. They are standard money derivatives, in other words.

Banks know that they are highly unlikely to be called upon to redeem all the fiduciary media claims to standard money in a given period so, as the Bank of England economists explain, they expand their issue of fiduciary media by making loans; they leverage. Between May 2006 and March 2009 the ratio of M4 to M0, how many pounds of broad money each pound of narrow money was supporting, stood around 25:1.

But because central banks and banks create different things consumer preferences between the two, standard money or standard money derivatives, can change. In one state of affairs, call it ‘confidence’, economic agents are happy to hold these derivatives as substitutes for standard money. In another state of affairs, call it ‘panic’, those same economic agents want to swap their derivatives for the standard money it represents a claim on. This is what people were doing when they queued up outside Northern Rock. A bank run can be described as a shift in depositors’ preferences from fiduciary media to standard money.

Why should people’s preferences switch? In the case of Northern Rock people came to doubt that they would be able to actually redeem their fiduciary media for the standard money it entitled them to because of the vast over issue of fiduciary media claims relative to the standard money the bank held to honour them. Indeed, when Northern Rock borrowed from the Bank of England in September 2007 to support the commitments under its broad money expansion it increased the monetary base just as the Bank of England economists argue.

But there are limits to this. A bank will need some quantity of standard money to support its fiduciary media issue, either to honour withdrawals by depositors or settle accounts with other banks. If it perceives its reserves to be inadequate it will need to access new reserves. And the price at which it can access those reserves is the Bank of England base rate. If this base rate is relatively high banks will constrain their fiduciary media/broad money issue because the profits earned from making new loans will not cover the potential cost of the standard/narrow money necessary to support it. And if the base rate is relatively low banks will expand their fiduciary media/broad money issue because the standard/narrow money necessary to support it is relatively cheap.

Some commentators need to calm themselves. As the Bank of England paper says, the central bank does influence broader monetary conditions but it does so via its control of base rates rather than the control of the quantity of bank reserves. The reports of the death of monetary policy have been greatly exaggerated.

Notes:

(1) “Banks create money. Literally. But they don’t do so by printing up more green pieces of paper. Let’s see how it happens. Suppose your application for a loan of $500 from the First National Bank is approved. The lending officer will make out a deposit slip in your name for $500, initial it, and hand it to a teller, who will then credit your checking account with an additional $500. Total demand deposits will immediately increase by $500. The money stock will be larger by that amount. Contrary to what most people believe, the bank does not take the $500 it lends you out of someone else’s account. That person would surely complain if it did! The bank created the $500 it lent you” – The Economic Way of Thinking by Paul Heyne, Peter Boettke, and David Prychitko, 11th ed., 2006, page 403. Perhaps the Bank of England economists need to read a better textbook?

This article originally appeared at The Cobden Centre

Do we have easy money?

The headwaters

This week marked the fifth anniversary of the 0.5% Bank of England base rate and the Bank of England’s Quantitative Easing program which has so far seen the Bank conjure up £375 billion of new base money and spend it on British government debt. It’s difficult to imagine money being any ‘easier’.

Or is it? At his Money Illusion blog this week, Scott Sumner asked

“1.  Japan has had interest rates near zero for nearly 2 decades.  Is this easy money, despite an NGDP that is lower than in 1993?  Despite almost continual deflation?  Despite a stock market at less than one half of 1991 levels.  Despite almost continually falling house prices?  If it’s easy money, how much longer before the high inflation arrives?

2.  The US has had near zero interest rates for more than 5 years.  Is this easy money?  If so, how much longer until the high inflation arrives?  If rates stay near zero for 2 more years, and inflation stays low, will you still call it easy money?  How about 5 more years?  Ten more years?  Twenty? (Sumner 2014)

It is a key tenet of Market Monetarist thought that a low base rate or Fed funds rate is no indicator of whether money is ‘easy’ or not[1]. The correct indicator, they argue, is the growth rate of nominal GDP; if it’s slumping money is too tight, if it’s roaring on it’s too loose, and if it’s ticking along at some predetermined rate all is rosy in the monetary garden. As a result of this analysis Market Monetarists like Sumner believe the Bank of England’s low base rates and vast monetary base expansion do not indicate ‘easy money’. Are they right?

Well, first we have to define what we mean by ‘easy money’. It’s a rhetorical term rather than a textbook one so here’s my definition (which, if you don’t accept it, probably scuppers the following analysis so feel to substitute your own); money is ‘easier’ the more people who want credit can get it[2].

There are two points to make. First, the choice of ‘credit’ rather than ‘money’ is deliberate. When most of us ‘borrow money’ we are, in fact, accessing credit which is some derivative of, or claim on money. Secondly, a point I’ve made previously (Phelan 2013), economy wide aggregates often tell us little of interest or use. Often more useful and interesting is to disaggregate. Instead of looking at the availability of credit to the British economy look instead at the availability of credit to different bits of it.

Looked at like this we would have to say that for most businesses and individuals in the UK, despite the tripling of the monetary base since March 2009, credit is not easily available and money cannot be said to be ‘easy’. The most recent Bank of England lending report in January noted that “The rate of decline in the stock of lending to UK businesses eased slightly in the year to November compared to 2012. The annual rate of growth in the stock of secured lending to individuals rose slightly to 0.8% in the three months to November” (Bank of England 2014) –November’s fall in business lending being the biggest in six months.

But banks certainly do have ‘easy’ money. That tripling of the monetary base, as I wrote recently (Phelan 2014), has flowed onto their balance sheets and stayed there. The money multiplier has collapsed and growth of base money, M0, has not led to growth in broader monetary aggregates such as M4, which would influence nominal GDP. The open handed stance of the Bank of England isn’t showing up as ‘easy’ money as Market Monetarists see it because ‘easy’ money for banks isn’t translating into ‘easy’ money for the rest of the economy[3].

Do we have easy money? On my definition that depends on who ‘we’ is. Banks face little constraint on their ability to access credit from the Bank of England so for them the answer is yes. The rest of us who rely on those banks find it rather tighter.

References

Bank of England. 2014. “Trends in Lending” January.

Friedman, Milton. 1998. http://www.hoover.org/publications/hoover-digest/article/6549

Phelan, John. 2013. “Output gaps and heterogeneity.” Accessed March 6th.

http://www.cobdencentre.org/2013/11/output-gaps-and-heterogeneity/

Phelan, John. 2014. “Britain’s inflationary outlook.” Accessed March 6th.

http://www.cobdencentre.org/2014/01/britains-inflationary-outlook/

Sumner, Scott. 2010. “Milton Friedman vs. the conservatives” Money Illusion, August 24th.

http://www.themoneyillusion.com/?p=6564

Sumner, Scott. 2014. “How much longer?” Money Illusion, March 3rd.

http://www.themoneyillusion.com/?p=26274


[1] Sumner (2010), for example, draws on Friedman’s analysis of Japan in the 1990s (Friedman 1998)

[2] For fans of mathematical notation, if E is monetary ease and C is availability of credit then E=f(C)

[3] If we think of a river, with M0 pouring out of the spring at Threadneedle Street and the broad delta downriver being M4, banks’ demand for money has built a big dam stopping the river flowing. The Market Monetarist solution to this is to get the spring pouring out enough money that it flows over the top of this dam – in Quantity Theory notation to offset the decline in V stemming from banks’ increased money demand (which with downwardly sticky P would pull down y) with sufficient expansion of M

Output gaps and heterogeneity

What shape is the Short Run Aggregate Supply (SRAS) curve? The question might sound tediously esoteric but it is, in fact, central to current economic policy debate.

In the long run almost all economists agree that the supply curve is vertical. The quantities of factors of production (land, labour, capital) available at a given time are fixed and even combined in the most efficient way can yield only a given amount of output. In this long run analysis the only way to increase the supply of goods and services available, the essence of economic growth, is to shift the vertical supply curve to the right by either increasing the amount of productive factors, or increasing the efficiency of their combination (their Total Factor Productivity).

Some economists think this also applies in the short run. As a result they argue that any attempted expansion of demand via monetary or fiscal policy, shifting the demand curve to the right, will simply result in rising prices. Output and employment will be unaffected.

But does it actually apply in the short run? After all, we see many factors of production lying idle. Unemployment, at 7.7%, is higher than at any time between January 1997 and May 2009. 14.1% of shops were empty in September according to the Local Data Company, barely down from 14.2% in February. Here we are in the ‘output gap’, the difference between current output and what output would be if all those unemployed workers were put to work in all those empty shops.

Couldn’t monetary stimulus bring these unemployed workers and empty shops together to increase employment and output without causing inflation? Monetary expansion will not cause higher prices, on this thinking, because rather than bidding up the wages of workers already employed or rents of commercial premises already occupied, the idle ones will be employed instead. That is what Bank of England governor Mark Carney sees when saying that monetary stimulus will continue at least until unemployment falls to 7%. Isn’t this the economist’s hitherto mythical ‘free lunch’?

A problem with this approach is that it views the factors of production as largely homogenous. Every square foot of empty commercial property, whether boarded up corner shop or out-of-town retail unit, is lumped in with every JCB as ‘capital’. All unemployed workers, whether builders or estate agents, are aggregated as undifferentiated slack in the labour market. What this approach misses, as does much clumsy, aggregative, ‘modern’ macroeconomics, is heterogeneity.

As economist Benjamin Powell points out, “A tractor is not a hammer”. An economy experiencing a tractor boom may find itself with a glut of unemployed tractors when that boom busts. Hammers, on the other hand, would be relatively scarce. As a result the returns on employing each capital good, tractors or hammers, will differ.

Any monetary stimulus attempting to bring these tractors back into employment will not be confined to spending on tractors. Some, probably most, will be spent on hammers which are not currently idle and whose supply will not expand to accommodate this new ‘demand’ immediately. It will simply bid up hammer prices. And if hammer supply does expand, that expansion will be revealed as an unsustainable malinvestment when the monetary stimulus is withdrawn.

And, a tractor not being a hammer (capital goods being heterogeneous in other words), they are not substitutes. An increased demand for one from monetary stimulus need not result in a proportionate increase in demand for the other. Those idle tractors will remain idle as the hammer boom takes off.

Just as a tractor is not a hammer, Mesut Özil is not Miley Cyrus; labour is also heterogeneous. If the economy had overinvested in midfielders during a singing bubble and there were now too many to gain employment as such in a sustainable pattern of demand, any monetary stimulus designed to get these guys back to work would begin driving up the wages of relatively scarce twerking pop stars before a substantial number of those midfielders had found employment.

Those footballers, like the tractors, do not represent ‘slack’ waiting to be picked up by a few more dollars. They are just dead capital and unsuitable labour, the product of malinvestments.

The lesson is that there is no single Short Run Aggregate Supply curve for the ‘the economy’. In each example above, at a given point the SRAS curve for tractors and running backs was horizontal while those for hammers and pop stars were vertical. Attempts to drive the economy along one aggregated economy-wide curve towards full employment will hit choppy waters sooner than monetary policy makers, with their crude view of a few macro variables, think. They might find they have less room for manoeuvre than their models tell them.

This article originally appeared at The Cobden Centre

No money down

It is famously said that a butterfly flapping its wings in Brazil can cause a hurricane on the Florida coast. But how did mortgage defaults in the United States lead to queues around the block outside banks in this country?

Back in 2001 the American economy was reeling under the double blow of the bursting of the dot com boom and the September 11th terrorist attacks. In order to keep the economy buoyant, the Federal Reserve cut interest rates 13 times between 2001 and June 2004 in an effort to boost consumption and prompt the US to spend its way out of the nascent recession. By December 2001 the Federal Funds rate was down to 1.75%.

Interest rates are simply the price of money. A 5% annual interest rate on a loan of £100 will mean that you will eventually pay back £105 if you pay it off at the end of the year. And, as interest rates (the price of money) fell, people suddenly found they could afford loans. These keen borrowers found eager lenders.

The lenders had a brand new way of working. Traditionally they could loan someone money to buy a house and they would have kept the house as collateral. Now, they sold the debt on the debt market to, let’s say, Third Party Inc. In essence, the mortgage repayments would now be going to Third Party Inc and, in the event of default, Third Party Inc would repossess the house and sell it in order to make back its initial outlay. These bundles were known, among other things, as Collateralised Debt Obligations (CDO’s).

But that wasn’t all. Third Party Inc could take this debt and package it with another one. The idea was that this would insure one with the other in the event that it ever turned sour. Risk spread was supposed to be risk lessened.

Sadly, these derivatives were less like steel rivets spreading the load through the structure of a building, and more like the cracks in a dam ready to burst. Back in 2003, Warren Buffet called them “financial weapons of mass destruction”. Nevertheless, the trade in these derivatives boomed as they were packaged and repackaged, sold and resold, and they shot through the global economy like shrapnel.

The insatiable appetite for more debt to be repackaged and resold led lenders to look to people with bad credit histories, who, with interest rates so low, could afford to take the debt on. This was the now infamous ‘sub prime’ market. And as new borrowers with cheap credit flocked into the market house prices boomed. In 2004-2005, five US states recorded house price rises of more than 25%.

But then the sub prime market dried up. Interest rates were now on the way up and borrowers were unable to keep up repayments. Defaults rocketed and lenders suddenly found themselves in possession of houses. The lenders tried to sell these homes to recoup the original loan but found that, with the cost of borrowing rising, new borrowers had been priced out of the market. This sudden rush of repossessed homes coming onto the market coupled with a reduction in potential buyers caused the value of the lenders assets to tumble. In parts of the US a house is cheaper than a new car.

Like a game of pass the parcel, the music had stopped and banks all over the world were anxiously unwrapping their CDO’s to see who was holding a portfolio of worthless bungalows in Florida or Michigan.

This was the credit crunch. Banks were no longer sure if the other banks were prime or sub prime and became reluctant to lend to each other. From August, when the squeeze began, the Interbank rate, the interest rate which banks charge each other, leapt by 75 points in four months. Money stopped flowing and credit dried up.

When the bottom was reached and banks sat, shocked and surrounded by torn parcel paper, the losses were posted. Merrill Lynch: $7.8 billion, JP Morgan: $1.3 billion, Citigroup: $9.8 billion, Morgan Stanley: $9.4 billion…

But how did the flapping butterfly, unable to meet its mortgage repayments or lend money to its fellow banks, lead to the hurricane which swept through Britain leaving desperate queues outside banks, a potential liability of £3000 for every British household and a nationalisation in its wake?

Traditionally people deposit money with banks who would then lend it out charging interest. Northern Rock had hit upon a different idea. Instead of limiting their lending to an amount backed by deposits, they funded their mortgage loans by borrowing on the money markets. For a while it worked and Northern Rock’s profits soared.

But when, in August, the credit market seized up, Northern Rock ran out of cash. In desperation, the bank went to the Bank of England on September 13th to ask for an emergency loan. With the credit market in a coma it looked as though other banks would soon be in the same situation. Their share prices began to fell, that of Alliance and Leicester providing a notable source of worry.

Were back at the creaking dam metaphor again. With a banking crisis in the offing the government piled in to prop up Northern Rock. But the law of unintended consequences came into play as Rock’s depositors took this government intervention as a sign that the bank was doomed. They began withdrawing their savings no matter how long they had to queue.

Thus, the government was called on to lend more and more. They desperately sought a buyer for the stricken bank which would guarantee repayment of the massive sums lent. However, due to the ongoing credit crunch, no buyer could afford to borrow the money to finance a takeover. The government, the taxpayer, you and me, were left holding the baby. By mid January the treasury had spent £55 billion to shore up Northern Rock. Compare this with the annual defence budget of £33 billion.

On February 17th the government gave up its forlorn search for a buyer who would take Northern Rock off its hands and nationalised it. The aim is to run the bank until a private sector buyer can be found. To do this, the bank will have to be running at a profit so as to attract buyers and this means that the government will be competing for market share with other banks. One wonders how shareholders in these other banks will feel now that they are subsidising a competitor since we all became shareholders in Northern Rock.

There is no telling how long this period of government ownership will last as a falling housing market makes mortgage lenders, such as the Rock, a bad investment. In the 1960’s and 1970’s the British government nationalised many struggling businesses in order to keep them going, such as Rolls Royce and even a brewery, but they often found themselves lumbered with them for the long term. Also, we now have the unpleasant prospect of the government, as owner of Northern Rock, having to evict home owners who fall behind with repayments.

What are the prospects in this grim panorama? In a situation like this, government can typically use either fiscal policy or monetary policy. In this instance, monetary policy would mean the lowering of interest rates with the hope of cutting the price of money and getting people borrowing and spending again. Fiscal policy would mean tax cuts with the aim of increasing people’s disposable income and prompting them to get back into the shops or estate agents.

The US has followed an aggressive fiscal policy. On February 13th the US Congress, with uncharacteristic speed, passed $168 billion worth of tax cuts and investment incentives, about 1% of GDP, in an effort to pump cash back into the economy.

This is not without risks. George W Bush inherited a budget which was in surplus to the tune of $236 billion but has seen this transform into a deficit of $286 billion. The US has got away with this profligacy thanks to the willingness of much of the rest of the world to hold dollars. But, as the US continues to splurge currency around the planet, these dollars are worth less and less. Soon, countries such as China and the Gulf states will begin to question whether they are content to hold onto an asset which is falling in value. The tax cuts are only likely to accelerate this process.

Gordon Brown and Alistair Darling may have even less room for manoeuvre. Despite his reputation for prudence, Gordon Brown has overseen a budget surplus of £14 billion in 2001 turn into a deficit of £43 billion in 2007. As demonstrated by the recent dispute over Police pay, the governments’ tight finances leave it with little room to cut taxes without pruning services further than already planned.

America and Britain have also gambled on an active monetary policy. America’s Federal Reserve has been on its biggest interest rate cutting spree in 25 years and rates have now fallen by 2.25% since the August crunch to just 3%. The Bank of England has gingerly followed suit with rates cut from 5.75% to 5.25% between August and February.

The problems with this are obvious. It was a glut of cheap money which started this whole process in the first place and we are right back to where we started. Besides, with the Fed cutting rates from what was already quite a low level, it has to be asked just how much more scope there is for further cuts. With inflation at a little over 2%, interest rates of 3% are barely positive as it is.

In Britain monetary policy runs into problems of inflation. As interest rates are cut more money flows into the economy. Yet, unless there is a corresponding increase in output, this money will be chasing relatively scarcer goods and inflation, or the rate at which prices rise, will increase.

The Treasury has long fiddled the figures on inflation by using the Consumer Price Index as a measure which leaves out spending on things, like mortgages and Council Tax, which have been rising fastest. Whereas CPI has inflation running at 2.1%, the broader Retail Price Index has it at 4%. A survey of British workers, which showed their expectations of inflation in the coming year to be 3.3%, suggests that the RPI might be nearer the mark and that the Chancellor has less room for manoeuvre than may be apparent.

But saviours may be ready to ride over the horizon, only they will be wearing Arab robes and Chinese sandals, not suits of armour. For decades the west, and the US in particular, have been spending more money than they have coming in. As a result countries all over the world have found themselves sat on vast reserves of foreign currency. Now deployed by governments as instruments of economic policy, they have become known as the sovereign wealth funds. Since August last year these funds, valued at around $2.9 trillion, have injected $69 billion into western banking.

Whether this is a good or a bad thing depends on how you feel about Globalisation. Though there is a certain irony in the rich world being bailed out by its developing neighbours, it does at least show that economic muscle is not as concentrated as it once was.

But while this welcome cash may be a good short term fix, it is not a long term proposition. The sovereign wealth funds are funded by savings, like the 40% of GDP which the Chinese have saved up. But, as these countries become more affluent, their people are going to want a more affluent lifestyle and this means they will have to save less. As the Chinese decide to eat more of the meat or wear more of the designer clothes their rising incomes can now buy them, the sources of the sovereign wealth funds riches will shrink. This bail out may well be a one off event.

Ultimately, whether it is monetary or fiscal policy or the unknown quantity of sovereign wealth funds, this is a problem caused by an excess of cheap money being solved with another dollop of cheap money. A line from Alice in Wonderland seems all too appropriate for this story; “That’s the reason they’re called lessons,’ the Gryphon remarked: ‘because they lessen from day to day’”