Albert Einstein called it the eighth wonder of the world. Warren Buffett described it as a snowball rolling down a hill, picking up more snow until it becomes a massive snowboulder. It is, of course, compound interest, that mechanism whereby interest is paid on the interest accrued on a debt. It has brought the UK’s government finances to the brink of disaster, but ignorance of its power is widespread, and not only among serving politicians, but also at the Bank of England, where they should know better.
A devastating analysis by Christopher Mahon of fund managers, Columbia Threadneedle, published last week in The FT when we were distracted by the noise of Trumpeteering, demonstrates how the Bank screwed up Quantitative Easing. The current estimate of the lifetime losses borne by the taxpayer is £115bn. This almost unimaginable sum may even rise further – it was estimated at £95bn as recently as last September.
Mahon provides a cruel comparison with the European Central Bank and the US Federal Reserve, and the relative performance of the BoE can only be described as woeful. QE seems a long way away now, but the pain of its compounding effect is only just beginning. It was a desperate experiment for desperate times, when the threat of recession or worse was real, and a policy of central banks (effectively) printing money to buy in government debt was widely considered the best way to avoid it.
To that extent, the experiment worked, but not only did the Bank buy the wrong stocks, it carried on its policy of financial repression long past the point where some of us who can remember the 1970s were warning about the dangers of inflation and the misery it inflicts on society.
The wrong stocks
The UK gilts market hosts more long-dated stocks than any other. These provide a sheet anchor in inflationary times, but during QE the Bank was such a determined buyer that it bid up prices, depressing yields to little more than 1 per cent. Canny holders, with experience of long-term UK inflation, were grateful for the opportunity to sell at prices they would surely never see again. Once the magic of QE wore off, prices for long-dated stocks collapsed. The Bank was sitting on vast losses, and as inflation took off and QE was replaced by QT (Quantitative Tightening), some stocks slumped by two-thirds – a massive fall for a gilt-edged bond. The Fed, meanwhile, had bought in short-dated bonds, where the scope for losses from higher interest rates was much less.
The wrong time
At the peak of the QE madness, the Bank owned 37 per cent of all UK government debt. It had effectively replaced a large portion of the gilts market with cash and short-dated debt. The Fed was also an enthusiastic buyer of US treasuries, but it bought in only 19 per cent at its peak.
Of course, they were all doing it. According to Mr Mahon’s calculations, the on-line losses from the QE programmes at the European Central Bank total 1½ per cent of GNP. Those at the Fed amount to nearly 3 per cent. Those at the Bank are over 5 per cent of Britain’s gross national product.
This is destruction of wealth on a massive scale. In line with British tradition, nobody is to blame. Andrew Bailey was Governor then, and he is now. Some at the Bank foresaw the problem and arranged a government guarantee for any losses before embarking on QE, thus avoiding a central bank having to file for bankruptcy, but the losses end up with the taxpayer whichever way you cut it.
All central banks were too slow to start raising interest rates, but the Bank’s Monetary Policy Committee, to its shame, ignored the warnings and kept Bank Rate at 0.1 per cent for many months too long. Andy Haldane, the sole dissenter at the MPC, was ignored. He has since left the Bank.
Having grossly overdone QE, the MPC compounded the error by aggressive QT. It is one thing to buy in your bonds, since a seller can always be found. If you are the seller, then the buyers will see you coming and charge accordingly. The other central banks are allowing their QE holdings to mature – but then they had not made the mistake of buying in so many long-dated bonds in the first place.
Of course, the long-dated bonds still in the Bank’s QE portfolio can be held to maturity, 20 years hence. Yet this just disguises the size of the losses and reflects the fact that a pound today is worth far more than a pound in 2045. This is compound interest at work, but it seems that nobody inside the Bank, up to and including the Governor, really understood the eighth wonder of the world.