The recent bad news on the jobs front in the United States - where unemployment remains stubbornly above 9 per cent and the latest data showed that job creation had stalled - has made the likelihood of further quantitative easing (QE) a racing certainty. The Federal Reserve is being forced down this route because the US economy requires more stimulus and, with interest rates at rock bottom, the price of money cannot be lowered. The central bank has little choice other than to raise the quantity of money. There are no ifs; the most pressing question is: when? And by how much? And of what type?
I have argued for some time that the Fed will start QE at its meeting in early November, so long as the data continues to get worse, as
I suspect it will. And yet, even then, the Fed's room for manoeuvre is limited, given that it can only acquire assets that are federally insured. Should it want to buy private-sector assets, it would need the permission of a dysfunctional Congress; the chances of that succeeding are zero. That leaves three realistic options: it can buy government bonds, mortgages backed by government-mandated Fannie Mae and Freddie Mac, or short-term municipal bonds.
There is a possibility that the Fed will start first with "Operation Twist" by selling short-dated treasuries and using the proceeds to buy long bonds. The aim is to flatten the yield curve and lower long-term interest rates, which would act as an economic stimulus. It would be a smart thing to do as part of the programme for QE3.
Battle of the QEs
Which brings us nicely to the UK, where the economy is slowing - witness recent indicators of consumer confidence and purchasing intentions, as well as rising unemployment. Even the minister for planning, Greg Clark, addressing the House of Commons on 5 September, conceded that the UK faces a "crisis of growth". Data from Eurostat published on 6 September showed that the UK ranked 25th out of 27 countries for GDP growth over the past 12 months, beating only Romania and Portugal.
Given that the government doesn't appear to have a plan B, it is left to the Bank of England's Monetary Policy Committee to act, especially as the Fed is poised to make a move. We are now in a world of competitive QE, and the MPC has to act to prevent the US gaining an advantage by further depreciating its currency against the pound. So it looks like Adam Posen of the MPC has been right all along and there will be more QE. My guess is this will happen at the MPC's October meeting, though there is some reasonable prospect that it could come even sooner, possibly on 8 September, after this magazine has gone to press. Either way, a further £50bn of asset purchases will be announced in the first instance. And that may be just the start.
But the big issue, as in the US, is: what type of assets should the MPC buy? In principle, it has an advantage over the Fed that it should exploit - it can buy private-sector assets. My suggestion is that it directly fund lending to small business, so-called "credit easing", rather than carry out further quantitative easing.
The Bank of England's latest Trends in Lending report shows that the stock of lending to UK businesses contracted by roughly £4bn in the three months to May. The decline was driven mostly by falls in loans to small and medium-sized enterprises. Larger companies, the Bank noted, "have wider access to funding sources than smaller companies, such as through the syndicated loan market and capital markets". By contrast, small firms have struggled to get financing; I have heard numerous stories of small business owners not going to see their banks for fear of additional charges being imposed and existing credit lines being lowered, or even removed.
There is mounting evidence that when capital constraints are lifted, such small and medium-sized businesses can grow rapidly. Monetary policy can offset not just fiscal contraction, but also existing banks' recapitalisation, by creating much-needed credit. Extending loans to small business is likely to give a substantial return.
The simplest way to do this would be for the Debt Management Office to issue a securitised bond of £25bn to start with, intended to provide small firms with loans at low rates of interest - say, 2 per cent - that the MPC would purchase directly. Loan applications could be sent to a new Small Business Administration (SBA) that would sit in the Department for Business, the Treasury, or even the Bank of England.
Another way would be simply to set up a small business bank, created with initial bonds funded by the MPC through its asset purchase programme. If it offered small-firm loans at low rates, the applications would flood in.
The precedent for an SBA already exists in the US. In the UK, it could allocate funds disproportionately to areas of high unemployment through agencies such as the Highlands and Islands Enterprise, the Scottish Executive's development agency, which knows the local economy well and dispenses grants and loans.
There are several other such agencies around the country which could help evaluate and distribute loans. Priority for receiving these should be based on the number of jobs that would be created. This idea has the added attraction that it provides small firms with an alternative to the banks, whose current fees are excessive because the banks lack competition.
This plan would help kick-start the economy, have a positive impact on growth and increase employment. Its attraction is that the money would be going to entrepreneurs - the makers - rather than to bankers, and it's likely to be hugely popular. So, go and do it, MPC.
David Blanchflower is the NS economics editor and professor at Dartmouth College, New Hampshire, and the University of Stirling