Britain's Secret Stimulus

After QE ended, the UK’s party finally got started. Photo by Chris Jackson/Getty Images.

The UK’s reacceleration continued in Q3, with GDP rising 0.8% q/q—the fastest in three years. All segments of the economy were positive for the second straight quarter—the first instance of back-to-back economy-wide growth since the recovery began, and without a drop of supposed “stimulus” in sight. It’s the latest example of the country’s post-quantitative easing (QE) improvement—a powerful but underappreciated precedent for the end of QE in the US.

The UK’s post-QE revival is barely even appreciated at home. Yes, many headlines welcomed the news, but plenty of skepticism exists. Some suggest, for example, Q3 growth was driven by construction (and, by extension, the “Help to Buy” program recently launched to jumpstart housing) and doesn’t reflect nationwide improvement. It’s true construction had the highest growth—2.5%—but the sector accounts for about 6% of the economy. The service sector represents nearly 80% of GDP and contributed the lion’s share of growth—0.57 percentage point, compared to construction’s 0.15 percentage point. And BoE Governor Mark Carney was quick to say the recovery “lacks traction.” In short, it seems fair to say, while folks might be a touch more optimistic, continued growth from here should have some surprise power.

Faster UK growth is gaining notice overall, but one crucial aspect of it isn’t: Namely, that it’s happening without QE. As we’ve written many times recently, QE isn’t stimulus—it’s an economic sedative. It flattens the spread between short- and long-term interest rates, weighing on banks’ potential operating profits (banks borrow short and lend long). This creates a disincentive to lend and weighs on money supply growth. If QE were true stimulus, broad money supply would rise, boosting growth throughout the economy. In the UK, it didn’t—broad money supply did grow at first, but it fell £153 billion between March 2010 and March 2012, then rose glacially after. GDP rose in fits and starts, contracting in 4 of 15 quarters.

The connection between the end of QE and faster growth should be too powerful to ignore. So why does no one connect the dots? One reason could be the continued fall in lending, which QE aimed to stimulate but didn’t. The rate spread has widened, but banks haven’t been able to take advantage since the BoE ordered them to implement Basel III’s 7% equity capital ratio by year-end—six years before the international deadline. Banks can’t lend if they have to hoard capital. Now, however, the BoE is finally giving banks some breathing room. Carney announced they can draw down liquidity buffers by about £90 billion, giving them the flexibility they need to lend more enthusiastically. Provided they take advantage, loan growth should pick up, giving the economy a long-absent tail wind.

The US today compares quite favorably with the UK last November, when QE ended there. For one, the economy has grown much more evenly, and the yield spread has already started widening as investors anticipate QE’s eventual end. Loan growth has also stayed positive, though lackluster, as banks have enjoyed a more favorable regulatory environment. The Fed has cracked down on banks like the BoE, but not as heavily. The US’s Basel III phase-in is more generous than the UK’s, and the few US banks that don’t yet meet the forthcoming standards have years to meet very small shortfalls. Simply retaining earnings should get them there—post-QE capital hoarding appears unlikely. Additionally, the US’s wholesale regulatory reform package (i.e., the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010) are over three years ahead of the UK’s, which is only now going through Parliament. US banks have already dealt with years of uncertainty and are now gaining further clarity—another factor supporting higher loan growth ahead. In short, if the UK was able to gain traction so quickly despite being on uneven footing when QE ended, imagine how well the US could do starting in a better place.

Except most folks can’t imagine this—they remain utterly convinced QE’s end will be just terrible for the US. Continued growth (never mind an acceleration!) would be a massive surprise to most—the sort of surprise stocks love.