About the New Economics Foundation

The New Economics Foundation is a think tank formed in 1986 which aims to build a new economy where people are really in control. We have established a reputation as a leading civil society voice on financial reform and monetary policy.

We would be pleased to meet with Treasury Select Committee members to discuss further any of the issues raised in our response and would be delighted to have the opportunity to give oral evidence.
 

1. Background and context

The financial crisis of 2008 and the resulting recession refocused attention on the role of monetary policy in stimulating the economy. In order to review the interventions of the Bank of England in context, it is firstly important to review the process by which money is created and allocated in modern economies. This is essential to understanding the transmission of monetary policy but is often poorly understood and widely misrepresented.

1.1 Money creation in modern economies

In modern economies the majority of money takes the form of electronic bank deposits, or ‘demand deposits’. In technical terms, bank deposits are simply a number in a computer system; in accounting terms, they are a liability of banks to their customers.

The process by which bank deposits are created has long been a source of confusion. Part of this stems from a common misunderstanding of what banks do. A prevalent view among the general public, policy makers and some economists is that banks are financial intermediaries that take money from savers and lend it to borrowers. Another general view is that banks borrow central bank reserves from the central bank and then lend them out to the public. A third view is that banks can only lend a multiple of the reserves they hold. All these views are incorrect.

The reality is that banks create new money in the form of bank deposits when they make new loans. If someone takes out a new mortgage from a bank, the money is not taken from someone else’s savings, nor is it taken from the bank’s own reserves. Rather, the bank simply creates the money electronically via the keystroke of a computer and credits the borrower’s bank account with additional deposits. When banks issue new loans, they expand both sides of their balance sheet simultaneously, creating an asset (the loan) and a liability (the customer’s deposit in the bank account).[1]

As a result, the money supply increases when banks make new loans and decreases when loans are repaid as bank deposits are destroyed. A survey of the history of economic ideas reveals that this is anything but a new insight. The process by which commercial banks create money when they issue new credit was central to the thinking of prominent figures of the discipline such as Knut Wicksell, Friedrich Hayek, Irving Fisher, John Maynard Keynes, and Joseph Schumpeter, and was an integral aspect of theories on banking and money at the beginning of the twentieth century.[2],[3]

However, as the twentieth century wore on, banks’ main role was viewed as intermediating between savers and borrowers. They were not granted any privileged position in orthodox theories and models of the economy. As Figure 1 shows, commercial bank created deposits now make up 97% of all the money used in the economy.

Figure 1. Money supply in the UK, 1969–2015

Note: Money created by banks relates to quarterly amounts outstanding of UK resident monetary financial institutions' sterling M4 liabilities to the private sector excluding intermediate OFCs (i.e., other financial corporations), seasonally adjusted.

The remaining money that circulates in the economy is cash – the £5, £10, £20, and £50 notes and the metal coins that most of us have in our wallets at any time. Central bank reserves are the third type of money – these are an electronic form of money created by the Bank of England. Unlike cash, however, members of the public cannot access or use central bank reserves. Only high-street and commercial banks, building societies, and a small number of systemically important financial institutions that have accounts with the Bank of England can use this type of money. A commercial bank must hold sufficient reserves to meet the demands of the general public for physical cash which, as described earlier, the Bank of England provides in exchange for central bank reserves.

Commercial banks also use central bank reserves to settle payments with other banks at the end of each day. Whenever payments are made between the accounts of customers at different commercial banks, they are ultimately settled by transferring central bank money (reserves) between the reserves accounts of those banks.[4] However, because there are only a few major banks, in any given day it is highly likely that there will also be a similar number of transactions going the opposite way. As a result, most of the transactions cancel each other out on aggregate, and only a small amount of central bank money is needed to settle the difference between banks at the end of each day. So there is no ‘money-multiplier’ type relationship between the amount a bank can lend and its holdings of central bank reserves (compulsory reserve requirements were abolished in the UK many years ago). Nevertheless, as will be discussed below, central bank reserves play a key role in the operation of conventional and unconventional monetary policies.

1.2 Conventional monetary policy and central bank operations

The objective of modern monetary policy is price stability, often defined as a low and stable rate of inflation. The Bank of England is tasked with keeping inflation at 2 per cent over the medium term. Sometimes broader macroeconomic goals are included, for example the Federal Reserve has the twin objectives of achieving maximum employment and price stability.

Before the financial crisis monetary policy was conducted primarily through adjustments to the interest rate that commercial banks had to pay to borrow central bank reserves. This rate of interest is referred to as the ‘bank rate’ or ‘policy rate’. The Bank of England is able to manipulate this interest rate by controlling the supply of (and demand for) central bank reserves via so-called ‘Open Market Operations’ (OMOs). This is where the Bank of England purchases (or sells) assets – usually government bonds – from the commercial bank in exchange for newly created central bank reserves[5].

It is through this process also that the Bank of England conducted its quantitative easing (QE) programme. The difference with QE is that the asset purchases were on a much larger scale and that the bank set up a separate vehicle – the Asset Purchase Facility (APF) – to hold the gilts. As the Bank of England itself has noted:

“There is nothing unusual about central banks purchasing assets per se… QE is just a return to the classic policy operation of the textbook: an open market operation. The only things that distinguish the present operation… are the circumstances under which they are taking place and their scale.” [6]

The rationale for conducting monetary policy through the manipulation of interest rates is along the following lines: when the central bank believes that the economy is heating up, it will raise base interest rates to reduce demand for new bank loans, which in turn will dampen economic activity. Conversely, if too little economic activity is taking place, the Bank of England will lower the bank rate on the basis that, since interest rates are the driving force of economic activity, this will stimulate demand for new bank loans and thus economic growth.

This theory is contested and there is evidence that interest rates tend to follow, not lead, economic growth.[7] [8] In addition, the theory rests upon the assumption that there is a ‘natural rate’ of interest under which the credit market will always clear and if the central bank can nudge the market towards this this will maximise output whilst retaining price stability. In fact, empirical evidence suggest that banks regular lend below a market rate of interest that would truly reflect the risk of a loan and instead require collateral to de-risk loans and quantity ration borrowers unable to provide such collateral.[9] For the borrower, interest rates are just one of many factors that businesses and consumers consider in their decisions around whether to borrow and invest. Of particular importance is confidence in the prospects of the wider economy – in other words aggregate demand may play an important role as well as supply.

Nevertheless, even if we accept the theory, a problem arises when interest rates have been lowered so many times – and without the desired effect – that they approach zero. The same economic theory would then suggest that interest rates would need to fall below zero, becoming negative – in effect punishing banks for holding reserves with the central bank by requiring them to pay a fee. This is widely described as interest rates ‘reaching the zero lower bound’. In such a situation, commonly termed a ‘liquidity trap’, the core mechanism of monetary policy becomes ineffectual.

2. UK monetary policy since the financial crisis

In January 2009 the Bank of England, together with the Treasury, created a new vehicle for carrying out the QE programme of assets purchases – called the Asset Purchase Facility (APF). When the MPC takes a decision to conduct more QE, the Bank of England creates new electronic central bank reserves and lends them to the APF by simply adding these numbers to the APF’s account. It is important to note that the Bank of England has made a loan, and that the intention is that at some point the loan will be repaid and these new reserves will be withdrawn from the economy. For this reason the phrase ‘printing money’ is very misleading as it implies the permanent creation of new interest-free money, not the temporary creation of money through making a loan at interest. In this sense, the Bank of England is no more printing money than a commercial bank such as HSBC is when it extends credit to its customers.

2.1  Understanding quantitative easing (QE) in theory

The process is best understood as follows: the Bank of England makes a loan to the APF which uses this to purchase gilts from the non-bank investment sector, such as from a pension fund. The pension fund’s holdings of gilts are reduced, with a corresponding increase in its holdings of commercial bank deposits. This is a change in the composition of the portfolio of assets in the pension fund, with no change to its liabilities and no change in the total size of the investors’ balance sheet. The pension fund’s bank gains additional central bank reserves from the APF on the asset side of its balance sheet and a matching increase in deposits on the liability side as it credits the pension fund’s bank account.

In summary, the new money (bank deposits) created through this process is now in the hands of the pension fund. QE as practised by the Bank of England creates new bank deposits for investors in the capital markets. But, as we shall see, these deposits will only translate into increased demand in the economy if they feed through to GDP-related transactions.

Figure 2 shows how QE could or should affect the economy. The blue boxes (and corresponding arrows) are intermediate steps where the outcome is indeterminate. The Bank of England is ultimately interested in achieving the outcomes in the green boxes – they all involve the creation of new GDP transactions and hence GDP growth. However, such outcomes are uncertain and it would appear just as likely, if not more so, that the red outcomes have occurred, given the current economic conditions. There are three main channels through which QE is thought to impact on the economy the portfolio rebalancing channel, the bank lending channel and the wealth channel or ‘wealth effect’ (Figure 2).

Figure 2: The effect of QE on the UK economy

The bank lending channel

As commercial banks hold significantly higher levels of central bank reserves as a result of QE, it is possible that additional liquidity and reduced cost of funding will enable banks to increase their lending to the real economy, creating credit for new GDP transactions. David Miles, a member of the MPC, in a speech in October 2011, stated that:

“When the Bank of England purchases gilts owned by non-banks, all else equal, banks’ deposits rise as do reserve balances at the central bank. To the extent that a bank’s reserve holdings would then come to exceed its demand for liquidity, it is likely to be more willing to expand lending. Or, if a bank had already lost some of its other funding, it might be able to avoid a contraction in its lending or a sale of less liquid assets.”[10]

The first phase of QE in 2009, when £200 billion was injected in the space of just six months, may have supported bank lending, or at least prevented a further fall in credit creation, although the Bank of England has played down this effect in its analysis. A number of other schemes aimed more directly at improving banks’ balance sheets were also underway at the time, including the Government guaranteeing bonds issued by the banks (the credit guarantee scheme), the SLS, and the partial nationalisations of RBS and Lloyds via massive tax-payer funded re-capitalisations. These interventions would appear to support the banking system more directly and hence prevent further contractions in lending.

Either way, the impact of expansion of central bank reserves on credit creation, is indirect and dependent entirely on banks’ confidence. Their overall effect is likely to be limited, simply because banks were already holding excess reserves before the policy was adopted. As discussed earlier, central bank reserves cannot in total be reduced by banks ‘lending the money’ – banks create new credit when they lend, for which they do not need reserves, and the reserves at the central bank cannot in aggregate be reduced by banks via any action of their own. Thus, in aggregate, banks must hold these large reserve balances.

The portfolio rebalancing effect

The Bank of England has placed the most emphasis on the impact of QE on changes in investors’ portfolios. As shown in Figure 2, the process is somewhat drawn out. Purchase of gilts from financial investors by the APF creates new deposits for those investors. The increase in central bank reserves (narrow money) has led to an equal increase in bank deposits (broad money). The important question for assessing the macroeconomic impact is what they will do with these deposits. The theory is that this ‘shock’ to their portfolio will lead to investors rebalancing their holdings by seeking out similar kinds of financial assets. They may want to do this for a number of reasons.

First, government bonds, particularly longer dated gilts (e.g. 10 or 25 years) will have a higher rate of return than deposits. Secondly, certain kinds of investors, in particular pension funds, will want to hold assets of longer maturity than deposits as they have correspondingly long-dated liabilities[11].

The hope is that investors will switch instead to corporate assets – bonds or equities (shares) – that will in turn support businesses operating in the real economy. However, investors have other options, as shown in the red boxes:

• They may choose to switch into foreign government bonds instead. Buying foreign government debt will likely push down the value of sterling. This is could be seen to be indirectly beneficial to the real economy in terms of making exports more competitive and the Bank has on occasion pointed to the fall in sterling as a positive outcome of QE.
• They may simply buy existing corporate securities from other investors rather than newly issued securities from companies. Only in the latter case, known as the primary market, will companies receive more funds and this is only a fraction of the overall turnover of capital markets. We examine the impact on corporate investment later.
• They may choose to invest in derivatives based on commodities such as oil or food, which will have the effect of inflating the prices of these assets.
• They may in the end choose to hoard deposits, in which case the newly created money will have made no contribution to GDP whatsoever.

Let us assume that investors choose to purchase newly issued corporate assets. This will bring down the cost of issuing new equity or bonds for firms and mean it is likely they will be able to access more finance. However, it is then up to the firms to decide what to spend this new money on. It will only contribute to GDP transactions and growth if it is invested in new production. In the current environment, it appears many large firms lack the confidence to invest and are happier just sitting on cash.

The wealth channel

An additional potential consequence of portfolio rebalancing and increased lending against asset prices is known as the ‘wealth effect’. As investors buy more equities this should push up their price, meaning holders of these assets will feel wealthier. They may choose to invest this additional wealth in consumption which would contribute to GDP growth (although it may not help the trade deficit if it involves buying goods that are imported).

However, again it is not clear that asset holders will do this. They might just buy other kinds of existing assets or save the money. Academic research shows that wealthier individuals tend to be less likely to spend any additional income on consumption[12]. Furthermore the impact on consumption for any consumer will depend on whether they feel it is a long-term or merely a short-term improvement in their economic position, and how the current increase in wealth affects their confidence about their future financial prospects. It is also possible that banks, which also hold assets, will also feel a ‘wealth effect’ because the value of their capital will rise. They may then pass on this effect via charging lower rates of interest[13].

2.2 Assessing QE in practice

Attribution issues arise when it is not possible to isolate the impact of one among many different causal factors. A number of other interventions occurred at the same time as QE: a historically unparalleled drop in interest rates, a massive increase in government spending as well as the liquidity and recapitalisation policies. Other countries – the USA, Japan, and the Eurozone in particular – were also undertaking QE-type policies meaning there were likely to be liquidity spill-over effects, in particular given the internationalised nature of the UK economy.

The counterfactual problem is that we can never know what would have happened if we had not carried out QE, so we can never truly know its impact. We can only observe how the economy has changed. QE was initiated during extraordinary economic times – with output and bank lending and confidence in stock-markets collapsing in a fashion not seen since the Great Depression.

Finally, whilst analysis of changes in financial markets (asset prices, risk spreads) is fairly amenable to direct observation, this is less true for broader macroeconomic impacts where significant time lags may be present. It may be for the latter reason that the vast majority of empirical studies of QE, both in the UK and internationally, have concentrated on the impact of QE on changes in financial markets. Such studies have been criticised for missing the point; since the ultimate objective of QE was to boost nominal GDP and inflation, measuring such intermediate variables appears not very useful.[14] [15]

Effect on gilt yields

QE does appear to have contributed to a lowering of medium- and long-term government bond rates[16] [17]. The Bank of England estimates that QE phase 1 reduced long-term gilt yields by around 100 basis points[18].

However, econometric studies suggest these effects may only have been temporary and had most of their impact in the first round of QE in 2008/2009 at the height of the crisis[19]. For later actions, it is particularly difficult to disentangle this effect from international dynamics that may affect foreign investors’ desire for UK bonds. Most obviously, the problems in the Eurozone have undoubtedly made gilts unusually attractive relative to Eurozone sovereign debt. Subsequent QE interventions might also appear to have had less of an impact because markets had already ‘priced in’ their probable occurrence. This ‘signalling channel’ – whereby the Bank of England makes its intention to buy up sovereign debt in large quantities – is inevitably likely to be stronger the first time the intervention was practise.

Effect on price of corporate assets

QE purchases of gilts appear to have helped boost equity prices. Bank of England research estimates that UK QE1 boosted equity prices by around 20 per cent[20]. Again, however, it is difficult disentangle international effects.

The bank lending channel

Initial large-scale QE purchases helped to improve bank liquidity. The inter-bank rate did fall significantly during the first phase of QE, suggesting the flood of liquidity restored the banks’ confidence in each other. However the problem is that whilst this increase in liquidity may have prevented a more severe contraction in lending, it has not stopped the contraction completely.

As can be seen in Figure 3, lending to businesses generally and SMEs in particular has only just got into positive growth territory, eight years after the financial crisis, and remains well below historical averages. In other countries, including the United States, lending to firms recovered much more quickly or did not plummet at all. This is despite a number of different subsidies offered to banks to subsidise SME lending, including Project Merlin and the Funding for Lending Scheme. Banks’ SME lending is also highly regionally unbalanced, with around a third going to London and the South East (compared to just 3% to the North East and 5% to Wales)[21].

Figure 3: UK bank lending by sector (12-month growth rate), 2003–2015

Source: Bank of England Interactive database, codes LPMB4TC, LPMVTYI, LPMVWNU, RPMZ8YT

Impact on government debt

There is fairly widespread agreement that QE has bought down the interest rates on government debt (gilts). Even if this did not stimulate purchases of corporate assets, it can still be seen to have had a beneficial macroeconomic effect for the UK in terms of reducing interest payments that might otherwise have been made to overseas investors in government debt. However, it might be argued that the potential impact on aggregate demand of reducing the government debt were not effective because of the austerity policies of the Coalition government.

Distributional impacts of QE

QE has important distributional effects. It supports asset prices, including equities (shares) and house prices and thus helps people who hold such assets – mainly richer and older parts of the population. Keeping interest rates very low also hurts savers and makes pensions more expensive. And keeping inflation above real wages hurts workers. So QE should not be seen as a ‘neutral’ intervention by the Bank of England. The Bank of England, in testimony to the Treasury Select Committee, calculated that the value of shares and bonds had risen by 26 per cent – or £600 billion – as a result of QE, equivalent to £10 000 for each household in the UK[22].

However, the distribution of such assets among households is extremely uneven in the UK, with 80 per cent of financial investments (excluding pensions and property) concentrated in those over the age of 45 and 40 per cent in the wealthiest 5 per cent of the population. At a time when fiscal policy is disproportionately affecting the poorer sections of society as the Government cuts benefits and public services, this huge boost to the wealthiest segment of population via monetary policy raises serious concerns; we suggest it calls into question the validity of the distinction between ‘redistributive’ fiscal policy and ‘neutral’ monetary policy.

Risks posed by QE

QE, as currently practised by the UK and other countries, carries with it a range of risks and unintended consequences. Most obviously, there is a danger that QE artificially inflates the value of certain assets, in particular equities and commodities. Deprived of government debt, investors’ search for yield may become increasingly detached from market fundamentals. The huge rise in equity prices since 2009 needs some explanation given the global economy has been in a slump, unemployment is rising and many developed economies have been cutting back on government expenditure. The combined effects of large-scale asset purchases by western central banks appear to provide it.

International financial institutions, including the World Bank, the International Monetary Fund (IMF), and the Bank of International Settlements have expressed concern about this phenomenon in recent times[23] [24]. They have also pointed to the potentially destabilising effect on developing countries as investors flood currency and commodity markets with QE funds. The IMF stated that:

More generally, effects on Emerging Market Economies can be destabilizing if amplified by market imperfections and relatively shallow markets. The limited ability to absorb capital and the tendency to trade on short-term trends can cause excessive currency appreciation and volatility, unsustainable credit expansion, and asset price bubbles (including in commodities, especially those held as assets, like oil). These could eventually undermine financial stability.

There was a large financial outflow from the UK following the first round of alongside major inflows in developing countries – in particular East Asia and the Americas – suggesting investors were using the funds to buy up assets in these countries.

4. The prospects for monetary policy

Clearly there are major side effects and risks associated with QE. However, central banks maintain that QE is only temporary and will be unwound when economic conditions normalise, thereby returning to conventional monetary operations of interest rate setting and inflation targeting. However, there are numerous reasons why a return to business as usual is not desirable.

4.1 Problems with interest rate setting and inflation targeting

As discussed above, 97% of the money in circulation is created by commercial banks and just 3 per cent by the central bank. Deregulation between the 1970s and 2000s has meant that the Bank of England now has little, if any, control of over commercial bank credit creation. Monetary policy, defined as control over the creation and allocation of money, would then appear to be mainly determined by the confidence of commercial banks that operate on the basis of market forces. 

As Figure 4 shows, since the mid-1980s bank lending has increased dramatically in the UK, but lending to business has not increased. UK banks prefer making loans that are secured against existing property or to other financial institutions rather than making loans that support productive activity. Today business lending makes up less than 10% of total bank lending whilst lending against real estate makes up close to 50% of total lending (figure 4).

This was the case for many years prior to the crisis, and rapid increases in mortgage lending has contributed towards a boom in house prices which are now nine times average incomes across England and Wales, and up to 20 times incomes in London and the South East.

Figure 4: Bank lending by sector 1986–2014

Source: Bank of England

Figure 5 shows bank lending divided in to four main categories as a % of GDP since 1963. Here we can see a huge growth in mortgage lending following the deregulation of the mortgage market in the early 1980s from 20% of GDP to 60% today. Although mortgage lending has reduced somewhat since the crisis, it remains at relatively much higher level than lending to non-financial corporations.  The very sharp rise in lending to the non-bank financial sector reflects a huge over-investment in financial securities, many of which we were related to real estate, in the run up to the crisis.[25]

Figure 5: Bank lending by broad sector as a % of GDP, 1963-2014

Source: Bank of England

Figures 4 and 5 do not appear to represent an efficient market allocation of capital unless we believe that favouring asset bubbles over productive investment is efficient. This calls into question the effectiveness of the principle underpinning modern monetary policy – that the creation and allocation of money is most efficiently left entirely in the hands of commercial banks that operate on the basis of market forces. 

4.2 The blurring of the monetary/fiscal policy dividing line

The separation between monetary and fiscal policy and central bank independence over monetary policy has been held up as key reason behind the relatively benign economic conditions enjoyed by western economies in the 15 years prior to the financial crisis. By providing central banks with operational independence and a strong focus on price stability, the idea was that not only actual inflation, but also inflationary expectations would be ‘anchored’. This would be beneficial for the economy since both companies and households would feel confident to plan investments well in to the future.

Recent developments suggest the ice may be melting on the monetary/fiscal policy divide. Most obviously, these are the addition to the Bank’s remit of ‘financial resilience’ and the creation of the Financial Policy Committee (FPC). The FPC’s job is to conduct ‘macroprudential policy’ which involves assessing system-wide risks to the resilience of the economy and which has powers of direction to intervene where it considers unsustainable risk is building up.

The FPC’s powers include the ability to influence bank credit creation via making adjustments to the amount of capital banks must hold against assets, both in total and by sector. Specifically, the FPC will bring in to force Sectoral Capital Requirements (SCRs)[26]. Thus if the FPC felt that excessive lending was being created for the real estate or domestic housing market, posing system risk to the economy, it could increase SCRs on these types of loans. It would also provide targeted incentives for banks to limit the expansion of riskier exposures.

The list of indicators upon which the FPC can alter SCRs includes Bank leverage ratios, average mortgage risk-weights, balance sheet interconnectedness (with other banks)intra-financial borrowing growth, derivatives growth, overseas concentration, credit growth to household and commercial real estate, debt-to-profit/income ratios for companies, households and non-bank financial intermediaries, price-to-rent ratios, loan-to-value- and-income ratios, and spreads on corporate and mortgage lending.

Even if the objective of SCRs is financial system resilience rather than GDP growth, they appear to be a first step towards the Bank of England regaining the power to more directly control credit creation and allocation in the economy. Senior members of the FPC, including Andy Haldane, and former member Adair Turner have already questioned whether the FPC should also have explicit powers to encourage more bank lending to particular sectors, the SME sector in particular.[27] [28]

Rather than being a radical departure in to the dangerous land of credit allocation, if the Bank of England was to take up Haldane and Turner’s proposal, it would simply be returning to what was quite standard practise in the post-war period. Then the Bank of England had its own (informal) qualitative and quantitative credit controls, known as ‘moral suasion’. As reported in a review of monetary policy in the 1960s, this was effective in limiting the total amount of credit banks could create and set quotas for specific sectors, always according priority to export finance.[29]

It should be noted that this period of credit guidance coincided with high rates of growth and employment in the UK and similar positive correlations have been observed in a range of other development and developing countries.[30][31] In contrast, cross-country studies where central banks have focused strictly on inflation targeting and left credit creation and allocation to ‘the market’, suggest there is no positive effect on nominal GDP growth or employment.[32]

Other recent examples of fiscal/monetary ‘blurring’ include the decision by the Treasury to move the profits of the APF on to the Government’s balance sheet (and, to some extent at least), the Funding for Lending Scheme (FLS) which subsidizes bank lending to a particular sector – in this case SMEs.

3. A new approach for monetary policy: Supporting the real economy

The Bank of England’s programme of interest rate setting and Quantitative Easing (QE) has failed to stimulate GDP and rebalance the economy away from its dependence on real estate and household debt. Both policies falsely assume that the UK’s risk-averse capital markets, corporate sector and commercial banking system can allocate capital efficiently to support the productive economy.

A return to conventional monetary policy, whereby a single tool – bank rate – is expected to be sufficient to target a single objective – inflation targeting – will not solve this problem. Indeed, it was this framework which led us into a financial crisis in the first place.

In our view, a broader mandate is required and central banks should return to having multiple objectives. We support a mandate for central banks that would include a range of macroeconomic and policy criteria beyond consumer price inflation and financial stability.  In particular, central banks should be considering: asset price inflation (in particular house price inflation), inequality and employment (and the regional dimensions of both), public and trade deficits and ecological sustainability. These were criteria that we set out in our report ‘Strategic Quantitative Easing’[33] published in 2013.

Central banks should have available a wider range of tools to achieve these targets than simply changes to short-term or, via standard Quantitative Easing, longer term interest rates.  The post-crisis period has shown that very low interest rates are not sufficient to produce nominal GDP growth (inflation plus GDP growth) when there are already high private and public debt levels relative to GDP.  In the post-war period mentioned, central banks helped reduce public debt to GDP levels by holding down interest rates and allowing moderate inflation as well as monetizing large quantities of public debt and directing credit to strategic industrial sectors.[34][35]

Even if debt levels were lower, however, it is not clear that adjustments to interest rates will be sufficient to shift the economy towards sustainable growth.  More generally, the Bank of England needs to take more seriously the fact that the commercial banking system no longer primarily creates money for productive activity (i.e. business investment) but instead creates the majority of new credit for investment in existing assets, in particular financial assets and commercial or domestic real estate.

In terms of future QE asset purchases, we would suggest the Bank should consider not just the quantity of asset purchases but also their allocation and make greater effort to ensure they support real-economy lending. In our 2013 report (p46-54), we suggested the Bank should create a separate ‘Monetary Allocation Committee’ made up of independent experts, who would choose which types of asset the Bank bought when it was repurchasing expired bonds or if it was expanding QE.  This proposal has added significance now that the Bank has committed to purchasing corporate bonds as well as gilts.

More generally, if commercial banks are to continue in their role as the main creators of money in the economy via credit creation, the central bank has duty to ensure such credit creation supports the objectives outlined above. As discussed above, already the Bank of England is returning to the forms of ‘credit guidance’ that were more common in the post-war period, for example via the Funding for Lending scheme subsidizing lending to Small and Medium sized enterprises and the imposition of Loan-to-Value and Loan-to-Income limits mortgage lend.  But the Bank could go further here and return to stronger forms of credit guidance used by many countries up the 1980s and still used by East Asian countries, to ensure bank credit flows in productive and strategically important sectors of the economy and not simply to inflating asset prices.

3 March 2017

Endnotes