Written evidence submitted by Positive Money (MON0024)
Positive Money welcomes the opportunity to respond to the Committee’s inquiry on the effectiveness and impact of post-2008 UK monetary policy.
We are a research and campaigning organisation, working towards reform of monetary policy to support a fair, democratic and sustainable economy. We are funded by trusts, foundations and small donations.
This submission will argue that:
● Loose monetary policy is ineffective because it relies on an already highly-leveraged private sector to take on more debt
● By artificially inflating asset prices, QE has contributed to inequality and worsened the housing crisis
● Monetary policy is running out of ammunition to respond to future crises
● A new relationship between the Treasury and the Bank of England is needed to allow the creation of new monetary policy tools
● A monetary-financed stimulus would be preferable to quantitative easing in its current form
The effectiveness of monetary policy in meeting the inflation target
The effectiveness of holding Bank rate near zero and whether extremely low rates can encourage more, rather than less, saving
1 Low rates are intended to boost bank lending, but most new lending goes towards non-productive sectors. Because of this, the Bank of England risks fuelling the same unsustainable build-up in private debt that caused the 2008 crash.
1.1 Before 2009, the MPC had never cut rates below 2% and since then, it hasn’t increased rates above 0.5%. This unprecedented policy position is intended to convince people to spend today what they would’ve spent tomorrow. But doing so risks resulting in a build-up of private debt. The Bank of England’s most recent Financial Stability Report found that the ratio of private debt to income had risen to 133% in the second quarter of 2016, prompting a warning from Mark Carney that it would be a key issue for the MPC in the coming year.[1] Empirical research by IMF economists Schularick and Taylor shows that a rise in the level of private debt is the most “powerful predictor of financial crises”, based on nearly 140 years of data on developed economies.[2]
1.2 This situation is exacerbated by the uneven sectoral distribution of bank lending. Since the financial crisis, the vast majority of lending has gone towards mortgages, consumer credit and financial businesses. As Figure 1 shows, the mortgage market recovered quickly, while lending to non-financial businesses remained negative until only recently.[3] This means that while low rates have encouraged households to take on more debt, they have done little to boost lending for the productive and the non-speculative economy. UK banks prefer making loans that are secured against existing property or to other financial institutions rather than making loans that directly support productive activity.[4]
Figure 1: Annual change in bank lending to all sectors in UK (source: Geoff Tily, TUC), showing that non-financial business net lending (green) was negative (more loans were repaid by businesses than new loans lent) until 2016.
1.3 A change in the base rate does not necessarily translate into lower borrowing costs for consumers. Following the Bank’s rate cut last autumn, the Governor urged banks to pass on the reduction immediately. But the Chief Executive of Lloyds Bank warned that “additional monetary measures will have only a marginal impact”, and refused to confirm the bank would pass on the full effect of any rate cut to borrowers.[5] Many households are now “credit-dependent”, relying on high-cost, unsecured loans to fund their living expenses.[6]
1.4 Raising interest rates will not solve the imbalance in the monetary system. In order to ensure that growth is sustainable and evenly-shared, the Bank must be able to boost demand and directly stimulate the productive, non-speculative economy. To do this, the Treasury must supply it with new monetary policy tools.[7]
The effectiveness of quantitative easing and whether it has met with diminishing returns
2 QE’s effectiveness has been limited because its intended transmission channels are not working as intended. Its impact on spending and lending has been muted, and its portfolio rebalancing effect has been of little benefit to the real economy.
2.1 According to the Bank of England, the main aim of QE is to encourage spending in order to meet the Government’s 2% inflation target. But QE has been an inefficient way of going about it. Our research shows that for every £1 of money created via QE, UK GDP increased by just 10-15p. These effects are small in comparison to the magnitude of the stimulus; it required £375 billion of quantitative easing, then equivalent to around 26% of GDP, to create just £37-£56 billion of additional spending.[8] Alternative forms of stimulus could have had a greater impact effect.[9]
2.2 On QE’s inception in 2009, it may have been the best tool available to address an immediate problem of illiquidity in the interbank lending market. It was necessary for the Bank to respond quickly, and an argument could be made that the effects of the financial crisis may have been worse without it. But we are in a different situation now. Banks do not need more liquidity in order to lend, the interbank lending market is not in danger of freezing up. The Bank has found no evidence that QE operated via a traditional bank lending channel.[10]
2.3 The Bank intends QE to support growth by encouraging investors to move towards riskier assets via the so-called portfolio-rebalancing channel, but the primary effect has been to drive greater investment into the financial and property markets. The idea behind the portfolio-rebalancing channel is that by buying financial assets with newly-created money, the central bank pushes up the price of those assets, which simultaneously pushes down their yield. The lower returns should force investors to rebalance their portfolio, moving their investments into riskier assets with higher yields such as corporate bonds and shares, directing more credit and investment towards businesses in the real economy.
2.4 There is ample evidence that the portfolio-rebalancing channel did not encourage investment or lending to businesses in the real economy. Instead of leading to new spending on goods and services, this money has generally remained in the financial sector and inflated the price of pre-existing assets. Ryan-Collins et al. argue: “It is highly uncertain that this mechanism of ‘portfolio rebalancing’ works in reality. Instead, as evidenced by current volatility in stock, bond and currency markets, investors reacting to QE are likely to channel their money mainly into financial assets. This inflates the price of such assets, and enriches the assets’ owners, with minimal positive impact on the real economy.”[11]
2.5 QE’s main impact has been to increase the price of financial assets. The Bank’s intention is that by increasing asset prices, QE automatically increases the wealth of the asset owners, which is believed to lead to a boost in their spending.[12] However asset-price inflation has worsened wealth inequality.[13] Its distributive effects aside, the wealth channel is considered weak because boosting the income of the wealthiest people is not likely to induce them to increase their spending in the real economy. Ryan-Collins et al. find that “Investors, companies and richer households seem to prefer holding on to the extra liquidity or wealth that QE has provided them with rather than invest their money in GDP-related transactions.”
The scope for further expansion of "qualitative easing" (e.g. corporate bond purchases)
3 Corporate bond purchases will only serve to funnel more money into financial and property markets, and we are doubtful that corporates will use lowering borrowing costs to invest in their UK businesses. It is problematic that the Bank should be picking winners in this way.
3.1 The Bank hopes that buying up safe assets such as gilts and corporate bonds, it will encourage investors to rebalance their portfolios towards riskier corporate bonds or equities, that will in turn support businesses operating in the real economy. But instead of encouraging investors to take on more risk, it is incentivising investors and savers to put the money into property and financial assets.[14]
3.2 Specifically, the Bank hopes that by lowering the yields on corporate bonds and reducing the cost of borrowing for companies, it will encourage investment. But the bulk of the Bank’s corporate bond purchases are aimed at multinationals, which have currently have amassed £4.1 trillion in cash reserves.[15] UK private non-financial companies are sitting on £1.8 trillion of assets, £0.5 trillion of which is believed to be cash. The fact that this money is sitting idly and not being invested suggests that corporates are not in need of cheaper funding to finance investment.
3.3 Where lower yields do encourage more borrowing, it may just prompt more financial engineering in the form of share buy-backs, which won’t trigger any new investment in the economy. Many corporates are expected to take advantage of the lower borrowing costs and issue more debt, merely to buy back their own shares. By buying back their own shares, they will boost the share price as well as shareholder profits. This form of financial engineering will trap money in financial markets, and will not lead to any of the much-needed investment that will boost productivity, incomes, and jobs.
3.4 If some corporates benefit from cheaper borrowing costs, it begs the question of whether the Bank should be making decisions which produce winners and losers in this way. Former MPC member David Blanchflower tweeted that the Bank’s corporate bond purchases amount to “unmandated fiscal policy”.[16] Although the Bank insists that its list of eligible bonds are issued by companies which make a “material contribution to the UK economy”, the list includes several foreign-owned corporations, such as Apple, Verizon and AT&T.
3.5 In deciding which types of companies should benefit from its bond purchases, the Bank is making decisions which are political in nature. We agree with Professor Blanchflower that this is a problem. Political decisions should be a matter for the Government. There must be a re-assessment of the Bank’s relationship with Treasury, to avoid the Bank becoming involved in political disputes.[17]
The unintended consequences of monetary policy
The impact on asset-price inflation, the housing market and financial stability
4 Monetary policy since 2008 has boosted asset prices and inflated the housing bubble.
4.1 QE is primarily aimed at inflating asset prices. The Bank of England explains that the intention behind QE is to lower returns on investment into traditional safe assets, and incentivise the private sector to rebalance their portfolios into riskier investments.[18] As the Bank buys billions of pound worth of bonds, it reduces both the supply of safe assets as well as the returns on those investments, while at the same time sharply increasing the supply of money.
4.2 On the one hand, a reduction in the supply of safe assets alongside a simultaneous increase in the supply of money means a lot more money chasing much fewer assets, leading to an increase in asset prices.
4.3 On the other, with fewer safe assets to invest in and with very low returns, savers and investors are prompted to search for higher yielding investment opportunities elsewhere; mainly the UK’s property market. With more people wanting to invest in property, demand for property goes up, and house prices increase.
4.4 Evidence compiled by ratings agency Standard and Poor’s shows that despite the share of rental properties having increased since 2007, the proportion of mortgage-financed buy-to-let purchases has fallen.[19] This suggests that additions to the rental market have been financed by cash purchases. In essence, investors have swapped their lower yielding assets (i.e. government bonds) for cash, and used that cash to acquire higher-yielding assets in the property market. In effect, QE has redirected investors’ money away from traditional safe investments into property. Because the supply of assets in the property market is relatively fixed, the substantial increase in demand for property resulting from QE has pushed up property prices.
Figure 2: Rental properties are increasing (blue), and buy-to-let mortgages are decreasing (red). This diversion is due to increasing cash purchases by investors wanting to rent out their property.[20] (source: Standard and Poor’s)
4.5 Because of the uneven allocation of credit, low interest rates also boost asset prices. Lowering base rates is intended to boost aggregate demand by reducing the debt servicing costs of existing borrowers and by making new borrowing cheaper. Cheaper borrowing costs stimulate bank lending, increasing the available purchasing power in the economy and therefore demand.
4.6 However, 80% of new lending tends to be for pre-existing assets in the financial and property markets. Given that supply in these markets responds to increases in demand very slowly, if at all, the major effect of this lending is to push up asset prices. Indeed, as Lord Adair Turner highlights, this can result in a pro-cyclical relationship where new lending leads to higher asset prices, which requires yet higher levels of borrowing, pushing prices even higher. 20
4.7 In addition, in a very similar fashion to QE, lower rates leads to lower returns on savings and investments in pensions. With much more attractive returns on property, lower interest rates re-direct money away from traditional saving instruments and into property.
The distributional impact
5 By inflating asset prices, QE worsens inequality.
5.1 Since QE is specifically designed to inflate asset prices, and because ownership of assets is highly concentrated amongst the wealthy, the wealthiest households stand to gain the most from QE. Moreover, by inflating the price of assets in the property market, the wealth of existing property owners increases, whilst making it more difficult for first-time buyers to purchase a property.
5.2 Accordingly, a general consensus among academics and policymakers has formed that QE has disproportionately benefited the asset-rich. For example, a 2012 Bank of England report was perceived as an admission that its own policies had significant distributional consequences.[21] Indeed, even former Chancellor George Osborne, responsible for authorising the bulk of QE, recently suggested that QE increases inequality.[22]
5.3 Recent remarks by the former Chancellor and the Prime Minister have prompted a different response from the Bank of England. The Governor had previously suggested that while monetary policy might have distributional consequences, it is for the government to offset them if they choose to do so.[23] But in more recent appearances, the Governor has suggested that in fact, monetary policy has benefited everyone and can be associated with a reduction in inequality. For example Carney stated:
“Even though it is explicitly not an objective of monetary policy, it happens to be the case that since interest rates fell to their lowest levels and QE was introduced that wealth has risen across all quintiles – and incomes has risen across all quintiles in this economy, as well as, moving record employment levels.”
5.4 To back this position, the Governor refers to ONS data showing that the bottom 20% of households have seen the largest proportional increase in their wealth since 2006. Similarly, the Governor made the point that the bottom 20% of income earners has seen the largest proportional increases since 2006.
Figure 3: change in net wealth of UK households from 2006 - 2014 (source: Bank of England)
5.5 The issue with this position is that interest rates were first lowered on December 6th 2007, from 5.75% to 5.5%. The most significant changes in interest rates only took place in late 2008 and early 2009 (from 5% to 0.5%). And according the Bank of England there are substantial time lags within which interest rates influence asset prices and the economy at large.[24]
5.6 Therefore, to accurately identify the impact of low interest rates on inequality, we must analyse the period following 2008, when rates were lowered. Similarly, QE only started in March 2009. Therefore, as Figure 4 below demonstrates, those in the bottom two-fifths of the income distribution have seen virtually no gains in their wealth since the implementation of QE and low interest rates. Indeed, those in the bottom 20% have seen their wealth fall over this period. By contrast, those in the top two quintiles have seen their wealth increase by almost 20% respectively.
Figure 4: changes in the wealth of UK households from 2008 to 2014 showing decreases for the bottom 20% (blue) and increases for top 40% (green and purple), since QE and low interest rates were introduced (source: Bank of England)
5.7 These figures also ignore the growth in intergenerational inequality that has taken place since the crisis. Indeed, according to Bank chief economist Andy Haldane[25], “All of the £2.7 trillion rise in wealth since 2007 has been harvested by those over the age of 45, two thirds by those over the age of 65. By contrast, those aged 16-34 have seen their wealth decline by around 10% over the period.”
6 QE worsens financial inequality
6.1 To gain a more in-depth understanding of how QE influences inequality, a closer look at financial inequality[26] is required.
6.2 Evidence provided by Standard and Poor based on the OECD Wealth Distribution Database shows that in the run up to 2008, the wealthiest households grew the proportion of stocks they held[27]. Prior to 2008, the wealthiest 10% of UK households directly owned 77% of all stocks and the wealthiest 1% held one third. By 2012, the wealthiest 10% increased their holdings to 86%, and the wealthiest 1% held over one half of total wealth in the form of stocks.
6.3 This increase can be attributed in part to the fact that after QE was started, less wealthy asset-holders sold stocks and moved into less risky assets like government bonds, resulting in the wealthiest growing their share of stocks. Consequently, between 2008-2012 the wealthiest 10% and 1% managed to grow their overall wealth held in stocks by 55% and 130% respectively.
6.4 Meanwhile, households in lower income brackets predominantly hold their financial assets in the form of bank deposits. So as the wealthiest financial asset holders have seen their investment income increase, due to stock markets being boosted through QE, those holding bank deposits have seen their investment income decreased due to ultra-low interest rates.
6.5 Overall, financial wealth inequality in the UK has increased considerably in the aftermath of the global economic and financial crisis. The share of net financial wealth (financial assets minus financial liabilities) held by the wealthiest 10% of UK households has increased from 56% in 2006-2008, to 65% in 2012-2014.[28]
7 QE worsens housing inequality.
7.1 By inflating the price of existing real estate, the wealth of existing property owners increases, while making it more difficult for first-time buyers to buy a house. In effect, this increases inequality, as Standard and Poor notes:
“(QE) is now also one of the drivers behind the widening wealth and income gap between younger and older generations and between those on the housing ladder and those not on it… Younger low- and middle-income households (would-be first-time buyers) are the ones affected most. As buying a home becomes ever more expensive, they are increasingly forced to spend a large share of their income on rent and are unable to save in order to buy a home or otherwise accumulate wealth.”
7.2 A recent study by the Institute for Fiscal Studies (IFS) shows how higher house prices is contributing to intergenerational inequality gap[29]. People in their early 30s are half as wealthy as people of the same age ten years ago. The report shows that 30-year-olds before the recession had an average wealth of £53,000, while 30-year-olds after the recession have an average wealth of £27,000 – the average 30-year-olds should be £26,000 wealthier than they are now.
7.3 According to the IFS, this is because younger generations are being priced out of the property market and are not receiving the same pension packages as their older relatives.
7.4 Indeed, home ownership among the 25-44 age group has drastically declined in the last 10 years, falling from 66% before the recession to 33%. In a corresponding fashion, the number of private rents more than doubled from 21% to 48% for this age category, over the same period. If this trend continues, then the gap in intergenerational inequality will only become increasingly profound. These trends suggest ownership will likely drop dramatically in the next decades, without viable alternatives to wealth accumulation, so perpetuating wealth inequality far into the future.
Figure 5: intergenerational gap of home ownership is increasing; owner occupiers is in decline for age groups 25-44 (red) (source: Standard and Poor’s)
7.5 It may take a decade or more for earnings to rise sufficiently to make the average house price ‘affordable’ again. The government may fear the political consequences of allowing prices to remain flat for such a long period. However a 2013 poll found that now only 20% of the public still consider rising house prices to be positive[30].
7.6 To the extent that QE and monetary policy contributes to low pension returns and higher house prices, it contributes to housing inequality and the ever-expanding intergenerational gap.
The implications of a large balance sheet and the Treasury indemnity for Bank accountability and its relationship with the government and other agencies
8 The scale of the Bank of England’s stimulus programme makes it crucially important that the relationship between the Bank and Treasury is fit for purpose.
8.1 In the era of central bank independence, there has been a broad consensus that the Bank of England should be left to carry out monetary policy in total isolation from the government’s fiscal policy. But monetary policy involves trade-offs that are fundamentally political in nature, and that consensus is beginning to break.
8.2 Last autumn, the Prime Minister has raised concerns over monetary policy’s effect on inequality, and pledged that a “change has got to come”. Lord Hague said that central bankers have collectively “lost the plot”.[31]
8.3 When the Bank works in isolation from the Treasury, the results are problematic. The Bank’s decisions about corporate bond purchases have raised concerns about it straying into an area which is political.[32] Bank officials have admitted that quantitative easing has disproportionately favoured the wealthy. The Bank’s research has found that the top 5% of households saw their wealth increase by up to £128,000. If fiscal policy had this effect, it would be politically highly controversial.[33]
8.4 Although the Prime Minister’s assertion about monetary policy’s distributional effects is correct, the Bank is operating within a framework which is set by her government. The Treasury gives the Bank the tools to do its job. If ministers are concerned about monetary policy’s effects, they should review those tools.
8.5 If the Treasury can arm the Bank with an appropriate set of monetary policy tools, which don’t worsen inequality, fuel the housing crisis or unfairly pick winners in the corporate bond market, the Bank can be left to make monetary policy decisions without unhelpful political interference.
8.6 There is also a growing support for a review of the mandate of the Monetary Policy Committee. If the Bank focuses only on price stability, as it does currently, it may neglect financial stability, and risk another financial crash.
The use of macro-prudential, fiscal and other policy to counterbalance any unintended consequences of monetary policy
9 Relying on other policies to counterbalance the negative outcomes of monetary policy is missing the point. Monetary policy doesn’t work because it relies on influencing a system of credit allocation which is dysfunctional.
9.1 Monetary policy in its current form is dysfunctional. Low rates and quantitative easing have been ineffective at stimulating the economy because they rely on boosting the supply of easy money, most of which goes towards property and financial markets.[34] This is making our economy more reliant on an oversized financial sector and house price bubbles.[35] QE has contributed to inequality, and has resulted in a sharp increase in the percentage of financial wealth owned by the richest households.[36]
9.1 There is a consensus, including in the current government, that the UK economy must be rebalanced so that it is less dependent on property and financial speculation. But this cannot be achieved through fiscal or monetary policy alone. Fiscal policy will not be able to rebalance the economy while monetary policy continues to encourage more money to be pumped into property and financial markets. And the Bank of England cannot direct credit towards productive activities without the Treasury’s cooperation.
9.2 Over the past seven years, the basis of the Treasury’s macroeconomic strategy has been to combine tight fiscal policy with loose monetary policy.[37] This strategy does not work. The IMF published a paper last year which argued that “the short-run costs in terms of lower output and welfare and higher unemployment have been underplayed, and the desirability for countries with ample fiscal space of simply living with high debt and allowing debt ratios to decline organically through growth is underappreciated.”[38]
9.3 Finance ministers and central bankers have pointed out that a more active fiscal policy would reduce the need for monetary policy to step in.[39] The Governor has rightly argued that monetary policy should not be “the only game in town” when it comes to supporting spending, and that there should be a “much better balance” between fiscal policy, monetary policy, and structural reform.
9.4 But evidence from other major economies shows that even if fiscal policy were looser, there would still be a need for monetary stimulus. For example, the Federal Reserve judged it necessary to expand its QE programme by $750 billion just a month after Congress approved the $787 billion American Recovery and Reinvestment Act.[40] So even if a more active fiscal policy can help to reduce monetary policy’s role, central banks will still have a crucial part to play in responding to economic shocks in the future.
9.5 Fiscal policy cannot offset monetary policy’s distributional effects. Mark Carney has acknowledged that monetary policy has uneven distributional consequences, but argues that it is the government’s responsibility to address any resulting imbalance.[41] But monetary policy’s distributional effects are large, multi-faceted and far-reaching. There is substantial disagreement, even inside the Bank, about exactly what they are. [42] Given this uncertainty, it is unrealistic to expect the Treasury compensate for them afterwards. It would be preferable for the Bank to use monetary policy tools which do not produce these effects in the first place.
9.6 Monetary policy needs to be reformed, and must work with fiscal policy to meet the Bank’s mandate in a way which supports the Government’s objectives. The Treasury must design new monetary policy tools which inject demand directly into the productive economy, to boost productivity, jobs and incomes.
The prospects for monetary policy
The impact and trade-offs of tightening monetary policy in the near-term
10 Both raising and keeping rates low is problematic and risks helping to create a future financial crisis
10.1 The Bank of England has forecast that inflation will rise beyond the desired level of 2%, and the Governor has indicated that he is willing to tolerate inflation “a bit” above the bank’s 2% target. But the coming months will bring significant upward pressures on inflation, and at the end of last year, the Bank was forecasting that inflation would rise to 4%.[43]
10.2 The Bank faces a dilemma. Under usual circumstances, the Monetary Policy Committee would raise interest rates to keep inflation under control. But normally too much inflation is a signal that the economy is at full capacity and in danger of overheating; and that too many people are borrowing, investing, and spending, which pushes prices up.
10.3 The problem is that this is definitely not the case; for the last eight years interest rates have been at historic lows. Indeed, the Bank reduced rates last year over fears that the Brexit vote would create uncertainty, which could lead to even less borrowing, spending and investment. Therefore, the Bank expects the economy to be running below full capacity.
10.4 The Bank is facing an extraordinary scenario where inflation will be higher than desirable, at a time when the economy is running below its capacity. As external MPC member, Michael Saunders recently said: “This is really the first time that the MPC has clearly faced the prospect of an inflation overshoot amidst continued slack at the 2-3 year horizon”.
10.5 The Bank, therefore, doesn’t want to raise interest rates to curb inflation, because the economy isn’t running at full capacity. And with one in 10 mortgagors already at risk of being trapped in ‘unaffordable’ borrowing, even a small rise could be catastrophic for many households. [44] A rate rise would risk depressing spending and investment in a time of great economic uncertainty.
10.6 This dilemma shows that the current monetary policy framework is broken. The Treasury must consider what alternative monetary policy tools would be more effective at managing demand.
Whether monetary policy is currently out of ammunition for the next crisis
11 Monetary policy is out of ammunition in the event of another financial crisis.
11.1 Over the past 30 years, the Bank has normally responded to economic shocks by cutting interest rates, with the intention of maintaining the flow of cheap credit to the economy. But with rates already at record lows, there is no room for a further reduction. The Governor has ruled out reducing rates below zero.[45]
11.2 In fact, prolonging low rates will contribute to a build-up of private debt, which makes the UK economy more vulnerable to a future crisis.[46]
11.3 Governor Carney insists that the Bank’s asset purchase programme could be extended in the event of another crisis. But QE’s effectiveness has been limited because its intended transmission channels are not working as intended. Its impact on spending and lending has been muted, and its portfolio rebalancing effect has been of little benefit to the real economy.[47]
11.4 Even if QE were effective, there is a question as to how much further it can be expanded without removing too many safe assets from the financial markets and depriving other investors of safe investments. The Bank of England has already had to start purchasing corporate bonds. As has been the experience of the Bank of Japan, there are risks associated with the central bank owning too high a proportion of government bonds.[48]
11.5 With central banks approaching the limits of what they can do to loosen monetary policy, some central bankers including Mark Carney have called for the Government to step in with structural reform, which includes trade liberalisation and measures to increase labour market participation.[49] But while some of these might increase potential growth over the long term, it is unlikely that they will make any difference to growth or inflation rates over the next 1-3 years.[50]
11.6 This is a very dangerous situation. With no way of responding effectively to a future crisis, and a number of potential threats facing the economy in the coming years, the UK could suffer a prolonged recession.
12 The Treasury must conduct another review of the monetary policy framework, and consider alternative options for the Bank of England’s mandate and tools.
12.1 Given the problems with keeping interest rates low and extending QE, the Treasury must consider what further tools it can give to the Bank in advance of a future crisis. The Bank must be able to boost demand and stimulate the productive, non-speculative economy. If indicators suggest that there is spare capacity in the economy, that aggregate demand is below a certain threshold, to the extent that price stability is endangered, then the Bank of England should step in. It should work closely with the Treasury to proactively create new money to finance a fiscal stimulus up until indicators for aggregate demand reach the desired threshold. Such alternative monetary policy tools could include using central bank money to fund infrastructure projects, house-building or a citizens’ dividend.[51]
12.2 A growing number of economists have argued in favour of some form of monetary financing. A letter from 42 leading economists accompanies this submission. They argue that “A fiscal stimulus financed by central bank money creation could be used to fund essential investment in infrastructure projects – boosting the incomes of businesses and households, and increasing the public sector’s productive assets in the process. Alternatively, the money could be used to fund either a tax cut or direct cash transfers to households, resulting in an immediate increase of household disposable incomes.”[52]
12.3 A range of proposals for monetary financing have been developed over recent years. These range from those that would differ very little from QE but would opt to purchase bonds that would better stimulate the real economy (e.g. through buying green investment bank or business investment bank bonds), through to those that would result in a net increase in private sector assets, and therefore a decrease in private sector debt, which would promote financial stability.[53]
12.4 As well as considering what tools are necessary to respond to the next crisis, the Treasury should consider alternative options for the Bank’s mandate. If the MPC focuses only on price stability, as it does currently, it may neglect financial stability and risk another financial crash. For example, through its current policies, the Bank risks fuelling the same unsustainable build-up in private debt that caused the 2008 crash. [54] The Treasury should consider whether financial stability should form a part of the MPC’s mandate.
12.5 There are good reasons for not solely relying on bond financing to provide a countercyclical stimulus. Keynes believed that governments should only turn to fiscal policy when all other options had been exhausted.[55] Fiscal policy is generally slower to respond to economic shocks than monetary policy. For example, in the aftermath of the Brexit vote, the MPC unveiled a new stimulus package within weeks, whereas it took until November for fiscal policy to be adjusted in the Chancellor’s autumn statement. In the absence of the interest rate cut and QE, by the time the Chancellor’s measures kicked in, the economy could have already been in a recession.
12.6 These tools should be considered in a further Treasury review of the monetary policy framework. The last such review took place under the Coalition government in 2013.[56] The new Government’s concerns over the impacts of monetary policy and the continuation of low rates and QE make it a priority for the Treasury to revisit whether the framework is operating effectively.
13 Summary
13.1 Recent monetary policy has resulted in bad side-effects and has shown limited effectiveness. Low rates are intended to boost bank lending, but most new lending goes towards non-productive sectors. Because of this, the Bank of England risks fuelling the same unsustainable build-up in private debt that caused the 2008 crash.
13.2 QE’s effectiveness has been limited because its intended transmission channels are not working. Its impact on spending and lending has been muted, and its portfolio rebalancing effect has been of little benefit to the real economy. Corporate bond purchases will only serve to funnel more money into financial and property markets, and we are doubtful that corporates will use lowering borrowing costs to invest in their UK businesses. It is problematic that the Bank should be picking winners in this way.
13.3 Monetary policy since 2008 has boosted asset prices and inflated the housing bubble. Because QE inflates asset prices, it has significantly worsened inequality. Specifically, QE worsens financial inequality, and housing inequality, because of the uneven distribution of home ownership.
13.4 But the problems with monetary policy will not be solved simply by adjusting rates. Both raising and keeping rates low is problematic and risks helping to create a future financial crisis. Even a small rate rise will be unaffordable for many borrowers, and keeping rates low risks fuelling a further build-up of private debt, because doing so encourages new lending into financial and property markets.
13.5 Equally, suggestions that fiscal policy can simply offset monetary policy’s side effects are misguided. Fiscal policy cannot remove the need for monetary stimulus, and cannot be relied on to offset monetary policy’s negative effects. Instead, monetary policy needs to be reformed, and the Treasury must work with the Bank of England to rebalance the economy.
13.6 Monetary policy’s huge distributional consequences and far reaching side effects, and its decisions are approved and underpinned by the Treasury. This makes it crucially important that the relationship between the Bank and Treasury is fit for purpose. Currently, fiscal and monetary policy work too often in isolation.
13.7 Monetary policy is out of ammunition in the event of another financial crisis. The Bank cannot cut rates any further because they are already at record lows, and the Governor has ruled out cutting them below zero. The QE programme cannot be expanded indefinitely because there is a risk in buying up too high a proportion of safe assets. Structural reforms will not take effect quickly enough.
13.8 The Treasury must undertake another review of the Bank of England’s mandate and tools. Included in this review should be consideration of the various proposals for some form of monetary financing. Many leading economists have argued that central bank money creation could be used to fund investment in infrastructure projects, a tax cut or direct cash transfers to households.