Written Evidence submitted by Professor Philip Haynes, University of Brighton (MON0025)

 

Introduction

  1. The evidence presented here argues there are continuing dysfunctions with existing approaches to monetary policy, including the post crisis experiment with Quantitative Easing (QE).

 

  1. Major problems with monetary policy predate the crisis. Post 2008 unconventional monetary policy was itself a response to the earlier failure of monetary policy. The great financial crash was caused by the unregulated growth of credit in the decades before 2008. An insufficient amount of this increasing credit was supporting new productive investment. Instead, it financed inflation in existing assets (like old housing stock and takeovers and acquisitions). Current evaluations of monetary policy therefore need to revisit the creation and allocation of credit.

 

  1. Figure 1 shows the exponential growth of credit in the UK, after 1980. The percentage of growth in lending from traditional banks was in decline, but the financial sector was deregulated and new institutions started to lend billions of pounds of credit. A major policy concern is that the yellow line in fig. 1 (indicating total credit growth) correlates with a rapid rise of house prices in the same period. This is because of the high proportion of total credit allocated to the housing market. Demand for housing was high and only a limited supply available.

Figure 1.  UK exponential credit growth, post 1980

(The red line shows the declining percentage [left axis] of credit supplied by traditional domestic banks, as new financial institutions and lenders emerge.)

Source: Dembiermont et al, 2013, Bank for International Settlements, graph 3, page 78

 

  1. It is also argued in this submission that there is a need for an alternative approach to monetary policy that puts less emphasis on unregulated credit in the private financial sector and more focus on targeting credit creation towards productive investment. Given the Bank of England (BoE) is a public institution, this investment should also be of national benefit (regardless of whether the credit is used by the private or public sectors).

 

  1. In addition, I argue that monetary policy suffers from a democratic deficit. It should prioritise national public policy goals over international market goals. This has implications for the accountability of monetary policy and the relationship between the BoE, elected Government and HM Treasury (HMT). This relationship needs reviewing, as recently argued by Ed Balls former shadow chancellor (The Guardian, 17th November 2016). 

 

  1. Insufficient time is given to debating monetary policies like QE in Parliament. The Prime Minister has recently indicated her frustrations with QE (Parker and Giles, 2016), but her Government seems to have little power or ability to change monetary policy. It is erroneous if the elected government is unable to influence a change in monetary policy.

 

Unconventional monetary policy: QE

 

  1. The first explicit aim of QE after the 2008 financial crisis was to achieve inflation at 2% (Joyce et al, 2011). A 2% inflation target was not met by BoE interest rate setting because of post crisis demand reduction in the economy.  Quantitative Easing sought to achieve an increase in demand and spending. Low inflation was needed to prevent deflation (and a further escalation of the economic crisis).

‘The aim of undertaking asset purchases was the same as a cut in the Bank Rate, to stimulate nominal spending and thereby domestically generated inflation.’ (Joyce, at al, 2011; p201)

 

  1. Joyce et al (2012) have researched the outcome of UK QE and concluded that at its peak influence it achieved an addition to annual CPI inflation of 1.25%. This was after the BoE purchased £200 billion of assets in 2009 and a further £75 billion purchased in 2011. Even when controlling for the post crisis increase in VAT, annual inflation moved consistently above the Bank of England’s 2% target for a period in 2011-12.

 

  1. A longer-term view of the effect of QE on CPI is more sanguine, suggesting a reduced effect on demand in recent years (Weale and Wieladek, 2016)

 

  1. The period of inflation linked to QE was at a time of falling incomes for many households (CCS, 2011). Research for the Office of National Statistics (Gittins & Luke, 2012) shows that household spending did not recover in comparison with the increase in inflation. This is a key part of the evidence. Rising CPI during times of income and public expenditure austerity hits poorer households harder.

 

  1. Research evidence shows that the other outcomes of QE were the rising price of assets and a selective reduction to the costs of servicing some debts (Bank of England, 2012, Joyce et al, 2011, 2012:  Haynes, 2012) 

 

Rising price of assets

 

  1. Joyce, et al, (2012) estimate previous QE boosted equity prices by an average of 20%. The resulting investment was global and not just focused in the UK (Ryan-Collins, et al, 2012). A minority of households benefit from higher equity prices with only wealthier households owning such investments.

 

  1. The new QE of 2016, post the Brexit vote, has focused on asset purchases in the corporate sector. Equity prices have risen, but the relationship with new QE is unclear. It has been argued by others that recent equity price rises are influenced by the falling value of sterling and British companies overseas gaining from the increased value of their operations. In terms of the democratic deficit of monetary policy, there has been disquiet that the BoE is purchasing shares in international companies, contributing to some extent to share price rises, and thereby enhancing the wealth and income of the better off.

 

Rising House Prices

 

  1. In addition, QE has become associated with rising house prices. The relationship between QE and house prices is difficult to evidence but related to the selective reduction in the cost of credit (see paragraphs 21-26 below). This makes it cheaper for the wealthy to buy more property.

 

  1. The historical monetary policy context for housing price rises is that since the liberalisation of monetary policy in the early 1980s there has been an exponential increase in private lending by banks and building societies (see figure 1, above). The majority of this credit growth was lent for purchasing property. This has built an economy that is over dependent on housing wealth and the consumption that is associated with this. This would be less of a problem if more of the credit supporting the housing market went into building new homes to increase national supply, but too much credit is recycled into inflating the prices of existing stock and there is insufficient production of new stock.

 

 

  1. UK monetary policy with its focus on price inflation over asset inflation, and monetarising current assets rather than new productive investment, has failed to provide a rebalancing of the economy. House prices and rents (housing costs per household) remain very high as a proportion of income when compared with other developed nations (Chan and Fraser, 2017). This is symptomatic of a monetary system that inflates second-hand property prices.

 

  1. Rents have continued to increase, even in times of falling real incomes.  This creates concern about the large amount of Housing Benefit that governments have to pay to landlords. Preventing housing asset inflation and the resulting economic and social difficulties should be an aim of Monetary Policy while working in parallel with fiscal policy.

 

 

  1. Other policy approaches that counteract housing credit market dysfunctions are needed. For example, in the Channel Islands, local governance enforces a dual housing market, so that local people can often access the housing market at more affordable rates in preference to non-residents.

 

  1. Other national economies have demonstrated that there are alternative models for monetary policy where credit supports high levels of investment in manufacturing, technology and innovation. These economies have historically been less dependent on credit secured against housing assets. Examples are Germany, South Korea and Taiwan. The UK is low down the comparative world league table of investment in the economy as a percentage of GDP (figure 2).

 

Figure 2. Investment as a percentage of GDP, countries compared, 2015

Source: IMF

 

 

 

Monetary savings - compared to other assets

 

  1. While some assets like equities and housing have increased in value because of QE, conversely the interest rate for monetary savings has declined. Interest rates remained artificially low due to QE purchase of treasury stock.

 

  1. Pensioners have suffered from low returns on their monetary savings. Governments have attempted to modify the impact on pensions with the so-called ‘triple lock’ to protect pensioners’ income.

 

  1. Low interest rates for savers are a disincentive to save. This remains another major consequence of current unconventional monetary policy.

 

Selective reduction in debt costs

 

  1. QE delivers a selective reduction in debt costs. The current low BoE base rate of 0.25% assists large banks and financial institutions, encouraging them to lend. However, they need to recapitalise and improve profits after the financial crash of 2008. Real commercial and household interest rates vary. The poor, seen as high risk, continue to be offered relatively high credit rates.  The cheap availability of credit to major banks is not always passed onto others as they seek to recapitalise and improve profits on new loans. Another version of this inequality is that while mortgage loan rates are historically low, large deposit ratios are required. Large deposits are only available to families and individuals who have already achieved substantial wealth.

 

  1. The BoE purchase of UK Treasuries via QE has reduced their yields and made it cheaper for the HMT to issue new debt. This has reduced government debt costs. One argument is that this has been an important public benefit at a time when the economy has been weak and allowed the continuation of public financing when tax receipts have declined.

 

  1. Others argue it represents a ‘missed opportunity’ and instead of cutting public expenditure as a share of the national GDP, there could have been a considerable increase in productive investment in capital public projects with a longer-term benefit to the economy.

 

  1. It is one aspect of the demographic deficit in monetary policy that this debate about the modern complexities of the interaction of monetary and fiscal policy (Turner, 2008) has not been adequately researched and debated in parliament. There has been an assumption that public sector austerity is the only possible policy direction. There has not been a political debate about the links between monetary and fiscal policy and their likely mechanics (Turner, 2008).

 

 

  1. Small businesses, the self-employed and poorer households do not enjoy the lower debt costs associated with QE because of being at a higher risk of default and having minimal assets as credit security (Office of Fair Trading, 2010).

 

  1. QE may have prevented price falls in some parts of the property market, but there is little evidence this has helped poorer sections of the population, especially where they are dependent on the private rented sector.  In many areas of the country, rents have increased well above other consumer prices. This is associated with the availability of cheap credit into the housing market for those fortunate enough and able to ‘leverage up’ on their current capital (in particular, the growth of the buy to let market). All this ‘scaling-up’ from those with existing capital further widens wealth inequality.

 

  1. QE achieved unequal reductions in debt costs, with only those with existing wealth benefiting from low interest rates.

 

 

 

 

Conclusions

 

  1. Modern monetary policy, post 1980s, is praised for its success in controlling inflation. Nevertheless, in the UK it has failed to manage the exponential rise of credit and thereby allowed asset inflation to rise in damaging ways. Monetary policy has had an insufficient focus on controlling asset inflation and encouraging productive investment. It has failed to take a whole systems approach to the macro economy (Haynes, 2012).

 

  1. These failures are most obvious in the case of house prices and the buying and selling of established businesses. Private Banks operating in this liberalised credit market have not behaved in the national interest, but lent where they see low risk profits. This is lending for purchasing property, or to finance mergers and acquisitions. There has been insufficient investment in small and medium sized businesses and entrepreneurial activity (where job growth is more likely). These investments would be more productive for the national economy.

 

 

  1. When there have been periods of rising CPI inflation this has a disproportionate effect on the poor who spend a greater percentage of their income on consumer goods like food and fuel. Evidence is that in an economy where prices rise faster than average incomes, total debt increases for poorer households (CCCS, 2011). 

 

  1. The fundamental problem of this housing debt-based consumerism is that the increased servicing of debt costs becomes a long-term drag on other economic activity and growth.

 

  1. The restructuring of the economy away from the unregulated and untargeted use of credit is therefore the direction that Monetary Policy should take (Ryan-Collins, et al, 2011). The central bank, in collaboration with government, should be more proactive in developing a strategic policy that targets credit towards productive growth in the UK economy (NEF, 2013). This is a whole systems approach to monetary policy (Haynes, 2015).

 

 

  1. Monetary Policy should aim to target credit at productive investment and counter the dysfunctional market effect on housing. Credit allocation needs to prioritise small and medium size businesses, public works, energy, transport, and social housing programmes that will deliver affordable rents.

 

 

RECOMMENDATIONS

 

  1. There needs to be a revision and reform of the working relationship between the BoE and HMT, to ensure that new forms of investment are possible, efficient and effective. This requires innovative and courageous policymaking. Brexit – assuming it unwinds some policy requirements from the European Commission – is an opportunity for such innovation.

 

  1. One specific example of the dysfunctional separation of monetary policy from public policy is the policy of privatising and distancing higher education student loans from government, so that students pay over 3% per annum to a loan company. This is despite BoE base rates being historically low at 0.25%. This is an example of where a monetary policy of lending should be in the national interest and prevent hundreds of thousands of young adults from becoming ‘subprime’ with no hope of ever paying their debts back.

 

  1. QE now has questionable value as an unconventional monetary policy. Latest research suggests a minimal upward impact on GPD and CPI (Weale and Wieladek, 2016). These small positives on the upside are cancelled out on the downside. QE is tainted as a policy instrument because of the unequal and ineffective distribution of cheap credit, while contributing to rising asset prices and increased inequality. There is political disaffection resulting from this growing inequality. These are observations made by the Prime Minister.

 

  1. Monetary Policy needs a breadth of objectives that include the national and public good. Monetary policy needs to achieve strategic public policy aims that are in the national interest (rather than the market interests of international corporate business). Policy should include different approaches to the creation and allocation of credit, insuring the public benefits from money creation rather than just private banks (NEF, 2017), and promoting productive investment.

 

  1. Bank of England monetary policy must be more accountable and demonstrate it is allocating credit in the national and public interest. There is no similarly important area of public policy where major policy decisions are remote from government and parliament. It is vital that the Chancellor as the lead member of the Cabinet for economic and monetary policy has a clearer remit and accountability for working with the BoE, and is accountable to parliament for this role.

3 March 2017

 

  1. References

Bank of England (2012) The Distributional Effects of Asset Purchases. London: The Bank of England http://www.bankofengland.co.uk/publications/Documents/news/2012/nr073.pdf

 

Chan, S. P and Fraser, I. (2017) Fears of a 'massive' global property price fall amid 'dangerous' conditions and market slow-down’ The Telegraph. London 2nd January 2017 http://www.telegraph.co.uk/business/2017/01/02/fears-massive-global-property-price-crash-amid-dangerous-conditions/

Consumer Credit Counselling Service (2011) Debt and Household Incomes. Leeds: Foundation for Credit Counselling.

Dembiermont, C., Drehmann, M and Muksakuratna, S. (2013) How much does the private sector really borrow? A new database for total credit to the private non-financial sector. BIS: Geneva: Bank for International Settlements.

Gittins, P.  and Luke, S. (2012) Impact of the Recession on Household Expenditure. London: Office of National Statistics.

Haynes, P. (2015) ‘The international financial crisis: the failure of a complex system’. In R Geyer and P Cairney. Handbook on Complexity and Public Policy. Cheltenham: Edward Elgar.

Haynes, P. (2012) Public Policy Beyond the Financial Crisis: An International Comparative Study. London: Routledge.

Joyce, M., Tong, M and Woods, R (2011) The United Kingdom’s quantitative easing policy: design, operation and impact. The Bank of England Quarterly Bulletin 2011 Q3 Vol  51 No. 3 200-212

 

Joyce, M., Miles, D., Scott, A and Vayanos, D. (2012) Quantitative Easing and Unconventional Monetary Policy – An Introduction. The Economic Journal 122: November 271-288

New Economics Foundation (NEF) (2017) Making Money from Making Money. London: NEF

New Economics Foundation (NEF) (2013) Strategic Quantitative Easing. London: NEF

Office of Fair Trading (2010) Review of High Cost Credit.  OFT 1232  London: OFT   http://www.oft.gov.uk

Parker, G and Giles, C (2016) ‘PM criticises “bad side effects” of monetary policy’. Financial Times, London. https://www.ft.com/content/841720a4-8b04-11e6-8aa5-f79f5696c731

Ryan-Collins, J., Greenham, T., Werner, R. and Jackson, A (2012) Where Does Money Come From? A Guide to the UK Monetary and Banking System.  London: NEF

 

Turner, G. (2008) The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis. London: Pluto Press

 

Van Lerven, F. (2016) A Guide to Public Money Creation. London: Positive Money

 

Weale, M. and  Wieladek, T. (2016) What are the macroeconomic effects of asset purchases? Journal of Monetary Economics 79: 81-93