Written evidence submitted by Professor Richard Werner (MON0036)

Submission by Professor Richard A. Werner, D.Phil. (Oxon), Chair in International Banking, University of Southampton, and member of Linacre College, University of Oxford, submitted by and on behalf of the author.

About the author: Professor Werner had warned correctly of the coming collapse of the Japanese banking system in 1991 (Werner, 1991). He warned in the early 1990s that lowering interest rates even to zero would not stimulate a recovery in Japan and neither would standard fiscal policy, if not backed with the right monetary policy tools. This is what happened. Instead, Professor Werner proposed a new monetary policy that he called “Quantitative Easing” in 1995, when he was chief economist of Jardine Fleming Securities (Asia) Ltd., in Tokyo (Werner, 1995). This policy consists of expanding credit creation for GDP transactions and helping banks to do so, which will boost nominal GDP growth and employment without causing further asset inflation or banking instability.

Executive Summary:

• To implement effective monetary policy, the relationship between key variables (interest rates, various monetary and credit aggregates etc.) needs to be understood. Such knowledge can be gained through a careful empirical examination of the data, not hypothetical-axiomatic theoretical dream worlds that are merely postulated (“neoclassical economics”).
• Such empirical research over many decades and many countries has established that interest rates are not a useful tool for monetary policy, since interest rates follow economic activity, and are positively related to it.
• What determines nominal GDP growth (real GDP plus inflation/minus deflation) is the quantity of credit creation for the real economy (transactions that are part of GDP; asset transactions are not part of GDP). This has been demonstrated in various tests, including statistical causality tests and the rigorous general-to-specific econometric testing methodology, demonstrating the veracity of the Quantity Theory of Credit. This quantity of credit for the real economy can be targeted by the policy-makers, as had been done successfully by Japan, Korea and Taiwan from the 1950s to the 1980s, and by China from the 1980s to the 2000s.
• Post-2008 UK monetary policy has placed too little emphasis on expanding bank credit creation for the real economy, especially bank lending to small firms. Instead, a policy misleadingly also called ‘quantitative easing’ was adopted, which however focused on expanding credit creation for non-GDP, i.e. financial/asset market transactions, fuelling asset price rises.
• In addition to targeting bank credit and ensuring it is expanded primarily for GDP transactions, especially business investment in the non-financial sector, a key missing policy concerns the structure of the banking sector: Empirical research has established that large banks primarily lend at a large scale to large borrowers. In the UK, the largest scale borrowers are in the financial sector. Together with mortgages, this is how the majority of bank credit is allocated in the UK, fuelling asset price inflation and inequality. Instead, bank lending to non-financial business investment in the real economy needs to be expanded, especially to small firms, which are the main employers. Currently, such bank credit is a tiny fraction of total bank credit. But it can be increased by suitable central bank policies, and by creating different types of banks: in Germany, the majority of bank credit takes the form of such desirable real economy lending, because the majority of banks are not-for-profit small and medium-sized local banks (1,500 of them in total, accounting for 70% of deposits). In the UK the top five banks account for over 90% of deposits. Thus public funds should be allocated via the British Business Bank or other institution to capitalise the creation of not-for-profit community banks lending to SMEs.

1. Effectiveness of interest rate & ‘quantitative easing’ policy in meeting the inflation target

Concerning so-called ‘quantitative easing’, it was right for the Bank of England in 2009 to belatedly acknowledge that the quantity of the money injected into the economy is more important than the price of money (the interest rate). However, the implementation of this new policy has been unsatisfactory. Empirical research has shown already 25 years ago that in a careful statistical horse-race of economic variables that can potentially explain nominal GDP growth (the key policy target we should all be concerned about, which combines real growth and inflation), interest rates dropped out as insignificant (and having the wrong sign, i.e. wrong direction), and so did traditional ‘money supply aggregates’ such as M2 or M3 (see Werner, 1992, 1997, 2005; Lyonnet and Werner, 2014; Werner, 2014; Ryan-Collins et al., 2016).

What has been shown to determine nominal GDP growth is the quantity of credit creation (consisting mainly of bank credit creation) for GDP transactions, i.e. bank loans to the real economy. True quantitative easing, as originally defined, indeed consists of expanding credit creation for real economy (GDP) transactions (Werner, 1995). The Bank of England’s ‘quantitative easing’ has never targeted this, but instead focused on asset purchases by the central bank (Lyonnet and Werner, 2012). However, the same model on the basis of which the true original quantitative easing was proposed (the Quantity Theory of Credit, see Werner, 1992, 1997; 2012, 2013), suggests that credit creation for non-GDP, i.e. asset transactions, will merely cause asset price inflation (which always prepare the beginning of the next banking crisis).

Interest rate policy targeting short rates is never able to influence economic growth. Careful and detailed empirical research has demonstrated that both short-term and long-term interest rates follow nominal GDP growth, and are positively correlated (Werner, 2005; Werner and Zhu, 2011; Lee and Werner, 2017). This means that instead of the postulated negative correlation (lower rates being associated with higher growth and vice versa), higher growth and higher rates are associated. Moreover, tests of statistical causality and timing demonstrate that interest rates follow economic growth, they do not lead, and they cannot be said to cause or influence economic growth (see Werner, 2005; Werner and Zhu, 2011; Lee and Werner, 2017). Thus it is not surprising that traditional interest rate policy has been ineffective.

However, there is some meaning in interest rate policy: the steepness of the yield curve (long term interest rates minus short-term rates) is important, because it determines the profitability of bank credit creation and hence its volume, and this way will affect nominal GDP growth. Thus it is important to have an upward-sloping yield curve that is as steep as possible: longer term interest rates should be higher than short-term interest rates and the larger the gap the bigger the incentive for banks to expand lending.

2. Unintended consequences of monetary policy

As mentioned above, the Bank of England’s policy has mainly served to support asset prices, as well as the profits of the large financial institutions. Rising asset prices create many problems, including a renewed risk of another financial crisis. They also further increase inequality, both across professions and income groups, but also geographically, as such financial institutions are centred on London. Whether this was intended or an unintended policy result is difficult to confirm. Most importantly, monetary policy fails to meet its main goal of delivering stable, sustainable, regionally well distributed and equitable economic growth (easiest measured by nominal GDP growth) without financial crises.

The Bank of England’s policy of bank regulation, which has so far failed to deliver the establishment of not-for-profit community banks (a key policy to ensure stable, sustainable economic growth, geographically even job creation and less inequality), has also had the consequence of exacerbating inequality and weakening job creation (for it is primarily small banks that lend to small firms). Specifically, the Bank of England has failed to offer the type of central bank services that are required for an open, competitive and stable financial system, namely payments and settlement services for all banks. Challenger banks cannot settle their payments transactions via a low-cost Bank of England account, and instead have to go through the cartel of big banks.

3. Prospects for monetary policy

Prospects for monetary policy can be drastically improved, and future banking crises averted, if the following set of policies is adopted:

1. Asset purchases by the Bank of England are stopped (they artificially boost asset prices and lower long-term interest rates, thus creating a flat yield curve, when in fact the yield curve should be upward-sloping to encourage an economic recovery), short-term rates are raised modestly to give the signal that the policy of near-zero rates has ended, and long-term interest rates are allowed to rise significantly. This will make it profitable for banks to engage in lending to the real economy, on which the loan margin will be substantial. Meanwhile, the asset bubble is not further encouraged, thus ending the diversion of bank credit for asset purchases.

2. The Bank of England acts as a true central bank for all banks, by offering cheap payment and settlement services to all banks in the UK, as many other central banks are doing as standard procedure. Currently, challenger banks face the obstacle that they have to work through the cartel of big banks that operate all payments systems (BACS, CHAPS, Faster Payments, SWIFT), but this cartel could easily be circumvented by challenger banks, if the Bank of England offered them accounts and the facility to settle with other banks via the Bank of England accounts at no cost. If the Bank of England is indeed a publicly owned bank serving the public interest, this should be standard procedure (e.g. see the truly publicly owned and public interest-oriented Bundesbank in Germany).

3. The Bank of England acknowledges the empirically proven fact that interest rates follow economic growth and are positively correlated with it, so that they cannot be useful as monetary policy tool, except in defining the steepness of the yield curve (defined as 10-year benchmark government bond rates minus overnight interbank rates). The Bank of England should announced that it is now monitoring the quantity and allocation of bank credit to different sectors of the economy. Banks are instructed by the Bank of England to lend for transactions that contribute to GDP, i.e. bank credit for the purchase of ownership rights of existing things and assets is discouraged and bank credit for business investment is encouraged. This can take the form of the well-established ‘moral suasion’, practiced by the Bank of England over many decades in the past, but could be more formalised, e.g. via prudential rules, such as bank credit for non-GDP transactions must not grow faster than bank credit for GDP transactions or similar formulations.

4. The government can increase bank credit creation for GDP transactions, and hence nominal GDP growth (and hence job creation and prosperity), by the relatively simple measure of stopping the issuance of government bonds and instead borrowing the funds required for the public sector borrowing requirement directly from the banks in the UK. This policy is called ‘Enhanced Debt Management’ (Werner, 2014). This will result primarily in credit creation for GDP transactions and hence nominal GDP growth, not asset inflation. Moreover, it will help stabilise the bond market, especially when the Bank of England ends the distortionary bond purchase policy. For details on this, please see Werner (2014).

5. The government, via Treasury and BIS, implements a policy of establishing or supporting the establishment of several dozen co-operative banks, several dozen community banks, and re-introduces the savings banks that Britain pioneered in the 19th century. Currently, the last such savings bank, the Airdrie Savings Bank, founded in 1835 and active since then in Scotland, has announced that it will close, as it sees no future for itself, given the regulatory regime, which makes life difficult for small banks, and the interest rate policy of the Bank of England, which consists of a very flat yield curve, which must kill all banks that aim at mainly lending to the real economy. The government should provide funding for Airdrie Savings Bank to ensure its survival and in fact expansion of activities. And it should help establish other such savings banks, which were erroneously phased out in the 1980s. The Bank of England, the British Business Bank and Green Investment Bank, among other government entities, can be instructed to provide capital for the establishment of several parallel and competing networks of such not-for-profit banks (one network being co-operative banks, another network being community banks based on the model pioneered by the Hampshire Community Bank, and another network being savings banks, based on the traditional savings bank model of which the Airdrie Savings Bank is the last surviving example). Monetary policy must be decentralised in this way, which is the only effective way to reduce inequality and ensure stable, sustainable growth without asset bubbles, banking crises and boom-bust cycles (as demonstrated by the past 200 years of track record of the German economy, dominated by competing networks of not-for-profit community banks, namely savings banks and co-operative banks).

Banking requires a certain degree of collaboration (close to collusion) between banks, since without it no ‘transfer’ of any ‘payment’ can take place (via payment and settlement systems and the ‘interbank market’). When banking is highly concentrated as in the UK, this collusion means a bad deal for the rest of the economy. In order to ensure true competition in banking, it is thus necessary to establish competing networks of different types of banks, which will collaborate among them but fiercely compete against the other types (see Patel and Werner, 2017).

5 March 2017

Bibliography:

Lee, Kang-Soek and Richard A. Werner (2017), Reconsidering the policy-bias towards interest rates: An empirical examination of the relationship between interest rates and nominal GDP growth in the U.S., U.K., Germany and Japan in the half-century before the 2008 crisis; University of Southampton Centre for Banking, Finance and Sustainable Development, discussion paper

Lyonnet, Victor and Richard A. Werner (2012). Lessons from the Bank of England on ‘quantitative easing’ and other ‘unconventional’ monetary policies. International Review of Financial Analysis. 25, 1-17, http://www.sciencedirect.com/science/article/pii/S1057521912000737

Priyen Patel and Richard Werner (2016), Competition in the UK banking sector, London: Federation of Small Businesses; forthcoming in book edition 2017

Ryan-Collins, Joshua, Richard A. Werner and Jennifer Castle (2016), A half-century diversion of monetary policy? An empirical horse-race to identify the UK variable most likely to deliver the desired nominal GDP growth rate, Journal of International Financial Markets, Institutions & Money, 43 (July), 158–176  http://dx.doi.org/10.1016/j.intfin.2016.03.009

Werner, Richard A. (1991), The Great Yen Illusion: Japanese Capital Flows and the Role of Land, Oxford Applied Economics Discussion Paper Series, Oxford: Institute of Economics and Statistics, University of Oxford, No. 129, December

Werner, Richard A. (1992), ‘Towards a quantity theory of disaggregated credit and international capital flows’, Paper presented at the Royal Economic Society Annual Conference, York, April 1993 and at the 5th Annual PACAP Conference on Pacific-Asian Capital Markets in Kuala Lumpur, June 1993, reviewed by the Economist on 19 June 1993 in the ‘Economics Focus’

Werner, Richard A. (1995), Keiki kaifuku, ryōteki kinyū kanwa kara, (How to Create a Recovery through ‘Quantitative Monetary Easing’), The Nihon Keizai Shinbun (Nikkei), ‘Keizai Kyōshitsu’ (‘Economics Classroom’), 2 September 1995 (morning edition), p. 26; English translation by T. John Cooke (November 2011), available at http://eprints.soton.ac.uk/340476/

Werner, Richard A. (1997). ‘Towards a New Monetary Paradigm: A Quantity Theorem of Disaggregated Credit, with Evidence from Japan’, Kredit und Kapital, vol. 30, no. 2, July 1997, pp. 276-309

Werner, Richard A. (2005). New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance, Basingstoke: Palgrave Macmillan, 2005

Werner, Richard A. (2012). Towards a New Research Programme on ‘Banking and the Economy’ – Implications of the Quantity Theory of Credit for the Prevention and Resolution of Banking and Debt Crises, International Review of Financial Analysis, 25, 94-105, http://www.sciencedirect.com/science/article/pii/S1057521912000555

Werner, Richard A. (2013). Quantitative Easing and the Quantity Theory of Credit. Royal Economic Society Newsletter, July, pp. 20-22 http://www.res.org.uk/view/art5jul13features.html

Werner, Richard A. (2014). Enhanced debt management: Solving the eurozone crisis by linking debt management with fiscal and monetary policy, Journal of International Money and Finance, 49, 443-469, http://www.sciencedirect.com/science/article/pii/S0261560614001132

Werner, Richard A. and Min Zhu (2012), The relationship between interest rates and nominal GDP growth in the U.S., U.K., Germany and Japan from the 1960s to 2008, paper presented at the International Conference on the Global Financial Crisis: European Financial Markets and Institutions, University of Southampton, Southampton Management School, held at Chilworth Manor House Hotel on 25-26 April 2013

4