The Bank of England’s programmes of Quantitative Easing (QE) and Funding for Lending (FLS) are failing to stimulate GDP and rebalance the economy.
Both policies falsely assume that the UK’s risk-averse capital markets, corporate sector and constrained banking system can be nudged into supporting the productive economy. We propose a new approach: one that channels investment directly into new housing, infrastructure and SME lending, boosting productivity and exports. QE must become less scattergun and more strategic, with reformed governance structures to match.
The way QE has been interpreted and applied in the UK has benefitted some parts of the economy at the expense of others. While it has assisted some borrowers (including the Government) who have enjoyed lower medium and long-term interest rates, it is bank credit for productive GDP transactions, not interest rates, that is the primary driver of nominal GDP. In other words, success in lowering interest rates does not necessarily translate into success in stimulating the real economy.
In theory, QE should induce investors to move money away from holding government debt and into the corporate sector, boosting investment, production and employment. But 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.
Funding for Lending has stimulated bank credit for the real economy more directly than QE. But in practice this credit has mainly been in the form of mortgage debt rather than corporate lending, and has been severely constrained by the continued weaknesses of bank balance sheets.
Even if bank lending does increase, we cannot be sure that it will lead to output, investment and employment rather than a new house price, commodities or stock market boom. Chronic structural weaknesses and perverse regulatory incentives mean that, without further policies, reliance on the UK banking system is not an effective channel for stimulating or rebalancing the economy.
It is time to seriously consider more strategic use of the Bank of England’s powers as a bank.
An estimated £550bn of investment in new low-carbon infrastructure is required over the next 10 years in the UK, and housing construction remains at its lowest level in the post-war period. We therefore propose that the Asset Purchase Facility buys bonds issued by agencies with a specific remit for productive investment within the UK, such as in housing-building and retrofit, infrastructure and small and medium enterprises (SMEs).
Both government and opposition parties now support the economic case for a national development bank. However – as is the case with our Green Investment Bank – lack of a banking license and the Government’s reluctance to commit taxpayer funds will severely limit the British Business Bank’s scale and impact.
Total capital for both these institutions of less than £4 billion compares with balance sheets of over £200bn for the Brazilian development bank and £400bn for Germany’s KfW.
Central bank support for national infrastructure investment has worked before. The Industrial Development Bank of Canada, which supported Canadian SMEs from 1946-1972, was capitalised entirely by the Central Bank with not a single penny of taxpayers’ money required. In New Zealand in 1936, the central bank extended credit for the building of new homes, helping the country out of the Great Depression. Moreover, the majority of the UK’s major international competitors, including emerging market economies, have public investment banks or equivalent funds supporting infrastructure or SME financing.
We also examine the case for the APF purchasing a wider range of assets from banks in order to free up their capital for more productive lending. This has been successful in the USA and might improve the impact of QE here, but overall we recommend strategic QE as the best approach to rebalancing the UK economy.
Would strategic QE blur the line between monetary and fiscal policy? In reality the distinction has always been blurred. We should now be asking what governance systems could allow us to carry out hybrid monetary/fiscal measures, and then selecting the most effective tools to deploy.
We suggest the formation of a Monetary Allocation Committee that would be accountable to the Treasury and Parliament but separate from the Bank of England’s existing Monetary Policy Committee (MPC). The new committee would decide how best to allocate new QE funding and any reinvestment of maturing gilts (almost £100bn are being repaid over the next five years).
The committee would be charged with carefully examining different sectors of the economy and spare capacity within them. It would make allocation judgements based on a broad range of macroeconomic and policy criteria, such as sustainable GDP growth, employment, financial stability, the trade balance and inflation and ecological sustainability. Meanwhile, the independent MPC would remain in charge of determining the quantity of Bank of England reserves created and remain accountable for inflation. This would maintain an appropriate separation of powers and ensure that inflation expectations remained anchored.
We have already entered the world of monetary policy activism; let’s make it as effective, transparent and accountable as possible.
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