Opinion: Getting radical with the money supply

Last week the OECD forecast that Britain was about to experience a double-dip recession, for the first time since 1975. Vince Cable in his Centreforum paper Moving from the financial crisis to sustainable growth asks “How far should monetary policy now be expanded further in the UK to boost demand and head off a period of poor growth?

He goes on to say “There is no possibility for further meaningful interest rate cuts – real short term rates are now minus 4 percent. That means further recourse to quantitative easing.

If we reached a situation where even more unconventional policy was required, the question would require a careful discussion between Bank and government, so that its monetary independence remained unimpeachable. In the meantime, it is surely right and sensible to have an open debate on the relationship between the Bank’s action and wider policy in this unprecedented, and difficult, economic environment. I have not raised here even more radical options like the use of QE to finance the budget deficit or to finance consumptions – these are options only for an extreme emergency. There is in any event a natural complementarity between government fiscal policy and the Bank of England, in that the Central Bank’s mandate leads it to help offset disciplined government fiscal tightening through QE provided it does not compromise the inflation target in the medium term or undermine the integrity and operational independence of the Bank.”

In a recent interview, Will Hutton questioned Vince on his attitude to maintaining a competitive exchange rate by requiring the Bank of England not to target inflation, but instead to target the growth of all goods and services in the economy, so called Money GDP.

Hutton claims such a move will do two things. It would guarantee to our banks that their balance sheets would become more manageable over time and we would also assure with QE that the exchange rate would remain competitive. Vince in response said, “that the economic logic is impeccable.”

There are those who argue that the Bank of England has in fact abandoned inflation targeting and in prioritising growth over inflation is, de facto, employing a policy of targeting nominal gross domestic product (NGDP). Mervyn King, however, would point to medium term indicators and surveys of inflation expectations to refute this contention.

Will we see the kind of emergency options, Vince has referred to, like the use of QE to finance the budget deficit or finance consumption. The economist Milton wrote, in 1969, about dropping money from a helicopter to stimulate the economy. George W Bush, after the World Trade Center attacks, sent most adult Americans a tax refund cheque. Ben Bernanke in a speech on deflation said:

A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.

One thing we know for sure, monetary policy will continue to do the heavy lifting in the effort to return the economy to its trend rate of growth.

* Joe Bourke is an accountant and university lecturer, Chair of ALTER, and Chair of Hounslow Liberal Democrats.

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16 Comments

  • It’s great to see some discussion of such things. Even if the Treasury and BoE have got everything right(!), the lack of discussion of alternatives and radical ideas – particularly by the LDs – is not healthy.

    This is not trivial. The BoE has now ‘spent’ over £5000 per person in the UK (£325bn!). Does the fact that it’s ‘new’ money reduce the need to ensure it’s put to the best possible use?

    With that money we could have paid for maybe 2 million homes. Is anyone going to argue that that wouldn’t have a gigantic economic impact (as well as slashing the long-term housing benefit bill)?

    Or, as you suggest, it could have been given to everyone in the country – perhaps in some time-limited form – rather than (directly) to banks. £5000 each is a pretty hefty stimulus. Graeme mentions the problem of private debt. Neither option of spending a decade paying that off, nor trying to return to debt-fuelled growth are attractive, so helping people pay off those debts (whilst also rewarding those without debt) could be essential to avoid this decade being a write-off.

    Others have suggested using QE to fund green investment or a national investment bank.

    Has the BoE’s choice of buying bonds been such a success that we shouldn’t be seriously considering these ideas?

    I’m not saying the Government should take control of monetary policy: the BoE could say “we think building 2 million homes is the best way to stimulate the economy – here’s an earmarked £400bn!” I’m sure the MPC members are very clever but I do worry that they don’t want to do anything too high-profile or political. By high-profile I mean something that the man on the street might notice (like being given thousands of pounds). They prefer to stick to operating in the obscurity of the financial sector, even if that’s not the best option. To quote Simon Jenkins, “”Helicopter money”, once a satirical monetarist metaphor, suffers only one serious objection as a cure for a nation suffering from collapsed demand. It is vulgar and undignified. It seems tacky, populist, messy, a smart-alec suggestion not fit for consideration by ministers, bankers or economists.” (http://www.guardian.co.uk/commentisfree/2012/jan/26/economy-uk-high-street)

  • Bill le Breton 3rd Apr '12 - 4:50pm

    Joe, you are to be congratulated for airing this subject. Before anyone clatters in with their thoughts on QE, they should have already read this Bank of England Working Paper (No 442) to be found here: http://www.bankofengland.co.uk/publications/Documents/workingpapers/wp442.pdf

    And this post by Britmouse covering the B of E MPC minutes for February brings the story up to date by showing the change in the prediction for inflation following the completion of the latest £75b of QE. http://uneconomical.wordpress.com/2012/02/22/mpc-turns-dovish/ Note that the Bank of England is ‘steering’ the UK economy based on targeting the prediction.

    At least one, if not two members of the Committee advocated a further tranche of asset purchases. “A case was also made for the larger amount of asset purchases, given the considerable margin of spare capacity remaining in the economy and the extent of deleveraging still likely to be required. There was a risk of a prolonged period of depressed demand causing inflation to fall materially below the target in the medium term. In addition, persistently weak growth might impair the future supply capacity of the economy through hysteretic effects: that risk could be attenuated by a more aggressive loosening of monetary policy in the near term.”

    The point is that there is a debate about whether monetary policy is still too tight – Graeme, I would point to evidence that low rates are (however paradoxical) associated with periods of ‘tight’ monetary policy – and another debate about how to loosen it further. Virtually all politicians are silent in this debate.

    I have long argued here that there was a liberal case to be made for loosening further, for campaigning for a level targeting of NGDP growth approach and for setting an above trend level for a few years to make up for the ‘hole’ in NGDP that inappropriate monetary and fiscal policy has caused. It is good to see Vince entering the lists.

    The following from the most recent Labour Market Statistics should remind us that expansionary deficit reduction was wrong and a disastrous error: “There were 29.13 million people in employment aged 16 and over, up 60,000 on the quarter. The unemployment rate was 8.4 per cent of the economically active population, up 0.1 on the quarter. There were 2.67 million unemployed people, up 48,000 on the quarter. The unemployment rate has not been higher since 1995. The inactivity rate for those aged from 16 to 64 was 23.1 per cent, down 0.2 on the quarter. There were 9.29 million economically inactive people aged from 16 to 64, down 78,000 on the quarter.”

  • I fear we will all be dead before councils grant planning permission for 2 million homes!

  • Andrew Suffield 3rd Apr '12 - 6:31pm

    Or, as you suggest, it could have been given to everyone in the country – perhaps in some time-limited form – rather than (directly) to banks. £5000 each is a pretty hefty stimulus.

    That would be massively inflationary. QE isn’t, precisely because all it does is linger around the bottom of a bank’s balance sheet to make the numbers add up.

  • Grame Cowie,

    You are right to point out that monetary stimulus does not address the underlying problems with financial institutions, private and public sector debt , competiveness and lack of productivity growth. It can however aid in stabilising the economy while longer term structural reforms are set in motion.

    Future inflation is not the problem right now, at least not in goods and services. The mass of liquidity created by central banks around the world, searching for yield, may inflate asset bubbles, but that is a global problem. Our focus here is on UK economic growth.

    After the first tranche of QE in 2010, Giles Wilkes, CentreForum’s then chief economist and author of the report, Credit where its due:making QE work for the real economy said:

    “In deploying quantitative easing, the Bank may have forestalled a total collapse in our financial system. But QE has been less successful at stimulating the real economy. Now it needs reform if it is to restore the confidence needed for sustained growth. Money that is subsidizing the borrowing costs of the state should instead be helping smaller businesses and households.

    “The Bank should start by targeting a high level of nominal growth until the economy is performing at its potential. This will reassure the private sector that liquidity won’t dry up in the near future, and so encourage more investment now. The second step should be for ‘credit easing’ to replace ‘quantitative easing’. The Bank’s independence of action on traditional monetary matters should be respected. But by putting taxpayer’s money at risk, QE is as much fiscal as monetary policy. So it is quite right for the government to direct the Bank to deploy the funds in the private economy, which is where it is really needed. For example, the money could help guarantee loans to small companies, or alleviate the dearth of financing for long-term infrastructure.

    “With incomes stagnating and huge spending cuts in prospect, the Bank is right to ignore scare stories about spiralling inflation. It should even consider expanding the programme if the economy stays weak. What it should not do, however, is increase the size of QE without changing the way it works. It is time that politicians realised that QE is their business, and that failure to make it work properly will be their failure.”

  • Richard Dean 4th Apr '12 - 12:46am

    That Bank of England Working Paper (No 442) is rather worrying. The BOE are not at all sure that what they are doing is the right thing, but they suspect that some aspects of QE created shocks that went against its aims. Echoes of Howard Davies and his 39 reasons. Plus they don’t seem to be too sure where all of the £200- billion went. but they suspect only 60% ended up as broad money. Helicopters might have been better!

  • @Andrew: But as this article, and other commenters and reports have suggested, higher inflation isn’t necessarily a bad thing (though it hurts my own bank balance). And one of Bill’s links shows the current forecast is for us to undercut the 2% target.

    That current asset purchases just “linger around the bottom of a bank’s balance sheet” might also suggest they’re not the best of possible schemes.

    I also don’t think the inflation argument – even if that were a problem – would apply so much to investment such as home building, which could be done so that assets were later sold on and that money destroyed.

    Tim’s point about planning permission is the bigger obstacle but CPRE claim there are 1.5m houses worth of brownfield land. Couldn’t QE build 500,000 homes (social or other)? 50,000?

  • Adam,

    Keynes never worried too much about being low key or too political.

    Keynes argued that when businesses and people cannot or will not invest, then the government must take on the role of filling the gap. The key is speed. The means, Keynes wrote in The General Theory of Employment, Interest and Money, really did not matter so much:

    ‘If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines which are then filled to the surface with town rubbish and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again, . . . there need be no more unemployment and with the help of the repercussions, the real income of the community would probably become a good deal larger than it is.’

    Of course, Keynes favored large public-works projects over the burying of bottles. Building roads in the right places, for example, would both put people to work and provide the basis for more commerce. At first, Keynes emphasized government spending as stimulus, but when pressed in 1933, he advocated tax cuts as well—specifically in response to criticism that public-works projects do not put cash into the system quickly enough.

  • Bill le Breton,

    The argument for NGDP targeting is one that is gathering momentum. While I would favour such a move, I do not see it as a panacea in its own right.

    I think fundamentally the policy issue comes down to an accurate analysis of the causes of the weak recovery and whether they are a temporary blip or longer lasting.

    If the UK is experiencing a ‘balance sheet recession’ (the term coined by Nomura’s Richard Koo to explain Japan’s lost decades) then Koo argues that the financial system won’t recover until corporates and households complete their deleveraging journey. When debt minimisation becomes a priority over profit maximisation, there is little private sector demand for increased borrowing, even at effective negative interest rates. In this situation, monetary policy is impotent, quantative easing will be ineffective in restoring demand and, in the absence of a major fiscal stimulus, there might be no alternative to the UK drastically lowering its living standards in order to restore balance.

    However, there are potential policy solutions for weak demand in the economy. Allowing the economy to stay weak represents an enormous waste and subjects large numbers of people to unnecessary unemployment – not a strategy that we should be supporting as Liberal Democrats.

    The policy response is complicated by the reality that the cause of the continuing recession is likely a combination of high debt levels in some sectors of the economy and lack of confidence to invest/spend in those sectors of the economy not troubled with excessive debt.

    There needs to be a combination of monetary policy and fiscal policy, crucially working in the same direction. Vince Cable is being gracious when he says “there is a natural complementarity between government fiscal policy and the Bank of England, in that the Central Bank’s mandate leads it to help offset disciplined government fiscal tightening through QE.” This just means that the BofE is trying to cushion the effect of fiscal consolidation on aggregate demand, while recognising the limitations of monetary policy.

    As more unconventional monetary policy is required the distinction between monetary stimulus and fiscal stimulus becomes increasingly blurred. Maintaining financial credibility and sound money will both remain important considerations in fashioning appropriate policies.

    I think Dr. Cable is pointing the way for what needs to happen, sooner rather than later.
    · Start by targeting a high level of nominal growth until the economy is performing at its potential.
    · Significant Credit easing measures, including programs for financing of large scale infrastructure projects such as a ‘regulated asset base’ replacing quantitative easing
    · Cycle sensitive budget deficit management
    · Financing of capital investment programs with the proceeds of asset sales e.g. from the sale of bank shares, post office pension fund assets, spectrum sales etc.
    · Allowing local government to pursue their own innovative ways of financing projects against their own balance sheets.
    · Rapid implementation of the Green Deal – a large scale program of home insulation
    · Sweeping away obstacles to investment in home building and community land auctions.

  • Adam,

    “Couldn’t QE build 500,000 homes (social or other)? 50,000?”

    We have recently discussed how your suggestion could be implemented: Building an economic recovery

    Vince Cable in his essay wrote:

    “There is a large pool of capital in financial institutions like pension funds looking for long term investment opportunities with a reliable, utility return. The issue is how to channel this money into large scale infrastructure investments, and quickly.

    Dieter Helm has described how a ‘regulated asset base’ – a regulatory regime – can be created to provide certainty and predictability – for institutional investors. The long term cost of capital is currently very low (negative in real terms) but much inflated in practice by political risk. The RAB model provides investors with, in effect, a long term contract to provide a secure revenue stream based on an assumed rate of return (typically around 5 per cent in real terms). An independent regulator sets the terms. This model is already applied in the water and sewerage sector, airports, railways and energy distribution.

    The debate around infrastructure is also part of a wider debate about how to engender long term investment in the interests of sustainable growth. There are activities outside of infrastructure which also require a long term perspective – investment in research and capital intensive manufacturing; oil and gas production and refining; and, arguably, housing”

    Investment of the proceeds of asset sales such as the Northern Rock shares and Post Office Pension funds in development land and the securing of finance, for the building of shared equity and affordable rent housing, from financial institutions like pension fund could deliver the results you are seeking.

  • Stephen W,

    Depends on what you call crazy.

    Hiking interest rates to 15% and spending £27 billion of reserves (losing £3.3 in the process) trying to keep sterling in the exchange rate mechanism in 1992 might be considered crazy with hindsight. Especially so, as the country was plunged into recession as large numbers of businesses’ failed and the housing market crashed. However, the ejection from the ERM and subsequent devaluation paved the way for an economic revival that brought down what had been persistent unemployment and inflation.

    There are a number of credible schools of economic thought on the fringes of mainstream opinion.

    Neo-chartalists subscribe to “Modern Monetary Theory”. They believe that because paper currency is a creature of the state, governments enjoy more financial freedom than they recognise. The fiscal authorities are free to spend whatever is required to revive their economies and restore employment. They can spend without first collecting taxes; they can borrow without fear of default. Sovereign states with their own fiat currency need not concern themselves with ratings and bond-markets. In fact, they need not bother with bond markets at all. Warren Mosler, a highly successful bond-investor and an idiosyncratic economist is one of the high profile advocates of this school.

    “Market monetarists” favour more audacity in the monetary realm. They argue that tight money is the cause of the recession and easy money can end it. The favoured tool of targeting Nominal GDP is gaining much credence.

    The “Austrian” school of economics is more for a hair-shirt prescription. Its adherents believe that part of the economy’s suffering is necessary, an inevitable consequence of past excesses. They think that central bank or government interference will only make things worse.

    Supply-side reforms in the area of regulation, planning restrictions and taxation undoubtedly are part of the solution but cannot, of themselves, bring the quick results needed to prevent lasting damage being done.

  • Thanks for your replies, Joe.

    What of the view that private debt reduction is going to be a persistent drag on the economy? I think this is the view of Koo and of Keen. Higher inflation and lower real interest rates should help, but at the moment there perhaps isn’t that demand for new credit (“The point here is that conventional monetary policy cannot work because the economy’s demand for credit is saturated”). Someone needs to increase spending and if it’s not the private sector, households or Government (all concentrating on their balance sheets or scared to be the first to invest), can’t the BoE play a role?

    Quite a few of us seem to be in agreement that transparently targeting higher inflation at the moment wouldn’t be a bad thing, but the question of how inflation would be achieved is really important (despite the Keynesianism?).

    We could have a form of QE or similar BoE policy that does a lot more to:
    1) increase inflation (decreasing real interest rates, devaluing the currency, reducing public and private debts)
    2) play the role of fiscal stimulus (e.g. housebuilding, infrastructure investment, helicopter money, tax-cuts on youth labour…) without increasing the national debt and ideally without encouraging private debt
    3) directly pay off people’s debts (e.g. helicopter money – Keen’s Modern Jubilee)

    I’m not sure current QE is the optimum use of new money for any of these (especially as the Govt doesn’t use any monetisation of debt to increase or even maintain spending?). From Bill’s links, it looks like £275bn has caused a peak of 1 % point extra inflation. Given that we may soon drop below 2%, how would we get the 4% for several years that some want?
    It also looks like QE’s boost to real GDP came largely from increasing asset prices, whereas increasing employment seems more important to me.
    I’m not convinced that the BoE needs to buy assets that can be resold to the market later on, though even if it must that would still allow housing/infrastructure investment, and I think the Treasury would manage without it buying gilts particularly.

    So I’m yet to be convinced of why the BoE shouldn’t – at its very simplest – create some money, give some to everyone and spend the rest on housing and infrastructure. As you’ve said, monetary and fiscal stimulus can become very blurred and I think both birds (and the debt problem) could be killed with the same stone. From your comments, Joe, are you saying that you’d like the BoE to use created money to back (rather than fund) infrastructure investment, instead of repeating its financial asset purchases? It’s one thing to target nominal GDP growth of, say, 6% but how would you achieve it? And what do you think of the debt issues I’ve raised (that lack of demand for credit is limiting the utility of monetary policy, and that we need a quick rather than protracted pay-off of private debt )?

  • I should add that when I said “It’s one thing to target nominal GDP growth of, say, 6% but how would you achieve it?” I was referring to the current situation where the interest rate’s already very low. But maybe there’s an interesting question here of whether the bank rate would be so effective or desirable a tool if we tried to move away from such a reliance on borrowing (or at least certain kinds) in future.

  • Adam,

    I think the drag of private debt is overegged. Most of the build-up in private debt was investment in housing. Household debt rose substantially as house prices increased and overall household net worth has increased. It could become a problem if interest rates increased but there has been a lot of pay down of debt over the past four years and those with base rate tracker mortgages have done very well. It is a more of a problem at lower income levels where unsecured debt (credit cards and personal loans) is still high as a % of income. We have not seen the confidence sapping levels of negative equity that were experienced in the early nineties.

    Tolerating higher inflation and lower real interest rates (as is clearly being done) may help spur activity, but confidence in being able to make a return on investment is essential to spur demand for new credit. I agree that conventional monetary policy (further base rate reductions) or more QE will not do it.

    The corporate sector (big business) has paid down debt and is awash with cash (over 700 billion). Companies need to be confident that they can rollover debt before they start returning cash to shareholders or making substantial investments. The BofE can play a role here with credit easing to ensure that corporate bond markets are operating efficiently and accessible to large companies. Credit easing is also playing a part in the small business loan market by using the BofE balance sheet to enable banks to offer lower cost guaranteed loans to small business.

    If the BofE can take on the risk of holding corporate bonds in the private sector and furnishing guarantees for small business loans, then it is logical that it can do the same for newly issued Infrastructure or National housing bonds. The bank would sell some of the gilts holds and buy the infrastructure/housing bonds. When the time comes to tighten policy these bonds would be sold back into the market.

    As regards steps to tackle unemployment, I favour direct action in the form of a job guarantee scheme. We have sufficient borrowing capacity to fund a scheme for putting one million people to work immediatly. Tax increases to reduce debt, such as restricting higher rate pension relief, can come later when the economy is back on track.

    To target Nominal GDP, the BofE neeed only make it clear that it will not tighten policy in the face of government initiated fiscal stimulus (so called leaning against the wind), until the NGDP target is firmly established.

    PS: I have read Steve Keens ‘Debunking Economics’ and like his idea of a modern debt jubilee. My initial thoughts were it will never get past the moral hazard argument and would put the entire insolvency profession out of work. However, that was before Greece actually did it with there debt holders. Maybe he has something there.

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