In a recent post, Global Warning, we looked at concerns about the global economy. One of these was about the ineffectiveness of monetary policy to stimulate aggregate demand and to restore growth rates. Despite the use of unconventional monetary policies, such as quantitative easing and negative interest rates, and despite the fact that these policies have become the new convention, they have failed to do enough to bring sustained recovery.
The two articles below argue that the failure has been due to a flawed model of monetary policy: one that takes too little account of the behaviour of banks and the drivers of consumption and of physical investment. Negative interest rates on banks’ holdings of reserves in central banks are hardly likely to push down lending rates to businesses sufficiently to stimulate investment in new plant and machinery if firms already have overcapacity. And consumers are unlikely to borrow more for consumption if their wages are barely rising and they already have debts that they fear will be difficulty to pay off.
As Joseph Stiglitz points out:
As real interest rates have fallen, business investment has stagnated. According to the OECD, the percentage of GDP invested in a category that is mostly plant and equipment has fallen in both Europe and the US in recent years. (In the US, it fell from 8.4% in 2000 to 6.8% in 2014; in the EU, it fell from 7.5% to 5.7% over the same period.) Other data provide a similar picture.
And the unwillingness of many firms and individuals to borrow is matched by banks’ caution about lending in an uncertain economic environment. Many are more concerned about building their capital and liquidity ratios to protect themselves.
In these circumstances, negative interest rates have little effect on stimulating bank lending and, by hurting their balance sheets through lower earnings on the money markets, may even encourage them to lend less
What central banks should be doing, argue both Stiglitz and Elliott, is finding ways of directly stimulating consumption and investment. Perhaps this will involve central banks “focusing on the flow of credit, which means restoring and maintaining local banks’ ability and willingness to lend to SMEs.” Perhaps it will mean using helicopter money, as we examined in the previous blog. As Larry Elliott points out:
The fact that economists at Deutsche Bank published a helpful cut-out-and-keep guide to helicopter 
money last week is a straw in the wind.
As the Deutsche research makes clear, the most basic variant of helicopter money involves a central bank creating money so that it can be handed to the finance ministry to spend on tax cuts or higher public spending. There are two differences with QE. The cash goes directly to firms and individuals rather than being channelled through banks, and there is no intention of the central bank ever getting it back.
So if the model of monetary policy is indeed flawed, prepare for more unconventional measures
Articles
What’s Wrong With Negative Rates?, Project Syndicate, Joseph Stiglitz (13/4/16)
The bad smell hovering over the global economy The Guardian, Larry Elliott (17/4/16)
Questions
- What arguments does Stiglitz use to support his claim that the model of monetary policy currently being used is flawed?
- In what ways has monetary policy hurt older people and what has been the effect on their spending and on aggregate demand in general?
- Why has monetary policy encouraged investors to shift their portfolios toward riskier assets?
- Examine the argument that ultra-low interest rates may result in a rise in unemployment in the long term by affecting the relative prices of capital and labour.
- What forms might helicopter money take?
- Would the use of helicopter money necessarily result in an increase in aggregate demand? What would determine the size of any such increase?
In a recent blog Accelerating interest in the interesting case of UK interest rates we compared the level of the official Bank Rate, which has now been at 0.5 per cent for over seven years, with a representative unsecured borrowing rate. In doing so, we found some evidence that credit conditions might be easing following the credit market disturbance of the late 2000s. Here we take the opportunity not only to review that data again one month on, but also to see whether a similar picture is true for the mortgage market.
Theories of the financial accelerator argue that the macroeconomic environment can affect commercial banks’ lending practices. One way in which this can operate is through the difference between banks’ lending rates and the official Bank Rate. We can think of such interest-rate differentials – or spreads – as a credit premium. The size of the premium may be thought to reflect lenders’ perceived risk of default by borrowers. It is argued by some economists that interest-rate differentials will fall when the economy is doing well and increase when the economy is doing less well. This is because the probability of default by borrowers is seen as smaller when the macroeconomic environment improves.
The effect of interest-rate differentials that are contingent on the macroeconomic environment is to amplify the business cycle. For example, a positive demand-side shock, such as a rise in consumer confidence, which causes the economy’s aggregate demand to rise will, in turn, lead to lower borrowing rates relative to the official Bank Rate. This financial effect further stimulates the demand for credit and, as a consequence, aggregate demand and economic activity. It is an example of what economists called the financial accelerator.
The chart shows the Bank Rate along with the average unsecured borrowing rate on loans by Monetary Financial Institutions (MFIs) of £10 000. Unlike secured borrowing, which we consider shortly, unsecured borrowing is not secured against property.
As expected, we can see that the unsecured borrowing rate is greater than the Bank Rate. In other words, there is a positive interest-rate differential. However, this differential is seen to vary. It falls sharply in the period up to the financial crisis. In early 2002 it was running at 8 percentage points. By summer 2007 the differential had fallen to only 1.7 percentage points. (Click here to download a PowerPoint of the chart.)
The period from 2002 to 2007 was characterised by consistently robust growth with the UK economy growing by about 2.7 per cent per annum over this period. This may point to economic growth can contributing to an easing of credit conditions as implied by the financial accelerator.
The story from 2008 changes very quickly as the interest-rate differential increases very sharply. In 2009, as the official Bank Rate was cut to 0.5 per cent, the unsecured borrowing rate climbed to close to 10.5 per cent. Consequently, the interest-rate differential rose to 10 percentage points. Inter-bank lending had dried up with banks concerned that banks would default on loans. The increase in interest rates on lending to the non-bank private sector was stark and evidence of a credit market disruption.
The interest-rate differential for unsecured borrowing has steadily declined since its peak at the end of 2009 as the unsecured borrowing rate has fallen. This implies that credit conditions have eased. In March 2016 our interest-rate differential for unsecured borrowing stood at 3.8 percentage points, not dissimilar to levels over the past 12 months. Interestingly, today’s differential on unsecured borrowing is lower than the 6.5 percentage point average over the period from 1997 to 2003, before the differential then went on its pre-crisis fall.
Our second chart repeats the analysis but this time for mortgages. The representative mortgage rate is the average standard variable mortgage rate.
Unlike that for unsecured borrowing, the interest-rate differential for mortgages is fairly constant up to the financial crisis. The widely report credit easing in the mortgage market appears to have operated more through amounts lent rather than through price, as evidenced by rising mortgage advance-to-income ratios. (Click here to download a PowerPoint of the chart.)
The second chart shows clear evidence of a credit market disruption from 2009. Hence, the markets for secured and unsecured lending saw credit conditions tighten with interest-rate differentials rising markedly. However, it shows that the higher interest-rate differential for secured lending following the credit market disruption remains. So while the differential has fallen sharply for unsecured lending the situation is quite different in the mortgage market. In fact, February and March 2016 saw the mortgage rate spread at 4.17 percentage points which is an historic high.
Our interest rate data show that interest-rate differentials can vary significantly over time. This is important to understand when we are thinking about the relationships between the macroeconomy and the financial system. Significantly, the data suggest that interest rates on different financial instruments can behave differently such that differences emerge in the patterns of spreads over the official Bank Rate.
The evidence on UK mortgage rates suggests that the market remains affected by the financial crisis and the credit market disruption that arose. Although the level of mortgage rates is historically low – which tends to capture many of the headlines – this masks an historically high premium over the official Bank Rate.
Articles
Bank warns EU vote may hit growth as it holds rates BBC News, (14/4/16)
Carney issues a warning as interest rates are held Belfast Telegraph, (15/4/16)
Bank Of England Leaves Interest Rates On Hold Sky News, (14/4/16)
UK banks plan to boost lending to households but not firms – BoE Reuters, (13/4/16)
Mortgage rates reach record lows as threat of Bank Rate rise evaporates Telegraph, Tara Evans (1/4/16)
Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database – interest and exchange rates data Bank of England
Questions
- Why would we expect banks’ borrowing rates to be higher than the official Bank Rate?
- How might banks’ credit criteria change as the macroeconomic environment changes? Explain your answer.
- As well as the macroeconomic environment, what other factors might lead to a change in the interest-rate differential between banks’ borrowing rates and the official Bank Rate?
- How would we expect a credit market disruption to affect the interest-rate differential?
- Explain how the financial accelerator affects the change in the size of the economy following a positive demand shock.
- Explain how the financial accelerator affects the change in the size of the economy following a negative demand shock.
- What is the impact of the financial accelerator of the amplitude of the business cycle?
- How might regulators intervene to minimise the effect of the financial accelerator?
- Why might explain the high interest-rate differential on mortgages that continues to persist following the financial crisis?
- Analyse the ways in which the financial system can stabilise or destabilise economies.
Project Syndicate is an organisation which produces articles on a range of economic, political and social topics written by eminent scholars, political and business leaders, policymakers and civic activists. It then makes these available to news media in more than 150 countries. Here we look at four such articles which assess the outlook for the European and global economies and even that of capitalism itself.
The general tone is one of pessimism. Despite unconventional monetary policies, such as quantitative easing (QE) and negative nominal interest rates, the global recovery is anaemic. As the Nouriel Roubini articles states:
Unconventional monetary policies – entrenched now for almost a decade – have themselves become conventional. And, in view of persistent lacklustre growth and deflation risk in most advanced economies, monetary policymakers will have to continue their lonely fight with a new set of ‘unconventional unconventional’ monetary policies.
Perhaps this will involve supplying additional money directly to consumers and/or business in a so-called ‘helicopter drop’ of money. Perhaps it will be supplying money directly to governments to finance infrastructure projects – a policy dubbed ‘people’s quantitative easing‘. Perhaps it will involve taxing the holding of cash by banks to encourage them to lend.
The Hans-Werner Sinn article looks at some of the consequences of the huge amount of money created through QE and continuing to be created in the eurozone. Although it has not boosted consumption and investment nearly as much as desired, it has caused bubbles in various asset markets. For example, the property market has soared in many countries:
Property markets in Austria, Germany, and Luxembourg have practically exploded throughout the crisis, as a result of banks chasing borrowers with offers of loans at near-zero interest rates, regardless of their creditworthiness.
The German property boom could be reined in with an appropriate jump in interest rates. But, given the ECB’s apparent determination to head in the opposite direction, the bubble will only grow. If it bursts, the effects could be dire for the euro.
The Jean Pisani-Ferry article widens the analysis of the eurozone’s problems. Like Roubini, he considers the possibility of a helicopter drop of money, which “would be functionally equivalent to a direct government transfer to households, financed by central banks’ permanent issuance of money”.
Without such drastic measures he sees consumer and business pessimism (see chart) undermining recovery and making the eurozone vulnerable to global shocks, such as further weakening in China. (Click here for a PowerPoint of the chart.)
Finally, Anatole Kaletsky takes a broad historical view. He starts by saying that “All over the world today, there is a sense of the end of an era, a deep foreboding about the disintegration of previously stable societies.” He argues that the era of ‘leaving things to the market’ is coming to an end. This was an era inspired by the monetarist and supply-side revolutions of the 1960s and 1970s that led to the privatisation and deregulation policies of Reagan, Thatcher and other world leaders.
But if the market cannot cope with the complexities of today’s world, neither can governments.
If the world is too complex and unpredictable for either markets or governments to achieve social objectives, then new systems of checks and balances must be designed so that political decision-making can constrain economic incentives and vice versa. If the world is characterized by ambiguity and unpredictability, then the economic theories of the pre-crisis period – rational expectations, efficient markets, and the neutrality of money – must be revised.
… It is obvious that new technology and the integration of billions of additional workers into global markets have created opportunities that should mean greater prosperity in the decades ahead than before the crisis. Yet ‘responsible’ politicians everywhere warn citizens about a ‘new normal’ of stagnant growth. No wonder voters are up in arms.
His solution has much in common with that of Roubini and Pisani-Ferry. “Money could be printed and distributed directly to citizens. Minimum wages could be raised to reduce inequality. Governments could invest much more in infrastructure and innovation at zero cost. Bank regulation could encourage lending, instead of restricting it.”
So will there be a new era of even more unconventional monetary policy and greater regulation that encourages rather than restricts investment? Read the articles and try answering the questions.
Articles
Unconventional Monetary Policy on Stilts Project Syndicate, Nouriel Roubini (1/4/16)
Europe’s Emerging Bubbles Project Syndicate, Hans-Werner Sinn (28/3/16)
Preparing for Europe’s Next Recession Project Syndicate, Jean Pisani-Ferry (31/3/16)
When Things Fall Apart Project Syndicate, Anatole Kaletsky (31/3/16)
Questions
- Explain how a ‘helicopter drop’ of money would work in practice.
- Why has growth in the eurozone been so anaemic since the recession of 2009/10?
- What is the relationship between tightening the regulations about capital and liquidity requirements of banks and bank lending?
- Explain the policies of the different eras identified by Anatole Kaletsky.
- Would it be fair to describe the proposals for more unconventional monetary policies as ‘Keynesian’?
- If quantitative easing was used to finance government infrastructure investment, what would be the effect on the public-sector deficit and debt?
- If the inflation of asset prices is a bubble, what could cause the bubble to burst and what would be the effect on the wider economy?
As John reminds us in his blog A seven year emergency we have now seen the official Bank Rate at 0.5 per cent for the past seven years. Understandably many attribute the financial crisis that led to the easing of monetary policy to the lending practices of commercial banks. Consequently, it is important that we better understand (and monitor) banks’ behaviour. Some argue that these practices are affected by the macroeconomic environment, with credit conditions varying across the business cycle. We consider here what recent patterns in interest rates might tell us about credit conditions.
One way in the macroeconomic environment might affect commercial banks’ lending practices is through the difference between banks’ lending rates and the official Bank Rate. We can think of such interest rate differentials – or spreads – as a credit premium. In other words, the greater are commercial borrowing rates relative to the Bank Rate, the greater the credit premium being demanded by banks. On the other hand, the lower the interest rate on borrowing relative to the Bank Rate, the smaller the credit premium.
Some economists argue that interest-rate differentials will fall when the economy is doing well and increase when the economy is doing less well. This is because the probability of default by borrowers is seen as smaller when the macroeconomic environment improves. If this is the case, it will tend to amplify the business cycle, since economic shocks will have larger affects on economic activity.
Consider a positive demand-side shock, such as a rise in consumer confidence, which lowers the propensity of households to save. As the positive shock causes the economy’s aggregate demand to rise, the economy grows. This growth in economic activity might result in lower borrowing rates offered by commercial banks relative to the official Bank Rate. Since savings rates tend to be close to the official Bank Rate, this also means that the cost of borrowing falls relative to the interest rates on savings. This financial effect further stimulates the demand for credit and, as a consequence, aggregate demand and economic activity. It is an example of what economists called the financial accelerator.
Similarly, the financial accelerator means that negative shocks depress economic activity by more than would otherwise be the case. A fall in consumer confidence, for example, would cause economic activity to fall as aggregate demand weakens. This, in turn, causes banks to raise borrowing rates relative to the Bank Rate and savings rates. This further dampens economic activity.
The chart shows the Bank Rate along with the average unsecured borrowing rate on loans by Monetary Financial Institutions (MFIs) of £10 000. (Secured borrowing is that which is secured against property.) We use this borrowing rate to capture general trends in commercial borrowing rates.
As expected, we can see that the borrowing rate is greater than the Bank Rate. In other words, there is a positive interest-rate differential. However, this differential is seen to vary. It falls sharply in the period up to the financial crisis. In early 2002 it was running at 8 percentage points. By summer 2007 the differential had fallen to only 1.7 percentage points. (Click here to download a PowerPoint of the chart.)
The period from 2002 to 2007 was characterised by consistently robust growth. The UK economy grew over this period by about 2.7 per cent per annum. This would certainly fit with the story that economic growth may have contributed to an easing of credit conditions which, in turn, helped to induce growth. Regardless, the falling interest-rate differential points to credit conditions easing.
The story from 2008 changes very quickly as the interest-rate differential increases very sharply. In 2009, as the official Bank Rate was cut to 0.5 per cent, the unsecured borrowing rate climbed to close to 10.5 per cent. Consequently, the interest-rate differential rose to 10 percentage points. Inter-bank lending had dried up with banks concerned that banks would default on loans. The increase in interest rates on lending to the non-bank private sector was stark and evidence of a credit market disruption.
The interest-rate differential has steadily declined since its peak at the end of 2009 as the unsecured borrowing rate has fallen. Hence credit conditions have eased. In fact, in February 2016 our indicative interest rate differential stood at 3.8 percentage points, unchanged from its level in January. This is its lowest level since July 2008. Furthermore, today’s differential is lower than the 6.5 percentage point average over the period from 1997 to 2003, before the differential then went on its pre-crisis fall.
Given concerns about the impact of credit cycles on the macroeconomy we can expect the authorities to keep a very keen eye on credit conditions in the months ahead.
Articles
Bank holds UK interest rates at 0.5% BBC News (17/3/16)
UK’s record low interest rates to continue in 2016 The Guardian, Katie Allen (3/3/16)
Big rise in consumer credit in January BBC News, Brian Milligan (29/2/16)
Household debt binge has no end in sight, says OBR The Telegraph, Szu Ping Chan (17/3/16)
Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database – interest and exchange rates data Bank of England
Questions
- Why would we expect banks’ borrowing rates to be higher than the official Bank Rate?
- What factors might lead to a change in the interest-rate differential between banks’ borrowing rates and the official Bank Rate?
- How would we expect a credit market disruption to affect the interest-rate differential?
- Explain how the financial accelerator affects the change in the size of the economy following a positive demand shock.
- Explain how the financial accelerator affects the change in the size of the economy following a negative demand shock.
- What is the impact of the financial accelerator of the amplitude of the business cycle?
- How might banks’ credit criteria change as the macroeconomic environment changes?
- How might regulators intervene to minimise the effect of the financial accelerator?
During the 1970s, commentators often referred to the ‘political business cycle’. As William Nordhaus stated in a 1989 paper. “The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power.”
In the past, politicians would use fiscal, and sometimes monetary, policies to manipulate aggregate demand so that the economy was growing strongly at the time of the next election. This often meant doing unpopular things in the first couple of years of office to allow for popular things, such as tax cuts and increased government transfers, as the next election approached. This tended to align the business cycle with the election cycle. The economy would slow in the early years of a parliament and expand rapidly towards the end.
To some extent, this has been the approach since 2010 of first the Coalition and now the Conservative governments. Cuts to government expenditure were made ‘in order to clear up the mess left by the previous government’. At the time it was hoped that, by the next election, the economy would be growing strongly again.
But in adopting a fiscal mandate, the current government could be doing the reverse of previous governments. George Osborne has set the target of a budget surplus by the final year of this parliament (2019–20) and has staked his reputation on achieving it.
The problem, as we saw in the blog, Hitting – or missing – the government’s self-imposed fiscal targets is that growth in the economy has slowed and this makes it more difficult to achieve the target of a budget surplus by 2019–20. Given that achieving this target is seen to be more important for his reputation for ‘sound management’ of the public finances than that the economy should be rapidly growing, it is likely that the Chancellor will be dampening aggregate demand in the run-up to the next election. Indeed, in the latest Budget, he announced that specific measures would be taken in 2019–20 to meet the target, including a further £3.5 billion of savings from departmental spending in 2019–20. In the meantime, however, taxes would be cut (such as increasing personal allowances and cutting business rates) and government spending in certain areas would be increased. As the OBR states:
Despite a weaker outlook for the economy and tax revenues, the Chancellor has announced a net tax cut and new spending commitments. But he remains on course for a £10 billion surplus in 2019–20, by rescheduling capital investment, promising other cuts in public services spending and shifting a one-off boost to corporation tax receipts into that year.
But many commentators have doubted that this will be enough to bring a surplus. Indeed Paul Johnson, Director of the Institute for Fiscal Studies, stated on BBC Radio 4’s Today Programme said that “there’s only about a 50:50 shot that he’s going to get there. If things change again, if the OBR downgrades its forecasts again, I don’t think he will be able to get away with anything like this. I think he will be forced to put some proper tax increases in or possibly find yet further proper spending cuts”.
If that is the case, he will be further dampening the economy as the next election approaches. In other words, the government may be doing the reverse of what governments did in the past. Instead of boosting the economy to increase growth at election time, the government may feel forced to make further cuts in government expenditure and/or to raise taxes to meet the fiscal target of a budget surplus.
Articles
Budget 2016: George Osborne hits back at deficit critics BBC News (17/3/16)
George Osborne will have to break his own rules to win the next election Business Insider, Ben Moshinsky (17/3/16)
Osborne Accused of Accounting Tricks to Meet Budget Surplus Goal Bloomberg, Svenja O’Donnell and Robert Hutton (16/3/16)
George Osborne warns more cuts may be needed to hit surplus target Financial Times, Jim Pickard (17/3/16)
6 charts that explain why George Osborne is about to make austerity even worse Independent, Hazel Sheffield (16/3/16)
Budget 2016: Osborne ‘has only 50-50 chance’ of hitting surplus target The Guardian, Heather Stewart and Larry Elliott (17/3/16)
How will Chancellor George Osborne reach his surplus? BBC News, Howard Mustoe (16/3/16)
Osborne’s fiscal illusion exposed as a house of credit cards The Guardian, Larry Elliott (17/3/16)
The Budget’s bottom line: taxes will rise and rise again The Telegraph, Allister Heath (17/3/16)
Reports, analysis and documents
Economic and fiscal outlook – March 2016 Office for Budget Responsibility (16/3/16)
Budget 2016: documents HM Treasury (16/3/16)
Budget 2016 Institute for Fiscal Studies (17/3/16)
Questions
- Explain the fiscal mandate of the Conservative government.
- Does sticking to targets for public-sector deficits and debt necessarily involve dampening aggregate demand as an election approaches? Explain.
- For what reasons may the Chancellor not hit his target of a public-sector surplus by 2019–20?
- Compare the advantages and disadvantages of a rules-based fiscal policy and one based on discretion.
In a recent post, Global Warning, we looked at concerns about the global economy. One of these was about the ineffectiveness of monetary policy to stimulate aggregate demand and to restore growth rates. Despite the use of unconventional monetary policies, such as quantitative easing and negative interest rates, and despite the fact that these policies have become the new convention, they have failed to do enough to bring sustained recovery.
In these circumstances, negative interest rates have little effect on stimulating bank lending and, by hurting their balance sheets through lower earnings on the money markets, may even encourage them to lend less
