At the Mansion House dinner on 15 June, the Chancellor, George Osborne, and the Governor of the Bank of England, Sir Mervyn King, announced a new monetary policy initiative to increase bank credit. The idea is to stimulate borrowing by both firms and households and thereby boost aggregate demand.
There are two parts to the new measures:
1. Funding for lending. The aim here is to provide banks with cheap loans (i.e. at below market rates) on condition that they are used to fund lending to firms and households. Some £80 billion of loans, with a maturity of 3 to 4 years, could be made available to banks under the scheme. The details are still being worked out, but the scheme could work by the Bank of England supplying Treasury bills to the banks in return for less secure assets. The banks could then borrow against these bills in the market in order to lend to customers.
2. Providing extra liquidity to banks through six-month repos. The Bank of England will begin pumping up to £5bn a month into the banking system to improve their liquidity. This is an activation of the ‘Extended Collateral Term Repo Facility’ (see also), which was created last December, to provide six-month liquidity to banks against a wide range of collateral.
But whilst it is generally accepted that a lack of borrowing by firms and households is contributing to the slowdown of the UK economy, it is not clear how the new measures will solve the problem.
In terms of the supply of credit, banks have become more cautious about lending because of the increased risks associated with both the slowdown in the UK economy and the euro crisis. They claim that the issue is not one of a shortage of funding for lending, but of current uncertainties. They are thus likely to remain reluctant to lend, despite the prospect of extra loans from the Bank of England.
In terms of the demand for credit, both businesses and consumers remain cautious about borrowing. Even if bank loans are available, firms may not want to invest given the current uncertainties about the UK, eurozone and world economies. Consumers too may be reluctant to borrow more when people’s jobs may be at stake or at least when there is little prospect of increased wages. Even if banks were willing to lend more, you cannot force people to borrow.
Britain fights euro zone threat with credit boost Reuters, Matt Falloon and Sven Egenter (14/6/12)
Debt crisis: emergency action revealed to tackle ‘worst crisis since second world war’ Guardian, Larry Elliott, Jill Treanor and Ian Traynor (14/6/12)
Q&A: Funding for lending scheme Financial Times, Norma Cohen (15/6/12)
Bank lending plan: How will it work? BBC News (15/6/12)
Bank of England’s loans to high street banks start next week Guardian, Phillip Inman (15/6/12)
Mervyn King: Bank of England and Treasury to work together The Telegraph (15/6/12)
Bank of England offers £80bn loans Channel 4 News, Sarah Smith (15/6/12)
Bank funding scheme plans unveiled Independent, Holly Williams (15/6/12)
Banking: King hits panic button Independent, Ben Chu (15/6/12)
Bankers raise doubts on credit scheme Financial Times, Patrick Jenkins and Sharlene Goff (15/6/12)
We should not pin our hopes on Britain’s plan A-plus Financial Times, Martin Wolf (15/6/12)
Throwing money at banks won’t solve economic crisis, Ed Balls says Guardian, Patrick Wintour (15/6/12)
UK lending plan faces risk of low take-up BloombergBusinessweek, Robert Barr (15/6/12)
Will Bank of England’s new lending schemes work? BBC News, Robert Peston (15/6/12)
Bank and Treasury’s plan A-plus for UK BBC News, Stephanie Flanders (15/6/12)
Questions
- How would the schemes incentivise banks to lend more?
- Explain what is meant by the Extended Collateral Term Repo Facility. How similar is it to the long-term repo operations of the ECB (see the news item More bank debt to ease bank debt)?
- What factors are likely to determine the take-up of loans from banks?
- Will the new arrangements have any implications for taxpayers? Explain.
- To what extent are fiscal and monetary policy currently complementary?
- What is the significance of calling the new measures ‘Plan A-plus’? What would ‘Plan B’ be?
This has been a week of gloomy prognostications. On Wednesday 16 May, the Bank of England published its quarterly Inflation Report – and it makes worrying reading.
The forecast of UK economic growth for 2012 has been reduced from 1.2% in the previous report to 0.8%. But the rate of inflation is forecast to remain above the 2% target well into next year. However, at the two-year horizon, inflation is now forecast to be 1.6% – below the target, thus giving the MPC scope for further quantitative easing.
In the introduction to the report, the Governor, Mervyn King, writes:
Over the past year or so, two factors have hampered the recovery and rebalancing by more than expected. First, higher-than-expected world commodity and energy prices have squeezed real take-home pay, dampening consumption growth. Second, credit conditions, far from easing, have in some cases become tighter. The direct and indirect exposures of UK banks to the euro-area periphery have affected funding costs as the challenges of tackling the indebtedness and lack of competitiveness in those countries have intensified.
And at the news conference launching the report, he said:
We have been through a big global financial crisis, the biggest downturn in world output since the 1930s, the biggest banking crisis in this country’s history, the biggest fiscal deficit in our peace time history and our biggest trading partner – the euro area – is tearing itself apart without any obvious solution.
The idea that we could reasonably hope to sail serenely through this with growth close to the long run average and inflation at 2% strikes me as wholly unrealistic. We’re bound to be buffeted by this and affected by it.
The following articles look at the Bank of England’s predictions and at the challenges facing the UK economy as the crisis in the eurozone deepens and as inflation in the UK remains stubbornly above target. They also look at the issue of the extent to which capacity has been lost as a result of the continuing weakness of the UK economy. As The Economist article states:
Business surveys suggest only a small proportion of firms are operating below capacity. That finding looks odd given the economy’s output is still 4% below its level at the start of 2008, and is much farther below the level it would have reached if GDP growth had continued at its long-term rate. The picture painted by surveys could be right if a chunk of the economy’s potential has been written off for good. But Sir Mervyn King, the bank’s governor, doubts this. There is “no obvious reason” why the economy could not rejoin its pre-crisis path, though it might take a decade or two to get there, he said on May 16th.
We look in more detail at the question of lost capacity in Part 2.
Articles
Bank of England cuts growth forecasts: Sir Mervyn King’s speech in full The Telegraph (16/5/12)
Bank of England sees inflation up and growth falling Independent, Ben Chu (17/5/12)
Hard going The Economist (19/5/12)
Bank of England optimism dented again Financial Times, Chris Giles (16/5/12)
Eurozone is ‘tearing itself apart’, says Mervyn King. True, but the UK’s problems are as intractable as ever The Telegraph, Philip Aldrick (16/5/12)
Inflation Report
Inflation Report: portal page Bank of England
Inflation Report: May 2012 Bank of England (16/5/12)
Additional Data
Statistical annex to European Economy. Spring 2012 European Commission, Economic and Financial AffairsAnnual macro-economic database European Commission, Economic and Financial Affairs (11/5/12) (see particularly section 6.5)
Forecasts for the UK economy HM Treasury
Questions
- What explanations are given for the rate of CPI inflation remaining persistently above the 2% target?
- Why have the prospects for economic growth worsened since the publication of the February Inflation Report?
- How might it be possible to have a narrowing (negative) output gap and yet a stagnant economy?
- Why may capacity have been lost since the financial crisis of 2008?
- Why has M4 declined despite the programme of quantitative easing? (See M4 in record fall despite QE.)
- What scope is there for monetary policy in achieving faster economic growth without pushing inflation above the 2% target?
The Bank of England was granted independence to set interest rates back in 1997. In setting rates its looks to meet the government’s annual inflation rate target of 2 per cent (with a range of tolerance of up to 1 percentage point).
The economic benefits of delegating interest rate decisions to a body like the Monetary Policy Committee (MPC) are often taken for granted. But, in David Blanchflower’s article in the Independent Newspaper on 14 May, the former MPC member questions whether, at least in recent years, better decisions would have been made by the Treasury and the Chancellor of the Exchequer. In other words, could politicians have made more appropriate monetary policy choices?
Central bank independence has become increasingly popular. Many governments have taken steps to depoliticise monetary policy choices and to hand over important powers, such as setting interest rates, to central bankers. One of the main advantages, it is argued, is that politicians are no longer able to manipulate monetary policy choices in order to try and affect their popularity and their chances of being re-elected. The policy announcements of central bankers are said to be more credible because they do not have the incentive to deviate from their announced policy. For instance, the low inflation announcements of elected policy-makers lack credibility because politicians have an incentive to inflate the economy and so boost growth and employment prior to the election.
The incentive for a pre-election dash for growth means that the general public are reluctant to bargain for low wage increases in case policy is loosened or is looser than it should be given the prevailing economic climate. In this case, it might mean that interest rates are lower than they would otherwise be in the run up to the election. In order to protect their spending power households bargain for higher wage increases than they would if the policy announcements could be trusted. In contrast, the low inflation announcements of central bankers have credibility and so inflation will be lower. In terms of economic jargon, central bank independence will reduce inflation bias as well as promoting economic stability.
Blanchflower questions whether the path of interest rates in the UK between 1997 and 2007 would have been materially different should the Treasury have been setting interest rates rather than the MPC. But, he believes that:
Interest rates would probably have been higher in 2007 as the housing boom was ranging and house price to earnings ratios approached unsustainable levels. Alistair Darling has made it clear he would have cut rates earlier in 2008, if it had been left to him….
Blanchflower argues that part of the reason that the Treasury might have made better choices in the more recent past is the narrow remit of the Bank of England to target inflation. He argues:
Now is the time to consider switching to a dual mandate that would include growth, which would give much needed flexibility.
Blanchflower calls into question the idea that targeting inflation alone can bring stability. The recent past he argues simply dispels this notion. To help form your own views try having a read of the full article and then answer the questions below.
David Blanchflower Article
The recession deniers have gone strangely quiet this month Independent, David Blanchflower (14/05/12)
Questions
- If economic growth is a good thing, why might we want to reduce the chances of policymakers manipulating policy to attempt a pre-election dash for growth?
- What do you understand by credible economic policy announcements? How might a lack of credibility affect the economy’s rate of inflation?
- What does central bank independence mean for the conduct of monetary policy in the UK? In answering this you might wish to visit the Bank of England website and read about the UK’s monetary policy framework.
- Try summarising David Blanchflower’s argument against the inflation rate remit of the Bank of England.
- What do you consider to be the possible dangers of widening the Bank of England’s remit beyond just targeting the annual rate of CPI inflation?
- Central bank independence is one way in which governments can constrain their discretion over economic policy. In what other ways can they constrain their policy choices?
- Do you think governments should have full discretion over their policy choices or do you think there should be limits?
Figures released by the Bank of England show that M4 fell by 5.0% in the year to March 2012. This record fall comes despite over £320 billion of assets purchased by the Bank under its quantitative easing programme. These are funded by the creation of reserves in the Bank of England. (See the Bank of England site for details of the timing and amounts of QE.)
Because of the considerable injection of new money into the banking system, notes and coin plus banks’ reserve balances in the Bank of England rose by 44.9%. So how is it that this measure of narrow money has increased massively and yet M4 has fallen?
One problem with using figures for changes in M4 to gauge economic activity is that they include intra-financial sector transactions – transactions between ‘other financial corporations’ (OFCs). Such transactions do not impact on the real economy. For this reason, the Bank of England prefers to focus on a measure that excludes these transactions between OFCs, a measure known as ‘M4 excluding intermediate OFCs’. This measure rose by 2.7% in the year to March 2012. Although this was positive, it was still weak.
So why does quantitative easing seem to be having such a small effect on bank lending? The following articles look at the issue.
Articles
Record collapse in UK money supply blamed on banks The Telegraph, Philip Aldrick (2/5/12)
UK March mortgage approvals rise unexpectedly London South East (2/5/12)
UK March Net Consumer Lending +GBP1.4 Billion NASDAQ, Jason Douglas and Nicholas Winning (2/5/12)
M4 Hits Record Low; Non-Residents Sell Gilts Market News International (2/5/12)
Data
Bankstats (Monetary & Financial Statistics) – March 2012 Bank of England (2/5/12): see Tables A1.1.1, A2.1.1 and A2.2.3
Questions
- How does quantitative easing impact on the narrow measure of money: notes, coin and banks’ reserve balances in the Bank of England?
- How might an increase in narrow money lead to an increase in broad money (such as M4)?
- How is it that notes, coin and banks’ reserve balances rose so rapidly in the year to March 2012, while M4 fell and even M4 excluding OFCs rose only slightly?
- Does this suggest that money supply is endogenous? Explain.
- How does requiring banks to rebuild their capital base impact on the relationship between narrow and broad money?
On 2 May 2012, Sir Mervyn King, Governor of the Bank of England, gave the BBC Today Prgramme’s public lecture. In it, he reflected on the causes and aftermath of the banking crisis of 2007/8.
He said that the main cause of the banking crisis was the risky behaviour of the banks themselves – behaviour that they had been allowed to get away with becuase regulation was too light. The cause was not one of inappropriate fiscal and monetary policy.
According to Dr King, there had been no classical macroeconomic boom and bust. True there had been a bust, but there was no preceding boom. Economic growth had not been unsustainable in the sense of being persistently above the potential rate. In other words, the output gap had been close to zero. As Mervyn King puts it
Let me start by pointing out what did not go wrong. In the five years before the onset of the crisis, across the industrialised world growth was steady and both unemployment and inflation were low and stable. Whether in this country, the United States or Europe, there was no unsustainable boom like that seen in the 1980s; this was a bust without a boom.
In terms of monetary policy, inflation had been on track and interest rates were not too low. And as for fiscal policy, government borrowing had been within the Golden Rule, whereby, over the cycle, the goverment borrowed only to invest and kept a current budget balance. Indeed, the period of the late 1990s and early to mid 2000s had become known as the Great Moderation.
So what went wrong? Again in the words of Dr King:
In a nutshell, our banking and financial system overextended itself. That left it fragile and vulnerable to a sudden loss of confidence.
The most obvious symptom was that banks were lending too much. Strikingly, most of that increase in lending wasn’t to families or businesses, but to other parts of the financial system. To finance this, banks were borrowing large amounts themselves. And this was their Achilles’ heel. By the end of 2006, some banks had borrowed as much as £50 for every pound provided by their own shareholders. So even a small piece of bad news about the value of its assets would wipe out much of a bank’s capital, and leave depositors scurrying for the door. What made the situation worse was that the fortunes of banks had become closely tied together through transactions in complex and obscure financial instruments. So it was difficult to know which banks were safe and which weren’t. The result was an increasingly fragile banking system.
But doesn’t his imply that regulation of the banking system had failed? And if so why? And have things now been fixed – so that banks will no longer run the risk of failure? Dr King addresses this issue and others in his speech and also in his interview the next day for the Today Programme, also linked to below.
Podcasts
The Today Programme Lecture BBC Radio 4, Sir Mervyn King (2/5/12) (Transcript of speech)
Also on YouTube at Governor’s Today Programme lecture, 2 May 2012
Sir Mervyn King: The full interview BBC Today Programme, Sir Mervyn King talks to Evan Davis (3/5/12)
Sir Mervyn King analysis ‘verging on delusional’ BBC Today Programme, Dylan Grice and Ngaire Woods (3/5/12)
Articles
Sir Mervyn King rejects criticism for crisis BBC News (3/5/12)
The boom and bust of Mervyn King BBC News, Robert Peston (3/5/12)
Sir Mervyn King admits BoE failed over financial crisis The Telegraph, Philip Aldrick (3/5/12)
Sir Mervyn King admits: we did too little to warn of economic crisis Guardian, Larry Elliott (2/5/12)
King Says BOE Will Risk Unpopularity to Prevent Crises Bloomberg, Jennifer Ryan and Scott Hamilton (3/5/12)
Data
Economic Outlook Annex Tables OECD (See Annex Tables 1, 10, 14, 18, 27, 28, 32, 33, 61 and 62)
Statistical Interactive Database Bank of England (See for example, A Money and Lending: counterparts to changes in M4, alternative presentation > Seasonally adjusted > Public sector contribution > PSNCR)
Questions
- Why was the period of the late 1990s and early to mid 2000s described as the Great Moderation?
- Chart the size of the output gap, the rate of inflation and public-sector deficits as a percentage of GDP in the UK and other major economies from 1995 to 2007. Is this evidence of the Great Moderation?
- To what extent would evidence of house prices, consumer debt, bank lending and the balance of trade deficit suggest that there was indeed a boom from the mid 1990s to 2007?
- What, according to Dr King were the main causes of the credit crunch?
- What, with hindsight, should the Bank of England have done differently?
- What UK body was responsible for regulating banks in the run up to the credit crunch? Why might its regulation be described as ‘light touch’?
- In what sense was there a moral hazard in central banks being willing to bail out banks?
- What banking reforms have taken place or will take place in the near future? Will they address the problems identified by Dr King and prevent another banking crisis ever occurring again?
At the Mansion House dinner on 15 June, the Chancellor, George Osborne, and the Governor of the Bank of England, Sir Mervyn King, announced a new monetary policy initiative to increase bank credit. The idea is to stimulate borrowing by both firms and households and thereby boost aggregate demand.
