Many surprises have rained down on us over the past 18 months, mostly unpleasant. But among the seismic shifts in response to these shocks has been in Britain’s monetary policy.
Even as recently as last summer, well into the credit crunch, we were in a familiar world. The Bank of England’s monetary policy committee (MPC) met each month, deciding whether to nudge interest rates up or down by a quarter, such small moves apparently still having a big impact.
True, everyone knew the transmission mechanism from rate cuts to the economy was clogged. Irrespective of what the Bank did, lending was impaired. These things were being addressed, but separately from monetary policy, where it was business as usual. Bank rate was 5% and when I said it should be lower, people warned that inflation was so bad rates would rise sharply.
On Thursday Bank rate was cut to 0.5%, after one of the most dramatic few months for monetary policy ever. None of us has seen rates this low. When the storm passes, we may never see them as low again. Boring it isn’t. The government has been interviewing for a new MPC member and probably asking “Do you own a flak jacket?” The past 300 years have seen about a dozen significant wars (many with France), bubbles, booms and busts. There has been deflation and inflation. But until now we had never had official interest rates below 2%, let alone within a whisker of zero.
More remarkable is the Bank’s view that this will not be enough. That was why we had the exchange of letters between Bank governor Mervyn King and the chancellor, Alistair Darling, authorising the Bank to press on with quantitative easing.
In normal times you would no more think of putting the subject on the front page than you would quantum mechanics. Who knows, perhaps A Brief History of Quantitative Easing could outsell Stephen Hawking. For that to happen, people would have to get over a big barrier of understanding. I have detected a condition you might call QE torpor, which is that when you try to explain it, people nod politely but their minds are elsewhere. With only a little effort you can put a whole room to sleep.
But let me try, and I’ll wake you up when I’ve finished. Suppose up in the loft you have a couple of paintings. The Bank gets in touch, offers to buy them, and credits your account with the proceeds. Flush with cash, you go out and spend.
Now imagine you are a bank. The Bank offers to buy, not paintings but financial assets, particularly government bonds. In return, it credits the bank’s account (banks have accounts at the Bank) with additional reserves. Flush with extra cash, the bank is secure, not about increasing spending, but increasing lending, and by a multiple of the increase in reserves.
This “money multiplier” in crucial. In normal circumstances an increase in reserves of £1m would lead to £20m of additional credit, though recently the ratio has been nearer one for one.
A similar effect is achieved, through a slightly more circuitous route, if Bank purchases are from institutions, such as pension funds and insurance companies, as many will be. An essential by-product of the process will be that it drives down bond yields — both government and corporate — cutting long-term borrowing costs.
The really difficult bit for most people is the question of where the money comes from. In January it was announced that the Bank would purchase assets from banks and institutions but that it would get the money — £50 billion — from the Treasury through the issue of new bills.
Now, that policy, which would have had no impact on the money supply (it was known as credit easing), is superseded by quantitative easing. Because the explicit intention is to expand the money supply, the Bank pays for its purchases by expanding its balance sheet, creating money. As I have said before, don’t try this at home, only central banks can do it.
This is, for all the recent talk of rampant Keynesianism, pretty much a textbook monetarist prescription. It is hard to think of a purer monetarist policy in Britain, including the Thatcher government’s monetarist experiment in the early 1980s.
With apologies for taking you back to dusty textbooks, think of the quantity theory of money, MV = PY. M is the stock of money in the economy, not just notes and coin but, in a modern credit economy, broad money, M4. V is the velocity of circulation, the speed money flows around the economy. P is the price level and Y the level of national output, or gross domestic product (GDP). Some may remember T — transactions — instead of Y.
The clear aim of quantitative easing is for the Bank to directly boost M, by “creating money” through purchasing an initial £150 billion of assets from the private sector (£75 billion in the next three months).
The quantity theory tells us how. Adjusting for the bank lending being channelled into the troubled financial sector, growth in the money supply, underlying M4, has slowed sharply. M is not increasing fast enough and neither is the right-hand side of the equation, PY — GDP in current prices or, if this is not too confusing, money GDP. The Bank’s aim is to get money GDP growth up from zero to about 5%.
So quantitative easing, by boosting the money supply, ought to boost money GDP. £150 billion will boost M4 by about 7.5%, which is significant. Recovery will ensue, and we will all be happy.
The first potential problem is fundamental — the direction of causation. Everybody agrees the recession resulted from the credit crunch, a freezing of funding sources and an abrupt reduction in the availability of credit and finance.
Suppose, however, the recession itself and a lack of appetite for borrowing have taken over as the driver of the money-supply slowdown. Boosting M might thus have only a limited impact and money GDP would continue to stagnate.
Both factors are in play. Borrowing attitudes are more cautious but credit availability is a real problem. A CBI survey last week found nearly 60% of firms had greater difficulty obtaining finance in the past three months. Quantitative easing will help if it feeds through to extra lending, admittedly in a system with less capacity because some foreign banks have gone.
A second potential problem concerns bank behaviour. The Bank was not entirely flying blind with last week’s announcement. It took plenty of soundings from the banks. But it remains possible that the boost in M will be entirely offset by a decline in V, velocity, as banks hoard the newly-created reserves. Velocity has been declining in recent months.
The final danger is that, now we have moved out of the monetary-policy comfort zone, calibration becomes impossible. We do not know whether £150 billion of easing will be too much — and therefore inflationary — or too little, though the Bank has the capacity to do more. The money and lending numbers will thus have to be monitored even more closely than usual. In this respect, we are all monetarists now.
PS: Sir Fred Goodwin has a lot to answer for. I am a fan of Radio 4 but if I hear another Thought for the Day sermonising on his pension I’ll switch to Heart FM. The Fred retirement pot prompted an episode of the Moral Maze last week that was one of its most irritating and ill-informed — and there’s quite a lot of competition. It was car-crash radio, and I nearly crashed the car listening.
The Goodwin episode has also given the impression that this is the norm for private-sector boardrooms. It is not. A survey by the Institute of Directors, to be published this week, shows that only 12% of its members are in final-salary schemes (compared with 90% in the public sector). On the question of inequality, raised by the latest outbreak of fat-cattery, things are also not what they seem. Research in the London School of Economics Centrepiece journal shows that earnings inequality was starting to decline, at least until the recession. It remains to be seen whether the downturn will be an even greater leveller.
From The Sunday Times, March 8 2009
Originally published at David Smith EconomicsUK.com and reproduced here with the author’s permission.