The Bank of England's new Quarterly Report publication on money, to which I have already referred, has profound implications for economic policy. Despite the fact that the Bank has admitted that much of conventional economic teaching on money is wrong, and that most economist's understanding of the way in which money is created is fundamentally flawed there is no sign that the Bank has accepted the consequence of this for its own policy-making. As it says in the report:
Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks' activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money – they could quickly ‘destroy' money by using it to repay their existing debt, for instance.
Monetary policy acts as the ultimate limit on money creation. The Bank of England aims to make sure the amount of money creation in the economy is consistent with low and stable inflation. In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves. This then influences a range of interest rates in the economy, including those on bank loans.
In exceptional circumstances, when interest rates are at their effective lower bound, money creation and spending in the economy may still be too low to be consistent with the central bank's monetary policy objectives. One possible response is to undertake a series of asset purchases, or ‘quantitative easing' (QE). QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies.
The flaw in this logic is, I hope almost immediately apparent, but I have highlighted the critical text just in case.
What is revealed is a fundamental paradox in the Bank's monetary policy. What it's role actually, and very obviously, is now revealed to be is as the regulator of available credit in the economy. It is the amount of credit that is available that permits, or prevents, economic activity. This has to be the case: it is credit that the Bank now admits creates money, and not deposits, and so it is credit that needs to be regulated, and not interest rates. QE has made that clear. A lack of credit had to be corrected (and was somewhat inefficiently, as it turned out) by the creation of QE: interest rates could not do the job.
What is now equally, and obviously, true is that on occasions when in the past there was too much credit in the economy, and the Bank has tried to curtail this with the use of interest rates, that policy also failed. A tangential instrument, which is what controlling the interest rate has always been, whose impact was focused on the cost of money, and not on the availability of credit, was bound to fail when excess credit creation was the problem.
The Bank does, therefore, now need to react to its own realisation that credit must be at the centre of monetary policy by putting credit controls at the heart of its agenda. Interest rates are a proxy for credit controls, but why use a proxy when the real thing is available?
There has, of course, been limited recognition of this by the Bank: they have already indicated that they may intervene if mortgage lending creates too large a housing price bubble, but the policy needs to go much further. Credit creation needs to be targeted by the Bank now. It is very obvious that our banks are not willing to extend the credit that small businesses need. It is equally obvious that they are willing to create far too much credit for property backed lending. Both lead to inappropriate and inefficient allocations of resources within the economy, and the interest rate is quite unable to differentiate between the two.
In that case, I suggest, the time has come for a much more interventionist policy on the creation of credit with particular targets for particular economic sectors whilst interest-rate policy has to be used as a general backstop, and not the primary tool for intervention.
Having said which, the Bank also needs to set out its reasoning on exchange controls because these too have a significant impact upon the capacity for credit creation, and such measures cannot now be ignored as a policy instrument.
The Bank's new recognition of how money is created is welcome: when it acts upon that realisation we may see the benefits.
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Don’t expect any action from the BoE it is hardly likely to do anything to interfere with asset bubbles and the free lunch/low productivity economy.
Ciaran Davies
You can’t be “very” Manichean, anymore than you can be “very” Jewish or “very” Sikh. You either are or you aren’t.
I may appear pedantic but basic errors like that don’t help your case.
There are lots of forces which will fight the recognition of the views but let us also be hopeful. Paradigm shifts -changes in the basic framework of understanding of a concept-happy when the the ‘old guard dies or retires’, according to Thomas Kuhn who devised the term. Official pronouncements are made by those at the top. The next generation are not quoted or keep quiet but it may be there are those who think very differently and will speak and act differently when they take over. We can hope.
“the Bank also needs to set out its reasoning on exchange controls ”
This is currently quite simple. The EU’s Single Market regulations make exchange controls illegal. This was referred to in the EU’s paper on the FTT. The FTT could not be applied to currency transactions because that would be a breach of the freedom of movement of capital.
Sure, it might be possible to change those basic rules of the Single Market. But that’s not going to be a job for the BoE now, is it?
Change will not happen until the benefits are considered, will it?
I find it extraordinary that you think we now have a future cast forever in the current EU mould
I’d even call it a little odd….
There is a precedent – I believe capital Controls were introduced in Cyprus in response to the Crisis there around a year ago. They remain in place, although they are as you posit, strictly speaking, illegal under EU regulations. There are also precedents in other areas. A number of ECJ judgements against Italy and France have been reiterated five or six times and still those member states continue in the behaviour which has been deemed illegal – so it comes down to how bound you wish to be by EU institutions and the rule of law in general. Extraordinary challenges might be deemed to require extraordinary measures.
Interesting
I had forgotten Cyprus
Thank you
EU law prohibits capital controls save where justified on grounds of public policy or public security. Both are tightly constrained by EU jurisprudence. Cyprus has a reasonable case they fall within the exceptions; the UK would not.
Such judgments cannot be ignored – anyone who doubts that should look at the many £bn the UK is paying out following adverse ECJ decisions.
These rules can only be changed with a treaty change, and therefore unanimity of the 28. Not going to happen.
I suspect some in the East assumed communism would last forever too
It’s remarkable how close libertarian and communist thinking is
Both are neo-feudal, after all
You have a very Manichean view of the world. The idea the EU is libertarian is eccentric, to say the least. The idea that libertarianism, communism and neo-feudalism have anything in common is… interesting…
My suspicion is my ideas only seem eccentric to a libertarian
Ciaran Davies
The UK does pay those fines you mention – France,Italy and Spain continue to ignore judgements and refuse payment of any ‘fines’ levied by the ECJ in those instances where multiple judgements have gone against them, to almost zero censure. That our government is idiotic enough not to follow a similar outlook makes us look foolish.
It’s rare I agree with the blog writer but on this there is I concur there is no guarantee the EU will survive in its current form even for the next decade let alone forever, though that subject is probably beyond the confines of this post.
How does someone decide how much credit should be made to which industry? Sounds like it would soon get based on politics, not economics. Although, maybe that is what you are calling for. Which basically means a fully planned economy.
All such policy is politics
Let’s not pretend otherwise
Let’s be explicit
Agreed, Richard, as is also the case with so-called “non-intervention in the markets”.
For “non-intervention” is effectively a form of intervention: if you see a little boy being bullied and harmed by a powerful, violent man, and don’t intervene, you have actually effectively intervened on the side of the bully.
In the same way, letting the markets rip, is really intervening on the side of those who believe the markets can resolve everything, when it is plain that they cannot.
Let us hope that we are seeing what Jim Callaghan spoke of (to his Foreign Secretary David Owen, I believe) when he went to the Palace to concede defeat, and hand over to Thatcher, a “once in a generation sea-change in politics”.
We CERTAINLY need such a sea-change, to start backing us out of the destructive cul de sac into which we have been driven by the voodoo economics of neo-liberalism – effectively “without a paddle” – unless we summon up the courage to recognize where we are, and turn round to make our way back to the real stream of history and real economics.
Govt. spending is politically based.
The other credit allocation should be by responsible banking i.e. for productive purposes rather than speculation. This is decentralized decision making. We used to do it before the 1980s as did most of the Western World.
Currently we have allowed the position where governments have to go to private providers for credit who then make political demands to suit them, and not the wider community. Thus the unelected can dictate. We have economics based on politics.
I’ll argue that HMGs of all colours have always interfered / monitored / controlled / influenced* (take yer pick) the marketplace and HMG has always been quick to operate the ‘levers of power’ to attempt to get the economic result it wants.
It does so with defence spending, health spending and the provision of all sorts of jobs of debateable value.
Perhaps the only difference is that for the first time the GotBoE is being far more open about just how political the banks thinking is. I’d be surprised if their wasn’t hefty political influence being spent by No.11 when it comes to how the BoE reaches it’s decision.
After all, the BoE has only fairly recently been made ‘independent’ – respectfully I’d say the BoE was never, ever a ‘Bundesbank’ – and nor is it now.
Just read http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2014/03/credit-controls-the-crisis.html take on your post. He makes the point that “The problem we had in the run-up to the crisis was not simply that banks were creating loans and therefore money. It’s that this money creation was not matched by issues of capital…Quantitative credit controls wouldn’t have prevented all this. At a time when banks wanted to leverage up, such controls might instead have caused them to buy back equity. This would have left them vulnerable to losses on bad takeovers or to a loss of interbank liquidity.” He acknowledges that credit controls might have some merit for other reasons but that “such limits don’t follow automatically from the Bank’s description of the money creation process, and they aren’t sufficient in themselves to prevent banking crises.”
I would never argue anything is sufficient by itself
The world is not that simple
mention should be also made of the Shadow banking system and its Jenga towers of rehypothecation -pull the wrong brick out and the lot goes -this is still poorly understood. Banks are not really banks the high street branches are ‘fronts’ for ‘a whole lot more.’