Is UK monetary policy on the right lines? 1 ½.

Posted by Tim Congdon in News Archive | 0 comments

I had hoped this week to finish my note on ‘Is UK monetary policy on the right lines?’. However, after writing 2,000 words (and putting together the data for four charts), I have run out of time. This note is therefore numbered 1 ½ rather than 2, and I will return to the exercise next week.

The note below concentrates on the years running up to the crisis of 2007 and, more particularly, of 2008, years which passed by the reassuring label of ‘the Great Moderation’. In this period the growth of the quantity of money was consistent with nominal GDP growth of about 5% a year and 2% inflation. Money balances grew as banks expanded their loan assets and ‘bank lending to the private sector’ was the dominant so-called ‘credit counterpart’ to bank deposits. A consistent negative influence on money came from banks’ capital- building. This was necessary of course as banks added to the risk in their balance sheets, and incurred non-monetary liabilities in the form of equity and bond capital. From mid-2007 the pattern of money growth changed radically. From Q3 2008 officialdom placed intense pressure on banks to hold more capital relative to their balance-sheet risks, causing i. a contraction in ‘lending to the private sector’ (in fact, implemented mostly by sales of securities), and ii. a massive programme of capital-raising. These two shocks caused money growth, which has been too high in 2006 and early 2007, to collapse and even threaten to go negative. In early 2009 policy-makers, facing a macroeconomic catastrophe, had quickly to find a means of boosting the quantity of money. (The next instalment of this note – which should be the last – will discuss the role of ‘quantitative easing’ in the resulting macroeconomic salvage effort.)

UK money trends in the run-up to the crisis of 2007 and 2008

As noted above, ‘in the normal course of events, in peacetime conditions apart from financial crises, banks grow their assets by increasing loans to the private sector’. Further, because of the addition of identical sums to both sides of banks’ balance sheets, this expansion of bank credit creates new bank deposits. The new bank deposits are money and can subsequently be spent an indefinitely large number of times. Indeed, the value of the payments arising from the circulation of money that already exists is, in any period, an enormous multiple of the value of the payments involved in money creation. Whereas the value of payments in the UK economy is about 50 times GDP, even in the credit boom years of the early 21st century new bank lending was rarely more than 15% of GDP.

The mechanics of money creation by banks bewilder many people, as something appears to be ‘created out of nothing’. The extra money has no immediately obvious and tangible expression beyond an entry on a bank statement.  The process therefore appears to be alchemy, even black magic, and many people go so far as to condemn it as morally repugnant. It has been said to resemble the miracle of ‘the widow’s cruse’ (i.e., a jar of oil that never ran out) from the biblical story of Elijah in the first book of Kings (chapter 17: 8 – 16).

But every balance sheet must balance, because assets and liabilities are always equal and in that sense nothing is being created ‘out of thin air’. Banks that take deposits in cash must (usually) be able to repay those deposits in cash. Consequently, most banks must hold cash against their deposits, even if the cash is not 100% of any newly-created deposits. They do meet withdrawals with cash and cash in note form is undoubtedly tangible. Further, the requirement that banks must hold cash on the balance sheet, even if it is a very low figure relative to assets, imposes a check on management expansionism. Two points explain how this check comes into play.

First, banks are of different kinds. Some take in retail deposits and are heavily involved in the payments transmission business, while others concentrate on lending and fund themselves by issues of long-term securities, by savings deposits which cannot be used to make payments or by borrowing from other banks. Only the first type of bank, which in the UK context is still typically known as a ‘clearing bank’, needs to hold cash on a routine basis, and only clearing banks possess the widow’s cruse. The second type of bank has to seek deposits (or other funding) before it can make loans. Secondly, the size of its cash holding does constrain the expansion plans even of a clearing bank. Clearing bank A may be increasing its loan commitments far more liberally than clearing bank B.  Suppose that bank A’s customers take up the facilities on a large scale. As a result, new borrowers from clearing bank A may be making far higher payments to the customers of clearing bank B than customers of bank B are making to bank A’s customers as a whole. Banks settle between themselves in central bank money, i.e., in cash. The result of excessively rapid growth in bank A’s credit may therefore be that it runs out of cash at the inter-bank settlement. If an adverse inter-bank settlement would leave a clearing bank with a negative cash reserve, it must quickly borrow cash from other banks ‘to square its position’. A clearing bank embarking on rapid balance-sheet expansion must therefore try to maintain a strong credit standing with other banks so that it can access inter-bank funds if it risks losing cash on a recurrent basis. These two points mean that, while some/many banks can usually expand loan assets and deposit liabilities by ‘a stroke of the pen’, and although the banking system as a whole certainly does possess the widow’s cruse, individual banks need to monitor their cash inflows and outflows constantly, and to keep inter-bank exposures under control. This is true whether the inter-bank market is purely domestic or global in scope, as it became increasingly with the boom in the so-called ‘euro-markets’ from the 1970s. The significance of these remarks became apparent in August 2007, when the inter-bank market closed to many banks, and will soon be discussed in more detail.Overseas sterling deposits of the UK banking system, 1991 - 2012

During the UK’s Great Moderation, monetary policy was simple. UK banks were generally regarded as some of the most creditworthy and robust in the world. They could therefore fund any assets they added to their balance sheets and borrowed on a large scale in the international inter-bank market. (See the chart above.) Meanwhile the growth rate of bank credit was sensitive to the short-term interest rate. (Residential mortgage lending is typically half of all bank lending to the private sector in most advanced economies and in the stable 1992 – 2007 period it responded in a fairly reliable way to changes in the short-term interest rate. See my evidence to the Treasury Committee of the House of Lord in November 2006 which showed a surprisingly high-quality relationship between the mortgage credit and bank credit to the personal sector, which was dominated by residential mortgage lending, in the 1995 – 2006 period.) The Bank of England could consequently keep the growth rates of bank credit and the quantity of money at moderate rates (i.e., rates compatible with 2% inflation) merely by tweaking the short-term interest rate.

Most members of the MPC were ignorant of monetary economics (in the sense of ‘the economics of the quantity of money’), and did not think their decisions had any bearing on the rate of money growth or that the rate of money growth had any relevance to nominal national income and inflation. (I know some readers may find this difficult to believe. I mean it.) Instead the MPC orthodoxy was that they were adjusting interest rates to measures of ‘the output gap’, with the aim being to ensure that the output gap was close to zero and that inflation (which was remarkably close to target for many years) would therefore not change. However, the benighted MPC members were rather like Monsieur Jourdain in Moliere’s Le Bourgeois Gentilhomme, who was amazed when he realized that he had been talking prose all his life. Just as M. Jourdain had been talking prose all his life, the MPC’s members had been taking decisions that affected the quantity of money for as long as the MPC existed. Regardless of the their views on the matter, the equilibrium levels of national income and wealth had to be consistent with the quantity of money throughout the Great Moderation. (This was true before and after the MPC’s establishment in 1997, and will always be true. A relationship between the quantity of money and incomes and relative prices had to hold, in just the same way that a relationship had to be hold between the quantity of energy or food consumed and incomes and relative prices, or indeed between any quantity of particular goods and services in the economy on the one hand and incomes and relative prices on the other.)Bank lending as a % of GDP

The consistency between money and national income, and its reconciliation with moderate on-target inflation, was ‘achieved’ serendipitously. The short-term interest rate that kept the output gap close to zero was (more or less) identical to the short-term interest rate that kept credit expansion in line with rates of money growth appropriate to the 2% inflation target. Macro outcomes were much the same as they would have been under a money-targeting regime, although no such regime was actually in place.

The simplicity of monetary policy in the Great Moderation was shattered in the Great Recession. The closure of the global inter-bank market in August 2007 presented a huge problem for those banks, which meant the greater part of the UK banking system, that had been borrowing from banks in the rest of the world. (See the chart above. HSBC was the major exception here, with a large excess of deposits over loan assets because of its Asian branch network.) The right answer was for the Bank of England to make available a large, although expensive loan facility to all banks subject to official regulation  and  therefore,  of  necessity,  with  positive  capital.  (That  was  what  the  ECB  did straightaway.) However, the Bank of England under Mervyn King shilly-shallied and procrastinated, and the run on Northern Rock began in September 2007.UK banks' capital-raising programme after 2008, set in a medium-term context

After the Lehman crisis in September 2008 officialdom decided that banks must keep far more capital and safe liquid assets, relative to their assets, than before. Because of these developments UK banks, like banks in all the nations subject to the new regulatory tightness (i.e., the nations that have central banks belonging to the Bank for International Settlements in Basle), had to shrink their risk assets. The demands for higher capital/asset ratios were the most serious change in the regulatory environment. The UK banks raised enormous amounts of new capital, with the total of new bond and equity capital raised in the two years to end-2011 exceeding £150b. Even so the enlarged capital buffers were not sufficient to comply with the official capital requirements with an unchanged total of risk assets. The stock of bank lending to the private sector, which had been growing at double-digit annual rates % in 2006 and early 2007, had to shrink.

As the chart above shows, bank lending to the private sector – understood as a credit counterpart to the quantity of money – was negative in most quarters from early 2009. In fact, the cumulative value of the quarterly changes in the lending counterpart to M4 from Q2 2009 to Q3 2012 was just under minus £200b., equal to about 10% of M4 at the start of 2009. Further, from late 2008 banks were also under pressure from officialdom to raise vast amounts of capital, which would also have the effect of destroying money balances. (When someone subscribes for a new issue of shares or bonds from banks, he or she pays the necessary sum from a bank deposit. The bank deposit therefore falls and the quantity of money goes down.) Again, look at the chart above. In the 13 quarters to Q3 2011 the change in banks’ non-deposit liabilities, which is to be interpreted (more or less) as the increase in their capital of all kinds, was almost £325b., roughly 15% of M4 in mid-2008. (Note that the concept of ‘bank lending’ here is not the same as that in the earlier discussion or the chart below [and given in the previous weekly e-mail] above. If a bank sells to a non-bank a security that is a claim on a private sector, the non-bank completes the transaction by drawing on a bank deposit in the M4 quantity of money, which therefore falls. But the bank has not asked anyone to repay a loan. The chart below relates to the total of bank loans exclusive of securitizations. The concept of bank lending relevant to the credit counterpart arithmetic is  one inclusive  of  securitizations, and is therefore  affected  by purchases and sales of securities to non-banks.)Credit trends in the UK

Because of the shock to these two influences on money growth (to repeat, a sudden collapse in bank lending to the private sector and massive recapitalization of the banks at officialdom’s behest), the prospect in early 2009 was for a collapse in the quantity of money at the sort of rate seen in the USA’s Great Depression. Unless an offsetting influence were somehow engineered, unless – in other words – the Bank of England (and/or the Treasury) could find a policy which would quickly create large amounts of money, the UK was heading for macroeconomic catastrophe.

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