Carney could rescue UK monetary policy but not with more stimulus

Patrick Minford
MARK Carney will arrive as the new governor of the Bank of England at a time when its policy is in disarray, but also when all the levers are in the Bank’s hands. He has a good chance to improve matters.

But what is the problem? The Bank is pursuing its loosest monetary policy of all time. The money it has “printed” via quantitative easing (QE) – the stuff that either is or can immediately be converted into notes in circulation, the “monetary base” – has expanded to eight times its 2007 value. That’s not a misprint; it has expanded by 700 per cent.

Virtually all that expansion is sitting in bank reserves – deposited and not lent. The banking system has created no additional money, and the total (“broad”) money supply has barely grown. Meanwhile, interest rates on government three-month bonds are held down close to the Bank Rate of 0.5 per cent, an all-time low that has prevailed for four years; on longer maturities, the government can borrow at rates below inflation. Yet rates on credit to small businesses remain, as far as we can measure them, stratospheric. SME lending continues to contract sharply.

The economy is growing weakly at best. Equity prices have soared as investors chase yield, yet large businesses refuse to invest, preferring to wait for recovery. As for inflation, it is now sagging towards 2 per cent, after a period of being driven up by commodity prices, now mercifully falling back.

In a nutshell, this dangerously expansionary monetary policy has had little or no effect on credit, real activity or the broad money supply, but has driven down yields on government bonds and other assets, damaging savers at the expense of government and large borrowers. Why?

What we have been discovering the hard way is that money does not course equally through all channels, especially when regulators insert large barriers. Small businesses always find it hard to get credit and face a rate much higher than the Bank Rate. It varies with general business conditions in a way that we do not observe very well; arrangement and other fees come and go, as do eligibility criteria and collateral requirements.

But in addition to the usual hurdles, small businesses now face a new and massive regulatory obstruction: as they are “high risk”, they push up a bank’s risk-weighted assets and force the bank to get expensive extra capital to satisfy the new capital ratios. The banks have reacted by refusing to expand their balance sheets by lending to these expensive firms. Instead, they have clung onto their “low risk” large customers and, of course, official paper – especially reserves with the Bank.

The credit channel to the dynamic part of the economy, the 50 per cent represented by SMEs, has been blocked. So all the money printed has gone into the other channels, causing a lake of liquidity to form around governments and large corporations. The economy has flatlined as these monopolistic elements bask in the luxury of doing nothing much except “cuts”.

Carney should change this. As the chief regulator, he should cut back capital requirements, or at least postpone them. As the banks come back to life, he can then junk the clumsy bureaucracy of the Funding for Lending scheme and the mortgage subsidy for first-time buyers. He will then need to tighten monetary policy as bank credit expands and recovery strengthens. All those bank reserves created by QE are like dry firewood waiting for a spark; not merely must QE be stopped as agreed by majority in the latest Monetary Policy Committe minutes, it must be removed fast. Interest rates must also rise to keep credit and money growth under control.

There will be difficulties in removing QE, as the Bank’s bond holdings will fall sharply in value with rising interest rates; also politicians will want to stop the Bank “spoiling the recovery”. But the Treasury will have to absorb the loss on the Bank’s assets and the politicians must be ignored.

People will worry that weakening regulation will lead to a future crisis. But it would be better to control excess credit expansion by monetary policy. The inflation target should stay at 2 per cent because, as a society, we decided to eliminate the deadly virus of unchecked and uncertain inflation. But the monetary control mechanism could supplement the target with a money supply target, which would proxy the otherwise unobservable cost of credit to SMEs.

If Carney can sort these things out, he will have more than earned his unprecedented gubernatorial package.

Patrick Minford is professor of applied economics at Cardiff Business School.