Quantitative easing won't help the real economy

 By Mukumbura

Yesterday the Bank of England again surprised the City by announcing a further £75bn’s worth of Quantitative Easing (QE), buying up government debt from the banks over the next four months. The hope is that QE will lower long term interest rates. The interest rate on the government debt being bought from banks now (mainly 3%) is higher than the new debt being issued by the government (0.5%). With lower long term interest rates, banks should start lending again.

There is some evidence from the last round of QE that long term interest rates were lowered. But there is very little to suggest that QE made any difference to credit reaching real businesses. Many argue that QE helped ramp up inflation as the banks spent this new cash on commodity speculation.

Indeed, QE was so unsuccessful in terms of boosting activity in the real economy, most obviously in terms of credit to small and medium size firms (SMEs), that on Monday George Osborne was forced to take the very un-conservative step of announcing that the Treasury itself was going to get in to the ‘monetary activism’ game.

Osborne’s ‘credit easing’ is basically the same as QE but involves the Treasury, via the Bank of England, buying corporate bonds issued by SMEs. This money goes directly to the businesses, bypassing the banks completely. However, the banks will likely make a great deal of profit from the scheme as they will be involved in packaging up the bonds, particularly for smaller enterprises. 

After all, even though banks have stopped lending to small businesses, it doesn’t mean they don’t know how to securitize debts and sell them on to the Treasury, moving the credit risk to the tax payer. We saw in the financial crisis just how good the banks were at this ‘originate and distribute’ model of securitization. 

‘Credit easing’ and the latest round of QE are just further examples of economic wrong-headedness and a failure to understand the big picture. Our banks are:

a) still hugely over-leveraged, and likely to become more so as the sovereign debt they hold with EU countries loses value, and

b) no longer structured in a way that means they are even capable of lending to the small businesses that provide 2/3rds of our jobs.  

The solution to these two problems is not to reward banks for failing to lend by pumping cash into them or encouraging them to carry on making money through securitization. Rather, it is to restructure them so they serve the needs of the real economy. This will take time, so in the meantime the Central bank should take a much more interventionist stance in terms of the creation and direction of credit. 

Luckily, Adair Turner, Chairman of the Financial Services Authority, appears to agree with the last sentiment at least. Last week at a conference in Southampton, he argued that the newly created Financial Policy Committee (FPC), the new regulatory body to oversee the stability of the economy, should have powers to steer the amount and distribution of credit created by banks. He suggested that the FPC should be able to adjust the risk-weightings attached to different categories of loan, so that banks would no longer find it cheaper to provide property-backed loans and create credit for financial speculation, rather than economically vital loans to businesses. In this way, to use his favourite phrase, banks could become ‘socially useful’ again.

We have huge amounts of spare capacity in our economy. Confidence is very low as no-one can see where the growth is going to come from. What is required are huge injections of money directly into productive activities – building houses, transport and energy infrastructure and cheap loans for small businesses. What is not required is more commodity speculation. So the question is, why doesn’t the Central Bank just do this? Why doesn’t it, together with the Treasury, as Evan Davies suggested on Radio 4 yesterday morning, turn RBS in to a national investment bank, recapitalize it with QE money and insist it only makes loans for housing construction and small businesses? Or, even easier perhaps, pump some serious funds in to the fledgling Green Investment Bank?

The strange defence of the Central Bank is that it ‘doesn’t pick winners’. Its not the job of the Bank to steer money in to one or other sector of the economy. Whose job is it then? How about the government?  Unfortunately, the government is not permitted to do so because of the Maastricht Treaty, which forbids direct spending by the government into the economy.

No, sadly in modern European economies it is only commercial banks or the Central Bank that has this magical power to create and allocate credit (and hence money), as nef sets out in some detail in our recently published book Where Does Money Come From?.

UK banks have failed miserably at the job of properly creating and distributing productive investment over the last decade. Instead, they have created a massive house price boom. The Central Bank’s defence of QE, that it ‘can’t pick winners’, must equally stand as an admission of guilt - it ‘props up the losers’ that are our failed banks. 

That doesn’t sound like an ‘independent’ central bank to me.