The BoE will have to become much more aggressive if its programme of QE is to prevent a depression

Through its programme of quantitative easing, QE, the Bank of England has created £325 billion, however this new money has failed to boost economic activity. This article explains how QE is designed to work and why it has failed to deliver the economic growth the government is so desperately seeking.

The Bank of England’s Mandate

Before we get into what QE is and why it has failed, it’s important to understand why the Bank of England (BoE) is so enthusiastic about it. To do this it’s useful to review the BoE’s mandate.

From the BoE’s website:

“Monetary Stability: Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government’s inflation target, which the Bank seeks to meet through the decisions delegated to the Monetary Policy Committee, explaining those decisions transparently and implementing them effectively in the money markets.

Financial Stability: Financial stability entails detecting and reducing threats to the financial system as a whole. This is pursued through the Bank’s financial and other operations, including lender of last resort, oversight of key infrastructure and the surveillance and policy roles delegated to the Financial Policy Committee.”

In short the Bank of England exists to ensure monetary stability, i.e. a constant rate of inflation (currently 2% but I expect this target to be raised), and to prevent systemic failures such as bank runs.

Understanding the BoE’s purpose helps in understanding why the bank has responded to the current threat, that of deflation, in the way it has. Deflation is defined as a decrease in the supply of money and credit within an economy, and the latest figures from the BoE (released last month) reveal the extent of the threat.

The UK’s M4 money supply figure – which includes cash outside banks (i.e. in circulation with the public and non-bank firms), deposits at private-sector retail banks and building societies, deposits at private-sector wholesale banks and building societies, and Certificates of Deposit (CD’s) – shrank by 5% in the past 12 months to a new record low. This is significant because Britain’s money supply grew every single year from 1963 until the credit crunch of 2009.

What is Quantitative Easing & how is it supposed to work?

Quantitative Easing, or QE, is a form of unorthodox monetary policy that is used by governments in times of crisis in order to increase the supply of money in the economy. QE is typically only used as a last resort when traditional methods, such as reducing the cost of money, i.e. interest rates, have failed.

The way QE works it this. The central bank, in this case the BoE, gets permission from the Treasury to create new money. It does this by crediting its own account electronically at the touch of a button. The BoE then uses this newly created money to buy assets such as government bonds from commercial banks and other financial firms such as insurance companies and pension funds.

The hope is that because these financial institutions now have new money in their accounts, they will be willing to use the money to invest in other companies or to lend to individuals. If they are willing to do this then as the money makes its way out into the economy, it boosts the supply of money in circulation.

The BoE’s programme of QE is designed to have two effects. The first is to tempt the banks into increasing lending to businesses and individuals, and therefore increase the amount of activity in the economy. The second is to lower the cost of borrowing. When the BoE buys bonds, it reduces the supply of those bonds in the market which should increase the demand for new bonds and, at the same time, reduce the cost of borrowing.

Theoretically, when the economy has recovered, the Bank of England can then sell the bonds it has purchased and destroys the money it receives for them, thereby reversing its policy of QE.

If everything goes according to plan QE should increase the availability of credit within the economy and therefore businesses should find it easier to borrow. That, in turn, should help to stimulate the economy.

Why QE failed to stimulate growth

Since restarting its QE programme in October 2011, the BoE has purchased £125 billion of government bonds, known as gilts. During that time however, banks have only pushed around £20 billion of the newly created money into the economy.

The problem is that banks are hoarding the money, in part because of the very real risk that new loans may not be paid back and in part because of new rules that require banks to hold a larger percentage of reserves.

If the new money isn’t lent into the wider economy then the supply of money is not boosted and the policy fails to stimulate growth.

Looking for a workaround

The Financial Services Authority (FSA) stipulates that UK banks must maintain a buffer of high-quality liquid assets such as government bonds and central bank reserves to allow them to survive for three and a half months in the event of a liquidity crisis.

Officials at the BoE are however concerned that an increase in reserves to meet these liquidity requirements will prevent them from being able to stimulate growth and therefore pull Britain’s economy out of recession.

The BoE’s Monetary Policy Committee (MPC) is now looking for a way around this problem, and is meeting with its Financial Policy Committee (FPC) to discuss whether banks’ liquidity requirements can be eased in order to encourage lending.

The bottom line

The BoE is trying to generate economic growth, by pushing cheap money out into the economy and encouraging us to spend it. However, if the BoE reduces bank reserve requirements in a further attempt to get them to lend, it’s highly likely that all they will do is further weaken the banks and therefore increase systemic risk.

The problem is that banks don’t want to lend and we don’t want to spend. Businesses are cutting back on spending, and thanks to high levels of debt and falling real incomes many households are simply not in a position to spend.

It was twenty plus years of spending money that we didn’t have that got us in this mess in the first place. The spending spree is over. The nation’s credit card is maxed out. Businesses realise it, households realise it, the problem is that the government doesn’t yet realise it. Or rather it doesn’t want to face the reality of a deflationary depression.

For the next few years I expect the government and BoE to continue to take the path of least resistance, only it will have to become much more aggressive if its programme of QE is to prevent a depression, especially when it comes to pushing their newly created money out into the economy.

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