The economy is stagnant, with GDP barely higher than it was after the deep recession of 2008–2009, and we seem to have run out of good options for fixing it.
It is well-known that conventional monetary policy fails in a deeply depressed economy because extra liquidity injected into the system as a result of lowering interest rates or Quantitative Easing (QE) largely ends up being hoarded on banks’ balance sheets, without stimulating lending to the real economy or the broad money supply. Over the past few years, growth in the broad money supply (what statisticians call M4) has been negative, in spite of quantitative easing.
Efforts by the Bank of England, meanwhile, to stimulate lending by giving banks cheap funding under its Funding for Lending Scheme (FLS) have been accompanied by declines in business lending in the UK. Things would probably have been even worse without QE or FLS but it is hard to argue that they have had a dramatic impact.
In the 1930s, John Maynard Keynes rightly pointed out that fiscal stimulus can be more effective in a deep recession because it does not rely on banks to pass-on the spending, while government borrowing is unlikely to push-up interest rates when there is a demand for safe assets. However, with debts and deficits already high, governments – especially those in the eurozone which have no monetary independence – have limited scope to stimulate more. Indeed, econometric studies find that public debt above 100% of GDP can impede growth.
Fiscal austerity isn’t much of an option either. The biggest customer in the economy – the state – cutting its spending inevitably undercuts demand, and this can actually make the deficit worse if it has a bad enough effect on tax revenue. A recent IMF study of 173 fiscal changes since the 1970s showed that austerity almost always produces recession and that the multiplier effect of cuts is at least 0.7 – meaning that cutting public spending by £1 reduces GDP by 70p. So we seem to have a dire situation where monetary policy has lost its impact and fiscal policy cannot move in one direction or the other.
But there may be a way out. Let’s perform a thought experiment: think about a country in the aftermath of a deep recession with a stagnant economy and banks that are unwilling to lend. One obvious solution would be to just bypass the banking system entirely: create a state-owned bank, capitalise it with, say, £20bn of public funds (or with new money created by the central bank to buy equity in the bank) and leverage this with another £100bn of funds borrowed from the central bank.
Such a bank could lend to the real economy and re-start growth. It would obviously need political independence and adequate credit standards, but these could be achieved through fairly standard corporate governance arrangements.
This plan would increase the monetary base (which includes note and coin and banks’ deposits with the central bank) by a certain percentage and broad money (which includes deposit accounts) by a lesser proportion. Inflationary effects would be offset by weak monetary conditions at the outset and increasing capacity in the economy after the stimulus. Whatever inflationary effects remained could be offset by the central bank tightening conventional monetary policy. The net effect of financial stimulus of the kind described combined with monetary tightening would be replace cash in the hands of banks with other assets and to increase the amount of cash in the hands of smaller businesses who would actually invest it.
In practice, one major barrier would be competition rules and EU state aid rules which prevent countries giving their firms an unfair advantage in the marketplace. But competition rules should be modified in an economic crisis, and if all EU countries agreed to follow a similar policy it wouldn’t distort international trade. The operational details of setting up a large bank would be a delaying factor but, in an economy fundamentally stuck in a rut, the no-growth problem will still be there after a year when the logistics have been taken care of.
This policy hasn’t been tested on a large scale so we can’t claim much empirical evidence that it would work – although the Federal Reserve did directly buy large quantities of commercial paper in 2008–2009, bypassing the conventional banking sector and ensuring that real-economy corporations retained access to credit. In any case, the principle is sound: bypassing the broken parts of the system to get the economy moving again.
Sean Harkin is a risk manager working in Edinburgh and the author of The 21st-Century Case for a Managed Economy.