Written evidence submitted by Professor
Sheila Dow, University of Stirling
1. The critical aspect of the Report is
the prediction as to when and how rapidly the economy will get
out of the current recession. This is critical for the resumption
of financial stability in that continuing defaults and uncertainty
about future prospects would further weaken bank balance sheets
and the financial position of firms and households. It could also
be argued that demand conditions are critical for the achievement
of the inflation target (neither deflation nor excessive inflation),
but given the continuing fragility of the economy and the financial
structure, it is hard to see inflation targeting as the central
issue. Indeed there is scope for judgement as to whether above-target
inflation in the longer term, for example, is a price worth paying
for avoiding further extensions to the economic and financial
crises. Given that the MPC is charged with achieving the inflation
target, it is difficult for them to be explicit about such a judgement.
But the public discourse about the economy and the role of the
Bank has now gone beyond the formal framework. For both the MPC
and the government the question is whether it is too early to
be thinking about an exit strategy from the current monetary and
fiscal policy stance.
2. The GDP projection is for a sharp improvement,
returning to positive growth in the new year, rising to close
to 5% in early 2011. Nevertheless the level of output is only
projected to return to its early 2008 peak by 2011. One source
of demand expected to drive this improvement is exports (depending
on the fall in sterling, but also resumed growth and/or unwinding
of savings elsewhere, such as these might be). And indeed focusing
on exports is identified as an important element in rebalancing
the UK economy (page 44). Domestic demand is expected to remain
weak due to the efforts of households and banks to rebalance their
financial structures, and consequent hesitancy among firms to
resume investment spending. It may therefore be that the predicted
sharp rebound is overoptimistic (and the uncertainties surrounding
the forecast are emphasised in the Report). Thus any talk of exit
strategies arguably is premature.
3. A major source of increased demand continues
to be the substantial fiscal stimulus, which has undoubtedly prevented
a much worse recession. On the other hand it is noted (page 43)
that fiscal consolidation will dampen improvements in domestic
spending, and anticipation of such widely-discussed consolidation
may bring this effect forward. This sounds an important note of
warning on fiscal policy. There is in fact no basis (other than
convention) for a set maximum to the public sector deficit which
would require active consolidation before resumed growth becomes
well established. Further the effort to reduce spending and/or
increase taxes could choke off such growth before it became established,
with the perverse effect of causing the public sector finances
to deteriorate further. Growth in itself would improve the fiscal
position by means of the automatic stabilisers (rising revenues
and falling recession-related expenditures), so consideration
of fiscal restraint is not only premature but may prove to be
less necessary than is commonly thought.
4. The third source of growth is the one
of greatest concern to the MPC, namely the policy of quantitative
easing. The intention was that this policy would encourage spending
through three channels: raising asset prices and thus wealth (and
thereby lowering yields and the cost of financing investment);
fostering more optimistic expectations; and increasing bank lending.
Asset prices have been increasing, notably share prices, and housing
to a lesser extent, and bond yields have been falling. Also there
is some sign of returned optimism among businesses, reflected
in smaller reductions in planned investment (Table 2.B, page 21).
But business intentions are still for significant falls in investment,
expected to worsen what is already a drastic actual drop in investment
(Chart 2.6, page 21). It is difficult to quantify the effect of
the quantitative easing policy on expectations, but its significance
should not be discounted; monetary policy is now often as much
about signalling as about price setting. But the hoped-for increase
in bank lending has not happened, and there is continuing uncertainty
as to whether bank lending could still be a force for economic
growth (pages 40-41). This is not altogether surprising since
banks' balance sheets are still fragile, since the banks are sensitive
to taking on more default risk in an uncertain economic environment,
and since credit is being extinguished as households aim to reduce
their own vulnerability by paying back loans. Indeed it is suggested
(page 17) that, even if companies' demand for credit were to increase,
this demand might not be met by the banks. The Bank had accepted
from the start that the policy might not increase lending as such,
but would at least return the mark-up of interbank rates on Bank
Rate to pre-crisis levels, and this has indeed occurred (Chart
1.13, page 15). The effect of the policy so far has therefore
been on financial markets without clear signs of effects on spending
plans. Nevertheless the MPC expect the latest additional tranche
of asset purchases to speed up the recovery.
5. The MPC has signalled that the quantitative
easing policy is winding down, and in some quarters concern is
being expressed about the consequences of the policy for excessive
bank lending in the future. Given the capacity of the banks to
expand lending, as indicated by their reserves position, it is
feared that a confident resumption of growth would become inflationary
if accompanied by a large increase in bank credit. But this bank
multiplier approach to credit creation has not been relevant to
UK banking for a long time. Effectively the Bank of England has
either supplied the banks with the reserves they need, or withdrawn
liquidity, in order to keep wholesale interest rates at the desired
level relative to Bank Rate. But, given Bank Rate, the banks effectively
decide how much liquidity they need. If the MPC judged credit
creation to be excessive, the Bank could attempt to tighten financial
conditions by withdrawing liquidity in the normal way, ie attempt
to enforce a higher interest rate. The main difference now is
the large scale of asset purchases.
6. Rather than being concerned about growth
in bank lending in general, some have expressed concern about
the purpose of borrowing, and the danger that credit is being
created, and could in future be created, more to fuel an equity
and housing bubble rather than firms' investment and households'
expenditure. This would require a different kind of response.
In order to steer bank lending towards recovery-oriented expenditure,
a range of measures might be considered ranging from fiscal incentives
to regulatory restrictions.
7. Meanwhile the MPC are concerned with
designing macroprudential controls more generally in order to
prevent a recurrence of the banking crisis. The Governor has laid
out his ideas for addressing the problem of large banks being
too important to fail (and thus taking on excessive risks), and
yet too expensive to bail out. He advocates the separation of
traditional banking (what he calls utility banking) from other
financial activities, and thus restricting the coverage of the
lender-of-last-resort facility. This proposal is consistent with
the logic of retail banking, whereby banks can support balance
sheets with widely diverging maturities between assets and liabilities
because their liabilities are money. The central bank supports
this system with the lender-of-last-resort facility in exchange
for regulation which restricts the activities of the banks, and
thus maintains confidence in bank liabilities. Effectively a deal
is done between the state and the retail banks. This is necessary
because, without a working monetary system, the economic (and
social) system simply could not function.
8. Retail banks which were smaller would
be less costly to bail out, making a guaranteed lender-of-last-resort
facility more palatable to the authorities. But the discussion
of regulatory changes (as in a recent speech by Paul Tucker) still
refers to future bank failures and how to resolve them. It is
implied that there would be less systemic effect from allowing
smaller banks to fail. Indeed banks would be required to set out
"living wills" in order to plan for a more orderly winding-down
than we have experienced during the crisis. But this acceptance
of the possibility of small bank failure ignores the systemic
effect of the failure of any bank in the form of puncturing confidence
in banking in general. This concern would imply that the emphasis
in considering a return to traditional banking be on returning
to a satisfactory deal whereby the Bank undertakes to guarantee
to supply the lender-of-last-resort facility in exchange for banks
acceding to restrictive regulation designed to limit moral hazard.
Just as the ideal would be for the general population not to think
about inflation at all, so it would be ideal if we could return
to not thinking about bank failure at all.
17 November 2009
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