Environmental Audit CommitteeWritten evidence submitted by the new economics foundation 1
Executive Summary
We recommend that the objectives, implementation and governance of Quantitative Easing (QE) are reformed to help fund the transition to a low-carbon economy.
An estimated £550 billion of investment in new low-carbon infrastructure is required over the next 10 years in the UK, but government budgets are under pressure, the banking sector remains severely constrained and the private sector lacks confidence to carry out the long-term investment required to green the UK economy.
We therefore propose that the Asset Purchase Facility buys bonds issued by agencies with a specific remit for sustainable investment within the UK, such as house building and retrofit and low carbon infrastructure. The use of a proportion of QE to fund long-term sustainable investment would be non-inflationary and in line with the Bank of England’s broader remit to support the Government’s economic policy.
Both government and opposition parties now support the economic case for a national development bank and Green Investment Bank, however the lack of a banking license and the Government’s reluctance to commit taxpayer funds will severely limit their impact. Total capital for both these institutions of less than £4 billion compares with balance sheets of over £200 billion for the Brazilian development bank and £400 billion for Germany’s KfW.
Central bank support for national infrastructure investment has worked before. The Industrial Development Bank of Canada, which supported Canadian SMEs from 1946–1972, was capitalised entirely by the Central Bank with not a single penny of taxpayers’ money required. In New Zealand in 1936, the central bank extended credit for the building of new homes, helping the country out of the Great Depression.
1 Can we afford to tackle the environmental crisis?
It is clear … that what a great nation can “afford” in periods of crisis depends not on its money but on its man power and its goods. Russia, Italy, Germany, Japan, the United States, all used money in the situations mentioned, but money was obviously not the dominant factor. Man power and materials were the dominant factor. Yet at other times, when crisis was not so acute, the money for necessary tasks could not be found. Unemployment, insecurity, want, dragged on. This is a puzzling paradox.
Stuart Chase, 1943, Economist, engineer and
adviser to Franklin Roosevelt and Lyndon Johnson.2
1.1 The challenge of building a sustainable low-carbon economy seems harder than ever in the context of a weak economic recovery. The recession has been the longest in two centuries, including the Great Depression, with output losses estimated to be equivalent to a World War. The most obvious cause of the problem is that the main providers of new money in the economy, private banks, are contracting rather than expanding their balance sheets. Net lending has been shrinking for the last five years since the financial crisis (figure 1).
Figure 1
BANK LENDING TO BUSINESSES AND HOUSEHOLDS, 2000–2013
1.2 In such a situation, it is left to the public sector to get money in to the economy. Governments, unlike banks, cannot create money; they can only borrow it from financial markets, thereby increasing public debt. However, the coalition government has committed itself to reducing government debt. This meant that fiscal stimulus—increases in spending or reductions in taxation—have been ruled out as an option for generating recovery.
1.3 Fortunately the UK has its own sovereign currency, leaving a third option. The Bank of England, as everyone now knows following Quantitative Easing (QE), also has money-creating powers. And it was left to the Bank to perform the rescue job of getting more money in to the economy when neither the private banks nor the government could do so. The policy was called “monetary activism”. So far, it has involved a drastic reduction in interest rates (held at 0.5% for four years), an injection of £375 billion (25% of GDP) in to the economy via QE and, most recently, the Funding for Lending Scheme (FLS) which subsidises commercial banks’ lending to the real economy (households and SMEs).
1.4 The Government’s hope was that the private sector, capital markets and the banks, with the support of easy money conditions, would take up the slack and invest in, and lend to, the real economy. Not only would this create growth, it would also create the right type of growth, rebalancing the UK economy away from its dependence on the housing market, consumption and the financial sector and towards manufacturing, construction and other export-orientated production. The results have been poor. Not only have we endured a record slow recovery but there is also little evidence of “re-balancing”. Manufacturing and construction in particular remain in the doldrums, which compounds a chronic lack of investment in productive sectors over the past ten years, when bank lending has flowed mainly into property and the financial sector (Figure 2).
Figure 1
BANK LENDING BY SECTOR (1997–2011)
1.5 The Bank set up a special body to conduct its QE purchases—the Asset Purchase Facility (APF). All the assets held in the APF are indemnified by the Treasury, however they do not count against the public debt nor are they part of the Bank of England’s balance sheet. Whilst the Independent Monetary Policy Committee (MPC) decides upon the quantity of assets that will be purchased via the creation of Bank of England reserves, it is the Bank of England Directors (some of whom sit on the MPC) who decide upon the type of assets that the APF purchases, and they have chosen almost exclusively to buy government debt (gilts) from financial institutions and other investors such as pension funds and insurance companies.
1.6 This is supposed to stimulate the economy by nudging investors to invest in other, productive sectors of the economy, and by reducing long-term interest rates making investment more attractive. However, the impact on the economy will be determined by what investors choose to do with the new money they receive from QE purchases. Only if it is invested in new production will it contribute to GDP transactions and growth. In the current environment, it appears larger firms are happier just sitting on cash. The Office of National Statistics recently estimated that the UK companies were sitting on £750 billion in cash, 50% of GDP.3 In other words, success in lowering interest rates does not necessarily translate into success in stimulating the real economy. Nor does it guarantee that investment will be directed into productive or sustainable sectors of the economy. Capital expenditure as a proportion of GDP, already on a long-term declining trend, has fallen significantly since the financial crisis and remains far below many of our main international competitors (Figure 3).
Figure 3
GROSS FIXED CAPITAL FORMATION AS % OF GDP
2. Strategic QE: Public Money for Public Benefit
2.1 We propose that the solution to underinvestment in productive and green sectors of the economy is to reform QE. Instead of buying Government bonds, the Asset Purchase Facility (APF) should purchase bonds issued by agencies with a specific remit for sustainable investment in UK housing, infrastructure and SMEs.
2.2 We propose that the APF could purchase bonds in intermediaries that specialise in providing funding to particular sectors of the economy that are recognised as having spare capacity. The existence of spare capacity and/or unfulfilled demand provides prima facie evidence of market failure, which should ensure compliance with EU state aid regulations (although this is a complex area where further research, including expert legal opinion, is required to define the precise structures and terms and conditions required to ensure compliance).
2.3 The advantages of this proposal are as follows:
Investment via purchase of newly issued bonds is a small evolution from current practice. Indeed, as the original mandate of the APF was to purchase corporate bonds, it may be seen as more in keeping with the intended purpose of the Treasury in authorising the creation of the APF than the purchase of government bonds.
Purchase of newly issued bonds, rather than existing bonds in the secondary market, provides a direct injection of capital into the economy instead of relying on financial investors to reallocate capital through the portfolio rebalancing effect.
The use of intermediaries ensures an appropriate division of responsibilities between investment professionals that have the expertise to assess and select individual companies and projects, and economists at the Bank of England who have the expertise to identify economic sectors that require capital investment.
The provision of patient capital to intermediaries is likely to provide opportunities to “crowd-in” private finance by giving confidence to private sector investors.
The terms of finance can either be at market rates or preferential rates. Market rates would allow for sale of bonds by the APF into the secondary markets at a later date, preserving maximum flexibility around monetary policy and also developing the breadth and depth of UK bond markets. Alternatively, low-cost finance via bonds with very low coupon rates held by the APF until maturity would expand the range of feasible projects to include economically beneficial investment that cannot be provided by the private sector because of extensive social or environmental externalities. This precedent has been set already by FLS and Help to Buy, both of which provide funding and guarantees at non-commercial rates to commercial banks. FLS funding can be accessed for as little as 0.25% per annum.4
2.4 One of the key obstacles to injecting funds into the real economy under strategic QE (or indeed tax-funded government investment programmes) is finding the means of deploying investment rapidly and efficiently. We examine a range of options which either exist already, or could be utilised with relatively little institutional and regulatory change:
National development banks, building on the British Business Bank (BBB) and the Green Investment Bank (GIB).
Housing construction, via a new intermediary to fund construction of new homes for social and affordable rent.
Housing retrofit, via the Green Deal Finance Company.
We do not consider this to be an exhaustive list and certainly should not preclude other options. They are intended to illustrate that strategic QE is possible in practice.
2.5 The economic case for a national development bank has now gained support from both Government and opposition parties. However, reluctance to commit taxpayer funds will severely limit its scale and impact. The same is true of the Green Investment Bank. Total capital for both these institutions of (£4 billion) pales in comparison with those of Germany, Brazil and Japan (Figure 4). Meanwhile, an estimated £550 billion of investment in new low-carbon infrastructure is required over the next 10 years in the UK, and housing construction remains at its lowest level in the post-war period.
Figure 4
ASSETS OF SELECTED PUBLIC INVESTMENT BANKS AS A % OF GDP (2011)
2.6 There are strong historical precedents for central bank support for national infrastructure investment, in particular in two of Britain’s ex-colonies. The Bank of Canada provided all of the capital for the successful Industrial Development Bank (IDB) of Canada in the period 1946–1972. Not a single penny of taxpayer’s money was required for a bank with a strict remit to lend only to SMEs. And in New Zealand in 1936, the Central Bank extended credit for the building of new homes, helping the country out of the Great Depression.
3. Implementing Strategic QE
3.1 Would using QE to fund sustainable investment blur the line between fiscal policy, the preserve of politicians, and monetary policy, the preserve of technocrats? In reality the distinction has always been blurred, and is further dissolved by unconventional monetary policy. Instead we should ask what the appropriate governance measures are for hybrid monetary/fiscal measures and then select the most effective tools to deploy.
3.2 We suggest the formation of a Monetary Allocation Committee which would be accountable to the Treasury and Parliament but separate from the Bank of England. This committee would decide how best to allocate new QE funding and any reinvestment of maturing gilts; almost £100 billion are being repaid over the next 5 years. The committee would be charged with carefully examining different sectors of the economy and spare capacity within them and make allocation judgements based on a broad range of macroeconomic criteria: for example sustainable GDP growth, employment, financial stability, energy security, the trade balance and inflation, ecological sustainability.
3.3 The MAC would be expected to coordinate closely with the FPC and the MPC and could have non-executive members of each plus the Treasury on its board. The quantity and maturity structure of asset purchases would remain with the MPC with its focus on longer-term rates and inflation.
3.4 Even though at arm’s length from the Government, it is important that the MAC does not have the ability to explicitly choose certain projects or companies over others. The APF should act via intermediaries such as the BBB, the GIB, the Green Deal Finance Company or a newly established Housing Investment Bank. Preventing the MAC or the APF from engaging in “picking winners” both ensures the correct division of responsibilities and isolates the MAC from any danger of political pressure to favour particular projects or companies.
3.5 QE has been criticised as posing the danger of increasing inflation. Would this be true for strategic QE used to fund sustainable investment? We contend that Strategic QE should not cause an adverse change in inflationary expectations for two reasons:
The objective of targeting QE on real economy investment where spare capacity exists is intended to avoid generalised price inflation.
The proposed institutional arrangements do not weaken the MPC’s independence or remit at all, and provide greater transparency by separating the control over the quantity central bank asset purchases from allocation decisions. It should therefore strengthen credibility overall.
3.6 If a loan funds the building of a house, or a railway or a broadband network, it is creating a productive asset. A productive asset creates value over many years, providing a continuous flow of increased products and services over time. Money spent on such an asset should thus be able to be absorbed in to the economy without creating inflation. In contrast, if new money is created and spent on existing assets, such as existing houses, equities, bonds, or derivatives, this does not create any new flow of value—instead it is more likely to simply increase the price of the asset (ie asset-price inflation).
3.7 The financial crisis has seen the creation of a variety of novel new institutions and interventions in the UK economy—including QE, FLS, the FPC, the Prudential Regulation Authority and the Financial Conduct Authority. The MAC would not seem to be qualitatively different to these other innovations. The FLS itself is overseen by a joint operating board of the Treasury and the Bank, suggesting there are no great barriers to the two organisations working together to direct credit in those areas of the economy where it is most needed.5
3.8 One of the clearest market failures, as Lord Stern has observed, is climate change. We must urgently address the lack of investment in the transformation of the UK economy to a low-carbon and sustainable economy that can stand the pressures of the 21st Century. We cannot use the excuse that we cannot afford such a transformation.
3.9 Reforming QE so that is less scattergun and more strategic, and more focused on long-term economic, social and environment benefits, provides a viable route to stimulate green investment without increasing government debt. The environmental pressures facing the UK and world are one we cannot afford to ignore.
Endnotes
1 Evidence that supports this submission is contained within an extensively referenced nef report entitled “Strategic quantitative easing: Stimulating investment to rebalance the economy”, available at http://www.neweconomics.org/publications/entry/strategic-quantitative-easing
2 Chase, S. (1943). When the War Ends: Where’s the money coming from? Problems of postwar finance (Vol. 3). New York: Twentieth Century Fund., p. 43.
3 The Guardian, 14 April 2013, Firms told to spend cash to boost economy, available at http://www.guardian.co.uk/business/2012/apr/15/firms-told-to-spend-cash-to-boost-economy [accessed 19th May 2013]
4 Bank of England. (2013). Funding for Lending Scheme extension: worked examples of borrowing allowance and fee. Retrieved from http://www.bankofengland.co.uk/markets/Documents/flsworkedexample2.pdf
5 Bank of England. (2013). Bank of England and HM Treasury announce extension to the Funding for Lending scheme. Retrieved from http://www.bankofengland.co.uk/publications/Pages/news/2013/061.aspx