Work Programme now yielding better results than doing nothing (just!)

The DWP published its latest statistics for the Work Programme just before Christmas, and the good news is, it’s now better than doing nothing – but only just.

work programme

Click the image to enlarge. The dotted lines show the minimum expected levels. These are based on what would be expected if the long term unemployed were just left to their own devices. The second graph shows the proportion of people who stayed on the Work Programme for 2 years, but who had a spell of employment during that time lasting for 6 months or more (or 3 months for certain groups). Of the almost 1 million people who spent 2 years on the Work Programme, just 28% fall into this category, while almost 70% were sent back to the Job Centre having been failed to be helped into sustainable work. This 28% is a mere smidgeon above the figure DWP thought the long term unemployed would achieve on their own devices. Better than nothing then!

This is a programme that has cost billions, but achieved astonishingly little. When the Work Programme started, the job market was in the toilet, so job outcomes were incredibly low. As the economy started to recover, it became easier to find unemployment people poor quality temporary and/or part time work, so the job outcome figures have picked up (while still remaining poor). In effect all it has done has transferred public resources into the hands of private outsourcing companies like Serco and A4E, who do little more than cherry pick the easy cases, while ignoring the rest. The job outcome figures for those who have come to the Work Programme via sickness/disability type benefits has been particularly poor, achieving barely half the job outcome rate deemed achievable without any intervention at all. A lot of these people are probably not well enough to be actively seeking work, but the Work Programme is failing badly for those who may be ready to return to the workplace.


Instead of wasting resources on pretending people can be got back into employment through improving their ‘soft skills’ or CV writing abilities, why not actually create some jobs?


Why has UK productivity been so slow to recover?

Over the last 12 months we’ve seen quite impressive falls in unemployment. At the same time though, growth in labour productivity has been disappointing to say the least. This apparent mismatch between rising unemployment and falling or static productivity has been labelled “The Productivity Puzzle”. Many possible explanations to the puzzle have been posited. In a recent entitled “The UK Productivity Puzzle”, researchers from the Bank of England reviewed some of these explanations to see if any provided satisfactory answers.

First though, what do we mean by productivity? The BoE paper says:

Labour productivity is defined as the quantity of goods and services produced per unit of labour input. Since the onset of the 2007–08 financial crisis, labour productivity in the United Kingdom has been exceptionally weak. While labour productivity — measured by whole-economy output per hour worked — started to improve in 2013 alongside the recovery in output that was taking place at this time, it is still some 16% below the level implied by a simple continuation of its pre-crisis trend.

It then puts current productivity in context against the period following previous recessions. This chart shows that the current period has seen by far the largest fall in productivity than during any other post-war recession, and the recovery has been the longest and slowest:



The BoE say the possible explanations for the weakness in productivity can be grouped into two broad hypotheses. The first is what they call ‘cyclical factors’. Chiefly that following the downturn, firms were unwilling or unable to lay off workers either because they needed a minimum number of staff to keep the business going, or because they were ‘hoarding’ labour, believing the downturn to be only temporary. While they operate in this manner, firms are less productive than they could be. The BoE dismisses this as a full explanation however, because employment has recovered strongly and GDP is growing, and prior to this latest recession, productivity recovered strongly alongside employment and GDP.

The second hypothesis the BoE sets out says that weak productivity is likely to persist due to a disruption in the ability of the economy to produce goods and services. They suggest a number of actions that could have caused this disruption, including impaired access to finance and greater uncertainty about the future which both act to dissuade firms from investing in new projects, which in turn impacted upon productivity.

The BoE find the second hypothesis more persuasive, citing a fall in innovation by firms since 2008, which they say has important implications for productivity. At the same time, the BoE cite problems with securing finance impacting upon form’s working capital positions which means their production process became less efficient.

The paper also raises the issue of high business survival rates, pointing out that while the level of company liquidations has been low since the onset of the crisis. the number of loss-making businesses has actually risen significantly (see chart below). The have been referred to elsewhere as ‘zombie firms’. What this means is that while the lower liquidation rate would mean lower unemployment than would otherwise be the case, the higher proportion of unhealthy (but surviving) firms would have a negative impact on productivity.



In drawing conclusions, the BoE paper attempts to quantify how each explanation for the productivity puzzle accounts for the 16% fall. This can be seen in the table below. With the caveat that a large amount of uncertainty remains, they say that 4% of the 16% can be explained by changes in the way productivity and and GDP are measured. They say the impact of hypothesis 1 is uncertain, but attribute 0% to this explanation. Hypothesis 2 though they think explains 6-9% of the 16% fall split almost equally between reduced investment and high business survival rates.



This then leaves 3-6% unexplained. So more research needed!

Economics textbook vs Bank of England

I blogged yesterday about this recent paper on money published by the Bank of England. The paper outlines the process by which banks create money and states a number of times that the reality differs from how most economics textbooks treat the subject. From time to time, when mainstream economics is challenged in this way, its defenders respond by saying one of the following things:

1. We already know that;

2. It’s not true that the textbooks teach in that (inaccurate) way;

3. The textbook version is just a simplification for new students, and more advanced courses teach the right way.

I thought I’d very quickly tackle points 2 and 3 by digging out my old undergrad textbook. The text we used was ‘Macroeconomics (5th Edition)’ by N. Gregory Mankiw. This was purchased in 2002 for the princely sum of £34.99,  but I believe this (updated) text remains the best selling macro textbook.

Very briefly then. The BoE paper writes:

“The reality of how money is created today differs from the description found in some economics textbooks”

Like what? The paper asserts:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

While the Mankiw textbook (p485) says:

“…financial markets have the important function of transferring the economy’s resources from those households that wish to save some of their income for the future to those households and firms that wish to borrow to buy in investment goods to be used in future production. The process of transferring funds from savers to borrowers is called financial intermediation.”

Back to the BoE:

“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them.”

BoE again:

• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

Mankiw (p487):

“Each dollar of the monetary base produces m dollars of money.  Because the monetary base has a multiplied effect on the money supply, the monetary base is sometimes called high-powered money.”

So it’s clear there are things in mainstream texts that would seem to be wrong or misleading, contrary to point 2 above, but is point 3 correct? Is it all just a necessary simplification as a starting point for learning complex ideas? While Mankiw does talk of ‘models’ it doesn’t say that the model does not really reflect reality and is just a simplification, and I studied economics to Masters level without being disabused of these ideas. It was only relatively recently I discovered these textbook example was not necessarily the truth. That could be a personal failing on my part, but I suspect I am not alone.




From the horses mouth: How money is created

The Bank of England published quite a nice briefing today entitled “Money creation in the modern economy“. It won’t surprise you if I tell you that a lot of central bank publications are quite heavy going for the lay person, but this one is actually quite an easy read. It sets out to bash a couple of common myths in how bank lending words, some of which is quite quotable, which is what I’m going to do now.

It’s a very common belief that banks take money from savers and lend it out to borrowers, and in doing so play an intermediary role. I think this belief is sometimes used to bolster the view that savers are virtuous and more saving would be a very good thing. While saving is a very good thing for an individual or household, if everyone saved as much as the could, we get into a paradox of thrift type situation – not good. So do banks take savers money and lend it to borrowers? Here’s what the Bank of England say:

“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.”

So rather than lending out savers deposits, what banks actually do when they make a loan is to create new money, which then becomes a deposit. The Bank of England paper explains it like this:

“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”

These things are not well understood by the general public, and it’s quite rare to find an honest attempt to explain them from an official source, so this paper is very welcome. Helpfully, the BoE produced this short video to accompany the paper. Have a watch!

Economist Ann Pettifor on Austerity, Osbornomics and what Labour should be doing

In a first for this blog, I put some questions to economist Ann Pettifor on economic recovery, private debt, and the way politicians talk about their economic plans. Ann is a Director of Policy Research in Macroeconomics (PRIME) and a fellow of the New Economics Foundation. She is well known for her leadership of an organisation Jubilee 2000, that placed the debts of the poorest countries on the global political agenda, and brought about both substantial debt cancellation, and radical policy changes, at national and international levels. In 2006 Palgrave published her book: The coming first world debt crisis. It came. I really appreciate her taking time out of her schedule to answer my questions so comprehensively. Hope you like it.

1. We are starting to see growth return to the economy. The Government says we are ‘turning a corner’. Do you agree with this assessment?

Austerity can do a great deal of harm to the economy, but try as they may, politicians and neoclassical economists cannot kill it off. And sure enough the patient shows signs of life. All the same, the policies applied by Chancellor Osborne and his deputy Danny Alexander, in particular the slashing of public investment after 2010, extended, quite unnecessarily, the longest post-crisis slump since records began.  Sixty-six months after the crisis the economy remains 2-3% smaller than it was in 2008. Sixty-six months after the 1929 crash, the economy was bigger by 5-8%.

This failure should not surprise us. Both Treasury politicians take a hands-off approach to the finance sector, and both are determined to shrink the public sector. The pro-cyclical application of austerity was an ideologically driven no-brainer for both men. Neither would have been willing to restrain the ‘irrational exuberance’ of the finance sector with a touch of austerity during the boom years; but both endorsed austerity during the slump.

As a result Chancellor Osborne and his deputy will go down in history as the Jehova’s Witnesses of economics. Unlike the Obama administration they have preferred ideology and prayer to the well-tried and tested economic medicine of fiscal stimulus in a slump: a point well made by Tim Harford in the Financial Times, Dr. Osborne’s bitter medicine.

As a result, unemployment remains unacceptably high – a reckless waste of Britain’s investment in the nurturing, health and education of 2.49 million people – 7.7% of the economically active. The immeasurable pain and anguish caused by unemployment, the family breakdowns, the mental health effects; the personal and social dislocation suffered – all these will remain as deep scars on our society and will blight their futures. A shocking 1.09 million of Britain’s young people are not in education, employment or training, according to the ONS. 584,240 young people were classified as unemployed between April and June, 2013.  While political leaders may enjoy prospects, for the young prospects are bleak.

Nevertheless employment has remained surprisingly buoyant. The pre-crisis decline in wages and the post-crisis slump has proved that wages after all are not so ‘sticky’. As Shaun Richards notes, UK real wages are now falling at an annual rate of 2% if based on CPI and 2.5% if based on RPI – “as the real wage crisis builds.”

GDP is just 2.2% higher today than in Q2 of 2010 (when the Coalition Government came to office). Given that UK population is increasing at about 0.8% per year, this means that GDP per head of population is completely flat, following the big drop in 2008/9.

Not much to write home about there.

And while the flickers of increased economic activity now evident are heartening, questions must be asked about how this very weak recovery will be sustained? By household and company borrowing?

I don’t think so.

British individuals, households, firms and banks are still heavily indebted, and the Chancellor has done little to help debtors pay down, clear or re-structure that debt – a hangover from the pre-crisis credit bubble.

So far from borrowing from banks, individuals and firms are saving, and effectively lending to banks, according to data from the Bank of England. There are two exceptions. Borrowing for mortgages has risen. Borrowing from non-standard financial institutions – e.g. payday lenders – is also up from £4bn in February to just over £5bn in August, according to the Bank of England.  This latter increase is not significant in itself, but because such borrowing is at higher (and sometimes obscenely high) rates of interest, and because wages are falling, signs that consumers are turning to pay day lenders in larger numbers, are worrying.

Nor has the government worked to re-structure the broken banking system – and so SMEs continue to be starved of credit and overdrafts.  This means that SMEs wanting to employ new staff, or to improve and update their businesses, fund investment out of cash flow, erratically.

By contrast, business is better-than-usual for bankers.  Not only are they too-big-to-fail, and too-big-to-jail, but the British government now actively subsidises their lending on existing housing – and in the process inflates house prices.  And the Chancellor is the banker’s strongest ally in Brussels where attempts are made to limit bonuses and tighten regulation.

Will recovery by powered by business investment?  I don’t think so. The ONS recorded the lowest ever capital spending by the private sector, in the first half of 2013.

And what of public investment? Will that sustain this ‘recovery’? Hardly. Under Labour between 2007 and 2010 public net investment increased by £7bn. In 2011 under the coalition government public investment fell by £9.7bn and was slashed once more in 2012 by another £9.6bn. Predictably, the deficit remains far higher than the Chancellor and his deputy intended.

Will exports drive the recovery? Total exports since Q2 in 2010 (when the coalition came to power) have risen by about £9bn in real terms (ONS) whereas imports have gone up by nearly £8bn. In the second quarter of 2013 there was an uptick in exports, matched by an uptick in imports, with a deficit of £5bn. However, the uptick in exports is not a trend, and it will take several quarters of export rises to convince economists that this sector will drive recovery.

So not much to sing about there.

Total industrial production makes up 15% of the economy (and includes manufacturing, oil and gas; electric, gas, steam and air; water supply and sewage). At the end of June 2013 industrial production was 4.2% below what it was in 2010.

Manufacturing is down 0.5% since 2010. North Sea Oil and Gas is down by a massive 25%. Construction is down 5.8% since 2010.

Not much joy there then.

Total services (which make up 78% of the economy) have risen by 4.4% since 2010. Health and social work are up by 7.4%; real estate is up 5% and wholesale and retail up by 5.7%. The finance and insurance sector has shrunk by 2.9% since 2010.

However the big rise in services is driven by professional, scientific and admin services, up 14.1% since 2010.

So we have scientists, the creative industries and administrators to thank for the growth in services, driving the recovery.

Is the rise in services sufficient to fuel and sustain recovery? I would be encouraged if it were not for the overhang of private debt that will once again threaten Britain’s large numbers of private, individual, household and corporate debtors when interest rates begin to rise. There were signs of interest rates tightening in the bond markets over the summer. Any further signs of recovery are bound to trigger rises in rates and these will, as before, lead to rises in mortgage rates and choke back any sign of recovery.  In September the Federal Reserve seemed prepared to ‘taper’ its $85bn monthly (QE) purchases of assets from the financial sector, but was deflected from its strategy of unwinding QE by rises in long-term bond yields – which similarly pose a threat to recovery in the US.

2. We’re repeatedly told that government debt is our biggest problem. But private sector debt is still almost 450% of GDP. Despite this, a lot of the Coalition’s economic policies seem to be about encouraging more private sector debt. Is there any reason to believe that government debt of around 90% of GDP is more dangerous than the much larger private sector debt? 

By simultaneously presiding over cuts in incomes, the Chancellor has made it harder for debtors to pay down their debts. Indeed falling incomes have led to a growth in household debt and a boom in payday and other risky lending. Private household debts have not been de-leveraged on any meaningful scale. Instead they are held in suspense – at about 140% of UK GDP. Low interest rates are used to lull private debtors into complacency.

The overhang of household, corporate and bank debt is a buffer that is likely once again to choke back any recovery – as it did in 2009 and 2011.

The ONS reports that household incomes fell for the first time in 20 years by an average of £615 in 2011. Under the Cameron government there has been no period when pay has not fallen in real terms. The last time pay rose higher than inflation (CPI) was in the period January to April 2010, according to ONS.

From this year benefits will only rise by 1% – less than current inflation levels, slashing the living standards of the most vulnerable. This too will drive more people into the arms of payday lenders and loan sharks – worsening debt at the lowest levels of income…

Unlike Mrs Merkel, who compared the fiscal budget with the private household of a Swabian housewife, I say that there is a huge difference between public debt and private debt. The key point to understand is that private and public debts are redeemed differently. Private debt is largely repaid from incomes, currently falling in the UK. However, budget deficits can be solved by various means. One crude measure is to impose austerity, cut government spending, and increase public sector saving in line with increased private saving. With both the private and public sectors saving, spending into the economy is cut sharply, which is bad news both for private firms trying to sell their wares, but also for Her Majesty’s tax collection officers. No wonder Britain’s firms and corporations are hoarding cash! Customers are not coming through the door, and the customer-of-last-resort – the government – is refusing to step into the breach.

Another more sustainable measure is for government to invest in employment. If government would undertake infrastructure investment to increase economic activity, including employment, and to raise incomes – hey presto, the budget deficit would fall, and the public finances would be restored to sustainability.

3. Now we have seen a moderate rise in growth, the government say they feel vindicated and that this proves that austerity has ‘worked’. Do they have a point?

This “recovery” is hardly based on austerity. Academics tried in recent years to prove that a high level of government debt causes economic slumps. Some renowned orthodox economists, like Professors Reinhart and Rogoff, were so keen to make what is effectively an ideological point, that they misused excel tables. However, the empirical evidence we have suggests the opposite: Austerity harms the recovery, whereas fiscal stimulus increases economic activity in a slump. This has been shown by – among others – Taylor and Jordan in their recent publication.

The problem of continuing high deficits despite austerity only reinforces my argument. Public spending cuts cannot help recovery nor can they fix the deficit. Instead, they cut economic activity and reduce tax revenues.

4. Whenever one of the main parties (usually Labour) proposes a new policy, the other parties immediately demand to know how it would be paid for. Tax rise or spending cut elsewhere. What do you think of this debate? For example, I’ve heard you talk of Labour’s announcements on childcare and the youth jobs guarantee as being ‘salami slicing’. Could you explain what you mean by that?

The Labour Party will only discuss its plans in microeconomic terms. By this I mean that it offers its plans for the future – e.g. banning the bedroom tax, and simultaneously explains what tax revenues would be used to compensate for the abolition of the tax.

This causes Labour to fall into the microeconomic trap set by the Chancellor: namely that public spending can only be financed by existing tax revenues – not by increased economic activity, rising employment and the revenues associated with increased economic activity.

This approach boxes in policy-makers – which is what it is intended to do.

Labour would be much better off by arguing that its central objective would be to increase employment – and to do this by using public sector investment to increase private sector as well as public sector employment. For example, investment in retrofitting Britain’s housing stock would be stimulated by public sector funding for this purpose. But the retro-fitting would be undertaken by the private construction sector, and would be labour intensive, while at the same time increasing energy efficiency and saving on household bills – which would increase household income.

The public sector investment could be financed in just the same way as the bailout of the banks was financed: by resources issued through the government’s nationalised banks: the Bank of England, the RBS and Lloyds Bank. The BoE can work with the UK Treasury and the Debt Management Office who would issue bonds for financing for example, the retrofitting of Britain’s housing stock. These bonds can be purchased by the Bank of England at a very low and even negative rate of interest. And the tax revenues that accrue from the retrofitting process would then be used to repay the low-cost debt incurred by government.

RBS and Lloyds Bank can be encouraged to lend to firms and SMEs at very low rates of interest. If they fail or refuse to do so, government can withdraw taxpayer-backed guarantees, and access to Bank of England low rates.

This method of financing is much to be preferred to the current approach of financing every opposition policy from the existing and declining tax base!

It’s not complicated!

Another way to think about government debt

The Tory Party conference is coming up, so expect to hear lots about how they literally saved the country from becoming like Greece, tackling the deficit head on and paying down Britain’s debt. The reality’s a little different though. Mercifully, and despite their better efforts, the deficit has remained high, as the government’s cuts have been offset by higher welfare spending and lower tax take. The high deficit seems to be supporting the economy just enough to allow a weak recovery at the moment. The national debt however, continues to grow.

All the main parties want us to fear government debt and play on our wish for our children to have a better life by constantly talking about the burden we are placing on future generations. To a large extent, this scaremongering has worked. Most people hate austerity, but accept “there is no alternative”. We must get the deficit down.

But should we be thinking about government debt as placing a burden on our children? How will we pay it back? For an alternative viewpoint, the following is an extract from a book called the “Seven Deadly Innocent Frauds of Economic Policy” by Warren Mosler. Everyone can and should read this book for free here. I’ve replaced some words to make it fit for the UK i.e $s to £s or the Fed to the Bank of England.

“Next, you need to know what a U.K. government bond (gilt) actually is. A U.K. government bond is nothing more than a savings account at the Bank of England (BoE). When you buy a gilt, you send your pounds to the Bank of England and then some time in the future, they send the pounds back plus interest. The same holds true for any savings account at any bank. You send the bank pounds and you get them back plus interest. Let’s say that your bank decides to buy £2,000 worth of gilts. To pay for those gilts, the BoE reduces the number of pounds that your bank has in its current (reserve) account at the BoE by £2,000 and adds £2,000 to your bank’s savings account at the BoE. (I’m calling the gilts “savings
accounts,” which is all they are.)

In other words, when the U.K. government does what’s called “borrowing money,” all it does is move funds from current accounts at the BoE to savings accounts (gilts) at the BoE. In fact, the entire £1.4 trillion national debt is nothing more than the economy’s total holdings of savings accounts at the BoE.

And what happens when the gilts come due, and that “debt” has to be paid back? Yes, you guessed it, the BoE merely shifts the sterling balances from the savings accounts (gilts) at the BoE to the appropriate current accounts at the BoE (reserve accounts). Nor is this anything new. It’s been done exactly like this for a very long time, and no one seems to understand how simple it is and that it never will be a problem.”

So rather than a burden, a more realistic way to think of the national debt is as the financial savings of the private sector. It’s not something we should be overly concerned about. Over the last few years, the private sector has been demanding to save (lend money to the government) as it has not been able to find profitable investments in the real economy. It wanted risk-free assets, and nothing is more risk free than putting money into a savings account at the BoE. This huge demand for risk free savings has keep the price of those savings high (and the interest rate low). So when the government boasts about keeping interest rates low, this has been a prize for failure rather than anything to be proud of. In a strongly recovering economy, the demand for risk free savings (gilts) will fall, so interest rates will rise. This will be a good thing as it will mean we should see more investing in the real economy.

When we hear politicians talk about the economy, up is down, left is right and black is white. The truth is often the complete opposite of perceived wisdom, so read Mosler’s book and have your mind blown.


How bank lending and QE actually works

What follows is basically a re-post of the first half of this, except I’ve reworked and extended some parts for a UK audience.

How bank lending works

1. Banks do not take in deposits from savers and then lend them out. Loans create deposits. When a bank creates a loan, it simultaneously creates a deposit. This is how credit grows, by banks expanding their balance sheets.

For example. You walk into a bank and want a loan to buy a car. The loan officer approves you. He does not go and get some depositors funds and transfer them to your account. He credits your account with a deposit, and creates an asset, the loan. The bank has a new asset, the loan, and a new liability, the deposit. They created the deposit by making the loan. Two new entries have been added to the ledger, and the bank has created the money you get in your account.

2. It is often said that banks take in deposits and then lend out a proportion of it, keeping some back as reserves, but bank lending is not constrained by bank reserves. The process described above is never interrupted by the bank manager worrying about reserve requirements. The bank will get its required reserves later by borrowing them in the interbank market, or trying to attract depositors. System wide, if banks are short of required reserves, ultimately the Bank of England will have to provide them by buying bonds on the secondary market (like it has done with QE). Reserves are provided to the banking system, with a lag, following bank credit expansion.

3. The money multiplier (where it is said that if the reserve requirement is 10% for example, a bank can take a deposit of £100, then lend out £90, take that £90 as a deposit, then lend out £81 and so on) is an exploded myth. Banks never make lending decisions on the basis of their reserves. As described above, if a bank needs to meet its reserve requirement, it borrows them at the Bank of England base rate. The Bank of England will always supply reserves at the target rate (now 0.5%), and so banks don’t worry about this. If a bank is in trouble with solvency and other banks refuse to lend to them, the bank will make use of the discount window and borrow at a penalty rate. But in normal conditions when a bank’s solvency isn’t questioned, banks will acquire reserves through the overnight loan market from other banks, and the Bank of England will provision whatever reserves are required by the system-wide demand to meet their target rate.

Banks create loans, and worry about reserves later. Reserves follow private bank credit expansion, they do not lead it.

Quantitative Easing (QE)

4. When the Bank of England does QE, it purchases UK Government debt on the secondary market. This has the effect of pumping new reserves into the banking system. It’s often said that QE is  inflationary, or even hyperinflationary, but this stems from a misunderstanding of the bank lending process described above. There is a belief for example that if a central bank were to inject £100bn say into the banking system, then the banks will create multiples of this amount in loans. But because, as above, the money multiplier story is a myth (at least in the way it’s presented) and because banks don’t lend out reserves, QE cannot be inflationary. This is what we have seen following QE. The government has injected £375bn of new reserves into the banking system, but the wider measure of the money supply has been growing much slower than before the crash.

The inflationary impact of QE is not clear cut, and there are those who argue it might even be slightly deflationary, as it reduces interest income to holders of government debt (gilts) because through QE the Bank of England are buying  gilts on the secondary market in exchange for new reserves (which pay a lower rate of interest), which in turn reduces income and spending in the economy. This is manifested in the £35bn in gilt interest the BoE has returned to the Treasury recently, which George Osborne has decided to use to reduce the deficit rather than recycling it back into the economy.

The description of the system outlined above is not commonly understood, including by politicians, and in misunderstanding it, a lot of the policy-making that follows is often misguided and sometimes counter-productive. I think the impact that additional monetary policy can have for example is wildly overblown, and the constant references to how the banks are not lending at the moment seems to misdiagnose the reasons why this is so. Maybe a topic for another day.


What are the Treasury and the Bank of England up to?

There was an interesting announcement yesterday by the Chancellor saying that excess cash held by the Bank of England’s Asset Purchase Facility will be transferred to the Exchequer.

It’s widely known that the BoE has been purchasing UK government bonds on the secondary markets via QE. To date it has bought £375bn worth. What is less known is that the Government has been paying the Bank of England interest on these bonds – around £35bn so far. Blogger Neil Wilson has written about this previously here, which Think Left drew attention to here.

These interest payments will now be returned to the Treasury on a quarterly basis, so in effect, the bonds held by the Bank of England will now be interest-free. Previously, we have been issuing more debt than we needed to in order to pay interest to the Bank of England, which was actually money the Treasury was entitled to. If it sounds crazy, it is.

George Osborne argues this change just brings the UK into line with the practice in Japan and the US. This is true in that the US Treasury regularly ‘sweeps’ the accounts of the Federal Reserve to return any profits it makes to the Treasury, but it represents something of a volte face and the timing is interesting. A while ago, I put a question to the Treasury about this via my MP and was told that profits from QE would not be returned to the Treasury until QE was ‘wound-up’. They were not able to say when they expected this to be. I had suspected Osborne was saving this up for some pre-election tax cuts, but desperation seems to have set in.

So what does this mean in practical terms? The timing is interesting, coming as it does just a couple of weeks before the Autumn statement, when the OBR was expected to announce that Osborne would miss his debt and deficit targets. As Duncan Weldon argues, this change could mean that Osborne could now remain on course. The payments from the BoE will mean the deficit will be lower than it otherwise would, and it looks like Osborne will not use this money to increase spending, but instead to reduce the amount he borrows externally. This appears to be a purely political move though, as good economics would say this money would be better spent on capital projects, direct job creation, or tax cuts for low earners.

There is a complicating factor here however, in that the Treasury ‘indemnifies’ the Asset Purchase Facility, meaning that if the BoE makes any losses when unwinding QE (if it sells bonds back to the markets for less than it paid for them), then the Treasury would have to cover the losses. So while this may be a short term (political) benefit to Osborne, in the longer term, it may actually end up costing the Treasury more. In reality though, I think it unlikely that QE will be unwound any time soon (in the next five years at least).

If all this sounds confusing, don’t worry, it is. Making the Bank of England a separate entity from the government means that it looks like the debt is a lot higher than it actually is. Officially, the national debt is over £1 trillion, but if the Bank of England consolidated its balance sheet with HM Treasury under the rules in IFRS-10 (h/t Neil Wilson again), the debt goes down to around £700m.

A lot of commentators reacted to the news quite hysterically by announcing that the Government had finally lost the plot and resorted to ‘printing money’ again. Jeremy Warner in the Telegraph was one of the first here (although he later rowed back somewhat). This is not what is happening though, and we are just bringing ourselves into line with the US and Japan, although as I said, the timing is interesting.

I’ve argued before that a lot of the hysteria about government debt is irrational. As the government issues sterling, it can never run out of money, neither does it need to tax or borrow in order to finance it’s spending. This latest announcement is just another reminder that much of ‘the debt’ is not really debt at all and certainly isn’t a burden on future generations.