It seems ironic now but the IMF had only just concluded, on the very eve of the crisis, that monetary policy was to be preferred for cycle management and that fiscal policy was best used for political and redistributive aims.
Discretionary fiscal policy at best provided “modest” countercyclical stimulus and even then only if it obeyed the rule of TTT: timely, targeted and temporary. This last because any fiscal stimulus that became entrenched tends to be neutralized by so-called Ricardian equivalence: wider government deficits trigger lower household consumption in anticipation of higher future taxation.
Ricardian equivalence could explain why corporates across the developed world, unconstrained by the debt that bedevils households, have nevertheless failed to take advantage of low rates to invest this downturn. According to the Office for Budget Responsibility (OBR), five years on from the original banking crisis, the UK government still faces a £111bn (almost 7% of GDP) budget deficit in 2013-14. To close the deficit by 2018, despite a forecast rise in total managed expenditure (TME) from £718bn to £775bn (1.55% per annum) OBR forecasts show annual taxes have to rise 27% (5% a year); from £577bn to £733bn.
As Prime Minister Hashimoto discovered with Japan’s disastrous 1997 sales tax hike, it is all too possible during resolution to raise the tax rate and yet lower the tax take. It is therefore imperative that the UK deficit reduction plan is based on nominal economic growth rather than a more draconian tax code. Normally this could be ensured by easier, counter-cyclical monetary policy. However, conventional monetary policy has an Achilles heel. Whereas fiscal policy is conducted via government agencies, the execution of monetary policy is sub-contracted out to the private sector, namely the banks.
This is all well and good as long as the banks are able and willing to faithfully transmit policy to the wider economy. The very nature of a financial crisis: i.e. the clear and present danger of systemic bank insolvency necessitates chronic balance sheet repair. Typically, from start to finish, bank loan contraction takes almost six years for single countries and most likely longer for the sort of, thankfully rare, synchronous crisis we still seem to be going through. A bank is effectively insolvent (i.e. unable to function) if its capital ratio falls below the regulatory minimum.
Our banks are subject to the Basel rules and operate at close to the maximum allowable leverage. They cannot therefore bear much in the way of losses (net of earnings) in any single year; hence the chronic nature of resolution. As new lending ceases and non-performing loans (NPLs) are gradually written off, bank losses become at the same time manageable but also stubbornly persistent. The problem for the UK economy is that, at least for those solely reliant on bank lending for their credit like households and SMEs, during bank balance sheet repair these sectors haven’t been able to get credit.
The outright decline in the stock of bank lending in 2009-10 would, all other things being equal, have shrunk broad money supply and that is the definition of deflation. The sort of sustained and significant decline in domestic bank lending the UK experienced would have undoubtedly engendered not a Great Recession but a full-blown depression; as indeed we saw in peripheral European countries like Ireland and Greece. However, although conventional monetary policy relies on the plumbing of the banks to reach the wider economy, there is another way.
Unconventional monetary policy, a.k.a. quantitative easing (QE), required the Bank of England (BOE) to buy assets, not from the banks as usual, but from the real economy. By crediting the sellers’ bank accounts, the BOE artificially expanded bank deposits, which is what we otherwise know as money supply. Because large-scale buying of this sort could naturally distort markets, Mervyn King confined QE purchases to the biggest, deepest market of all, the Gilt market; though largely avoided buying gilts at issue, which would look too much like debt monetization.
In the US, Ben Bernanke’s Fed had fewer qualms and predominantly bought residential mortgage backed securities (RMBS) in order to deliberately lower fixed mortgage rates too. Instead of declining in a deflationary depression, UK broad money supply (M4 excluding intermediate OFCs) remained flat throughout the 2009-2011 period. However, as the chart below shows, the MPC then decide to initiate another round of QE during 2012. At least as far as any contraction in bank lending was concerned, QEII was surplus to requirements. As a consequence, instead of remaining flat, broad money supply since 2012 has expanded. Between the start of 2012 and the end of February this year, new bank lending has declined by £20.6bn yet broad money supply has instead risen by £170bn. Up to £175bn of that difference can be directly attributed to QE.