What the Bank of England should’ve done
The BoE’s swift response to the pandemic was honourable; however, more could’ve been done
“The Central Bank is an institution of the most deadly hostility existing against the principles and form of our Constitution.” Thomas Jefferson 1803
Thomas Jefferson criticised the creation of a First Bank of the United States as it was not beneficial to his ideal of an agrarian lifestyle. Over two centuries later, central banks play a critical role in stimulating consumption and demand during economic crises. The recent coronavirus outbreak is a prime example of this.
As a result of the SARS-CoV-2 virus, UK GDP declined by 9.9% in 2020, the steepest drop since consistent records began in 1948. From October to December 2020, the estimated unemployment rate was at its highest rate for five years. Consumer spending contracted by 23.6% in Q2 of 2020.
Getting people back into jobs, firms back into business and preventing any long-term scars left by the crisis on the UK economy presented an onerous task for the Bank of England (BoE) to overcome. It confronted this unprecedented demand and supply shock by lowering interest rates, providing support to banks and businesses and by ramping up quantitative easing (QE).
However, these policies were suboptimal, as explained later, so this essay proposes an alternative response to the coronavirus pandemic through two core policies:
- Maintaining the Base Rate at 0.75%
- Increasing quantitative easing by £555bn during 2020, expanding the stock of assets held in the Asset Purchasing Facility to £1tn
The Bank of England’s response
On 19th March 2020, the special Monetary Policy Committee meeting voted to cut the Bank Rate to 0.1% alongside the Term Funding Scheme with additional incentives for SMEs (TFSME), aimed at reinforcing the transmission of the reduction in the Bank Rate. The TFSME allowed banks to support lending to SMEs while providing insurance against adverse market conditions.
They also introduced further quantitative easing and, following the additional programme in November 2020, the Bank of England’s total purchases of UK government bonds totalled £875bn, as well as £20bn of sterling non-financial investment-grade corporate bonds — roughly 40% of annual (pre-Covid) UK GDP.
Other measures included:
- The Covid Corporate Financing Facility (CCFF) — the joint HM Treasury and Bank of England lending facility designed to support businesses in paying their staff and suppliers by offering cash for their corporate debt.
- Supporting banks and building societies by reducing the number of financial resources they need to set against their lending to UK businesses and households. Banks agreed not to pay any dividends to their shareholders in 2020.
Flaws in their policies
The policies implemented by the Bank of England focus on stimulating investment in the economy now, a ‘spend now, pay later’ approach. However, the long-term robustness of the UK economy and those living on low incomes were neglected due to the top-down approach taken.
The lowering of interest rates is an irreversible policy. It has been proven by years of secular stagnation, a period of little to no economic growth despite low interest rates, throughout Europe and Japan. Despite generous monetary policy measures, it took until August 2018 for the Base Rate to finally rise above the 2009 level. The fundamental reason behind this is because economies are saving more than they invest, driving down the neutral interest rate below zero in some cases. Direct and targeted approaches must be taken to encourage consumption.
Additionally, persistently low interest rates are likely to affect the profitability of financial firms who are responsible for 6.9% of total economic output in 2019 in the UK; a nation home to the second-largest financial sector in the world, London. The share of economic output produced by the financial sector in the UK has fallen since the GFC (see figure 1), a result of a low Base Rate, sacrificing the profitability of our dominating financial sector.
Finally, monetary policies can be considered a hidden tax on the wealth of middle-class savers and pensioners. Individuals on fixed incomes, particularly pensioners, are disadvantaged by a low Base Rate due to their effects on bond yields. At current UK 10 year Gilt yields, it would require almost £6.5mn worth of UK Gilts to receive £50,000 of income in retirement. Whereas in July 2018, only £3mn was needed to achieve the same income, further encouraging savings, the opposite of the policy’s intentions.
QE threats the economic outlook and equality of the UK. Despite being a necessary policy tool during crises, it is still a more modern approach and should be approached cautiously.
Although it may improve banks’ liquidity, it may not encourage them to lend it out but instead, be used to strengthen reserves. Richard Murphy, an economist and accountant, said, “it will improve banks’ liquidity, not the UK economy.” These withdrawals of money from the circular flow will consequently dwindle the multiplier effect. Also, larger firms will buy smaller ones who cannot access these loans and are left financially vulnerable, leading to the formation of monopolies and contributing to an inequitable society.
Helicopter money has been deployed by the Federal Reserve in the US. Most Americans have received $3200 of payments since the pandemic hit. Of the first checks sent out, they spent 40% and used a further 30% to pay down debts. As a result, families are liberalised of their financial burdens throughout an arduous period for many.
Additionally, the marginal propensity to consume (MPC), a component of Keynesian macroeconomic theory, is negatively correlated with gross income. Therefore, inflating the rich’s wealth is not only vastly unfair but is also wasteful and inefficient; demand would bounce back stronger if more money was provided to the poor. Following the financial crisis, quantitative easing, worth around 14% of GDP, over the period March 2009 to January 2010 was estimated to have raised the level of real GDP by 1.5% to 2%. If this was instead distributed directly to the people, with an MPC ranging from 33% to 57%, it could have raised the level of real GDP by 4.7% to 8%, an impact three to four times greater.
Policy proposals
The following policies would ensure that our economy remains robust and stable beyond the crisis while presenting opportunities to reduce inequalities. They do not object to the actual response by the BoE but instead accentuate some while introducing a new one.
Quantitative easing should have taken a bottom-up approach. Instead of pumping banks and building societies with liquidity and cash that is likely to be used to strengthen their reserves, it should have been accessible to and targeted at individuals and smaller companies.
Introducing a ‘People’s QE’ would achieve this. It involves supplying money directly into the pockets of the UK population, known as ‘helicopter money’. It bypasses banks who may use the extra cash to strengthen their reserves and increase their liquidity. Similar to the idea of a Universal Basic Income, it will help to lift them out of relative poverty while inducing spending in a depressed economy. As their marginal propensity to consume is higher, it is a much more effective tool that makes the best use of any stimulus provided.
A 19.8% contraction of GDP in Q2 of 2020 would require a subsequent, approximate 25% increase in GDP to return to previous levels. Assuming 5% of that growth is recovered due to an increase in overall demand, the other 20% must be stimulated. A further 3.1% growth is required per quarter to take the UK to pre-pandemic levels by Q4 2021. Thus, using an MPC of 50%, QE worth 6.2% of GDP is required each quarter, around £19.6bn, totalling £118bn. Spread evenly across the 27.8 million households in the UK, they should each have received around £700 per quarter or £4240 over the six quarters. This is a generous windfall compared to the US stimulus checks discussed previously.
To reach small businesses, £100bn worth of additional corporate bonds should have been purchased in SMEs only, complementing the existing TSMFE. Providing direct loans to SMEs will help to drive innovation, which thrives during economic crises, make up for their lack of access to bond markets, and prevent the formation of monopolies through mergers and acquisitions.
Finally, £335bn of UK government bonds is a reasonable amount that the Bank of England should have purchased to improve banks’ liquidity and encourage them to lend more. A smaller inflationary impact on asset prices and maintained levels of credit and liquidity would have resulted from this. It would have also helped counteract the second policy change proposed; maintaining the Base Rate at 0.75%.
The Bank Rate should not have been lowered to 0.1% so hastily and abruptly. Although it may dampen demand during the pandemic, keeping interest rates at 0.75% would prevent a prolonged period of secular stagnation and enable interest rates to rise to new highs in the future. Markets would have remained more rational and appropriately priced, while pensioners would have avoided the struggle of achieving their financial goals due to low yields on government bonds.
Despite all this, the new policies come with downsides. Helicopter money may only be effective at lifting people out of poverty if the recipients make financially sound decisions that aid their long-term wealth. There is a risk that the money is squandered on luxury goods or services that lose value immediately after consumption — such as cars, clothing or accessories. These items do not appreciate and will provide no income or capital gains in the future, and consequently, households may remain in the poverty trap.
Higher interest rates are also a gamble. It means that companies cannot invest as lucratively as money is more expensive to borrow. Instead, they may save when higher business confidence and returns on investments become more attractive in the future. The very act of saving instead of investing is the reason for stagnant growth over the past decade and should be avoided.
Conclusion
The Bank of England should be praised for their actions; the UK economy grew the quickest in the third quarter of 2020 than any other quarter in history. The haste and efficiency of their response were remarkable and very much required. However, this speed may be the reason that aspects of their policies were flawed.
The long-term consequences of our economy and desire for an equal society have been forgotten. Hence, the new proposals outlined aim to mitigate the risks of prolonged secular stagnation and increased inequality by optimising the distribution of funds provided to the economy, enabling the UK to prosper in the future.
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Ted Jeffery
