Too good to be true

“If it seems too good to be true…read the fine print to see what it will cost you.” Anonymous.

New leader of the UK Labour party, Jeremy Corbyn’s economic policies, dubbed “Corbynomics” by the media, have been a big talking point in UK policy-making circles over the past few weeks. The proposal causing the biggest stir, certainly within economics arena, is “People’s QE”. A variant on the ‘conventional’ Quantitative Easing that the Bank of England (BoE) undertook between 2009 and 2012, Corbyn and his advisers believe People’s QE is a sure-fire solution to the UK’s economic woes.

For those who aren’t familiar with the working of conventional QE, it works as follows: The Bank electronically creates money (by basically increasing the number of 0s in their bank account) and uses it to buy UK government bonds from private investors. This leaves these investors with unwanted cash which they then invest in other assets (because holding cash gives you 0% return). This then lowers longer-term borrowing costs, which should act as a stimulant for borrowing and spending which, in turn, stimulates growth and inflation.

So what is People’s QE? Well, it begins the same as QE, with the BoE creating money. But this money is then only allowed to be used “under government direction and subject to government guarantees” to buy bonds of a new institution set up to promote investment and innovation the UK, called the National Investment Bank (NIB). Moreover, it is believed that the debt created by the NIB can be subsequently cancelled on a technical detail.

I believe there are two big issues with this policy: 1) the threat to the BoE’s independence and 2) the belief that the debt can be cancelled. I will deal with the first in this post.

What is Central Bank Independence?

Gordon Brown, as Chancellor of the Exchequer, made the BoE independent from the Treasury in 1997. But what does independence mean? Broadly, it can split be into two parts - goal independence and instrument independence. Goal independence is when a central bank is free to set its own targets and mandates, absent of government involvement, whereas instrumental independence is when a central bank is free to choose the means by which to meet their targets or goals (with the instruments assigned to them).

As the Treasury sets the BoE’s mandate - to deliver price stability (low inflation at 2%) and support the Government’s economic objectives including those for growth and employment - it is clear that the BoE is not goal independent. But, it can choose how and when it changes interest rates to try to meet this target, and hence can be considered to enjoy instrument independence. 

Interestingly, a survey of central bankers around the world conducted by the Centre of Central Bank Studies at the BoE, showed that members didn’t consider goal independence high up on their list of determinants for central bank independence as a whole. Instead, they focussed on instrument independence and not having to finance the government deficit (i.e. not printing money for the government to spend) as two cornerstones of central bank independence. 

Worryingly enough, these are exactly the two attributes of central bank independence that People’s QE threatens. Under this new regime the Bank of England will take policy orders from the Treasury on how much, and when to create money for NIB purposes.

Richard Murphy, the economist whose ideas Corbyonmics is born from, is ‘quite sure’ that the BoE is not actually independent anyway, and hence the loss of independence doesn't matter:

"… If those who do really think that such decisions are wholly uninfluenced by the Chancellor of the day then I very politely suggest that they have suspended their disbelief in ways that our counter to sound analysis. I am quite sure that it does not happen like that, whatever the rules might say. The fact that the OBR is forecasting rate rises at the end of the year is, for example, the surest indication from the Chancellor to the BoE as to what they might do. Let’s not pretend otherwise."

Though he doesn’t give any sound evidence for his case, the fact that the OBR is forecasting rate rises at the end of the year, he says, is the Chancellor signalling to the BoE of what they should do. The BoE’s formal forecast of the Bank rate is just above 1% in 2016 Q3, so could it be that the OBR is merely following the Bank’s guidance? Moreover, given most economists are also expecting a rate rise towards the end of this year/early next year, the OBR’s forecast of the same really tells us nothing at all. Having spent an enormous amount of time at the Treasury and Bank of England as a consultant, Simon Wren-Lewis argues against Murphy on this point from an anecdotal standpoint. Granted, the legislation does say that the Treasury can “give instructions to the Bank on interest rates for a limited period”, in extreme circumstances. Given the financial crisis in 2008 was not considered an ‘extreme circumstance’ for the Government to direct the BoE, I can’t imagine anything aside from a World War that would be. So for the purposes of the near future, we can assume this is irrelevant.

The implications of the loss of central bank independence

A wealth of academic research stands behind the decision for BoE's independence. Empirical evidence suggests that central bank independence, on average, leads to low inflation (see here and here for good summaries of the literature). Independence increases the central bank's credibility insofar as it can't be swayed by political agendas. For example, around election time, governments are well-known to increase spending to stimulate economic growth to show the electorate what a great job they’ve done. If the central bank is sucked into these illusory political manipulations, its credibility for price-stability will be lost. Every election year, governments will likely force the BoE to loosen policy even  if it may actually need tightening. The loss of credibility of the BoE in and of itself will lead to unstable inflation and growth as businesses and consumers struggle to plan for a future with too much uncertainty. 

This loss of independence likely also reduces the BoE’s effectiveness in managing the economy. Consider the following scenario: Inflation has been rising for some time and the BoE wants to raise rates. At the same time, the Treasury believes that there is not enough investment in the UK and commissions the BoE to create £50 billion to buy NIB bonds. In effect, we have the BoE tightening policy by raising interest rates, while at the same time loosening policy by injecting £50 billion into the economy. The BoE would be fighting against itself in its entire existence. In short, the loss of independence could very easily lead to a neutralisation of the BoE’s ability to meet its inflation target.

Secondly, every piece of academic literature that I have read on this issue has encouraged precluding central banks from funding the fiscal deficit (i.e. creating money for the government to spend; see here and here for examples). In this case, with essentially unlimited money at their disposal, the government has a free-pass. The issue here is one of precedent. Even if the current government emphatically argues that People’s QE will be only used to fund investment projects, what is stopping another government from using it for another purpose in the future?  All it takes is one crossing of the line and a slippery slope awaits. Though a very different time and circumstance, given the right (or wrong!) unfolding of events, we could find ourselves in a 1920s Germany under Hjalmar Schacht, where the cost of living goes up by an order of 15x in 6 months, and where workers carry wheelbarrows of cash to the shops on payday to buy groceries before prices go up again. (OK, this is clearly an exaggeration, but you get the point!)

The Bottom Line

To be clear, I am in support of a National Investment Bank, which I think will help with the UK recovery enormously. Business investment has been seriously lacking in the UK since 2009 and it is no doubt the time, just as it has been over the past 6 years, for the government to fill the gap. Unfortunately, the costs in the fine print of "People’s QE" are just too high for it to be the panacea that Corbynomics makes out.