The Bank of England has set up a new research hub, called “One Bank Research”, which is tasked with looking at some of the fundamental question about the future of money and banking. In the past, the Bank’s research has often had the aim of backing up the policy decisions of the Governor or the MPC. The One Bank Research initiative’s agenda, released last week, asks questions that already start to challenge the Bank’s existing policies.
Three highlights from the research agenda are below.
1. The conflict between monetary policy and financial stability
The Bank of England has two remits: to maintain price stability (i.e. low and steady inflation) and to maintain financial stability (i.e. no financial crisis).
It hasn’t done particularly well with the second part of its remit. One of the reasons for this is that there’s a fundamental conflict at the heart of the existing monetary and banking system. Central banks attempt to ‘maintain price stability’ by lowering (or raising) the base rate of interest. This is supposed to feed through to the rates that banks charge their customers to borrow, which encourages them to borrow more (or less) and therefore enables the banks to create more (or less) money.
The problem arises from the fact that encouraging people to borrow more means they end up with greater debt, relative to their income. And higher levels of private sector debt (i.e. debt of households or, to a lesser extent, businesses) have been shown to increase the risk of financial crisis (see this academic paper by Taylor and Schularick for more).
The research agenda recognises this conflict:
First, lower interest rates improve financial stability via the balance sheet channel by stimulating aggregate demand, increasing the value of legacy assets and reducing the real debt-service burden of households and non-financial corporates. Second, lower rates can increase financial instability via the leverage channel, by incentivising households, corporates and financial institutions to take on more debt (Adrian and Shin (2008)). Finally, a low interest rate environment can also affect risk-taking by reducing asset price volatility and hence perceptions of risk (Borio and White (2004) and Borio and Zhu (2008)), and increasing incentives to take risks in order to maintain nominal target returns (Rajan (2005)). A number of empirical studies point to evidence that lower interest rates are associated with greater risk-taking by banks (for example, Maddaloni and Peydro (2013), Dell’Ariccia et al (2013)). [page 3]
Although the Bank hasn’t said this, it’s Positive Money’s view that as long as we rely on banks to create the nation’s money, central banks will continue to stimulate the economy through low interest rates. This will lead to dangerously high levels of household debt, and ultimately a financial crisis. One simple way of breaking out of this Catch-22 situation is for the central bank to take back the power to create money from the banks, so that it can create money without waiting for any household or business to decide to go further into debt.
2. Are interest rates the only tool the Bank of England should be using?
The usual trick of pushing interest rates down failed to get the economy out of the last crisis. Even with rates at close to zero, an over-indebted public did not want to borrow more from banks, and therefore the usual channel of money creation stopped working. This led the Bank of England to do some money creation directly, through the Quantitative Easing scheme (QE), in which they created £375bn of new money which was then pumped into the financial markets. (More on how QE works here).
There’s an assumption that this was just an emergency measure, and that eventually central banks will return to simply managing interest rates, without all its ‘unconventional monetary policy’ tools. But the Bank of England says that research is needed to address the question of “what role monetary policy guidance and unconventional monetary policy instruments such as quantitative easing (QE) play in normal times” (p6).
Positive Money would never advocate more Quantitative Easing in its current form, as it has inflated asset prices, increased wealth inequality but done very little to benefit the real economy. However, there is certainly a role for the Bank of England to create money, either in parallel to, or instead of, the banks. The fact that the Bank is asking these questions is a good sign that they’re looking outside the usual orthodoxy of pushing interest rates up and down. Encouragingly, one of their key questions for further study is:
Should interest rates continue as the primary instrument of monetary policy or should unconventional tools such as QE and forward guidance be continued even after economies return to more normal conditions?
3. Should the safety nets that the banks enjoy be widened to include the rest of the financial sector? (Please, no.)
The Bank writes:
Central banks around the world made extensive use of their balance sheets during the financial crisis…And the crisis also led to a number of changes in the design of central bank operational frameworks. With the benefit of hindsight, which of these interventions were most effective, through which channels and under what circumstances? Are there other tools which central banks should have available to deploy in the next crisis? What system should central banks use to control interest rates? Should central banks look to expand their counterparty lists further and provide liquidity insurance facilities to non-bank entities?
The last sentence is concerning. The phrase “liquidity insurance facilities” mean that the Bank of England will provide money to financial firms who are ‘illiquid’ i.e. who can’t make their payments to other firms or to customers. In the past, the Bank would only provide this liquidity support to banks. Whilst this had the effect of making the banking system less prone to periodic panics, there’s also evidence that it leads banks to take greater risks, knowing that they can fall on the Bank of England if they get into difficulty.
Extending this liquidity support to a wider range of financial companies means widening the safety net. This potentially puts the taxpayer on the hook for the failures of even more of the financial system. There’s also a moral question: why should financial sector firms be able to call on the Bank of England to get the funds to make its payments, when any firm in the real (non-financial) economy would go bust in the same situation?
We’d argue that we should be going in the opposite direction: reforming the financial system so that we no longer have to provide safety nets to support the financial sector when it goes wrong.
4. Should the Bank of England be issuing digital currencies?
The research agenda starts to discuss whether the Bank of England should start issuing ‘digital currency’, building upon the payments technology underlying Bitcoin (but hopefully without its many currency design flaws). This is where it gets interesting – and complicated. We’ll be addressing the questions they ask, and our initial answers, in a post in the next few days.