August 9, 2022
As recent research from the New Economics Foundation has highlighted, we are relying on huge subsidies to influence the behaviour of banks. But what if we could replace the carrot with a stick? We can not only look to the past for inspiration on how to do this, but to the digital money of the future.
With inflation high, public spending and central bank ‘money printing’ has become the scapegoat, leading to calls for spending cuts and/or higher interest rates to combat it. This not only overlooks how inflation is being driven primarily by supply shocks beyond our immediate control, but also the fact that most of the money in our economy is not ‘printed’ by the state, but created by private banks when they make loans – the vast majority of which goes towards bidding up the price of existing assets (including commodities we rely on) rather than increasing the economy’s productive capacity.
Responding to inflation by simply raising the base rate will raise the cost of all investment, including the kinds that will increase supply capacity. We know that a genuinely fair green transition – which would bring down energy costs and ensure price stability – will require huge amounts of public investment, which higher interest rates will only make more expensive. We need a more sophisticated approach to ensure our short term response to inflation doesn’t jeopardise longer term sustainability and the need to genuinely ‘level up’ the country.
Especially in the context of higher inflation, to maximise ‘fiscal space’ for mission-oriented public investment, policymakers will need to relearn how to guide private investment to ensure that it is complementary to public policy objectives, and isn’t competing for real resources in ways which bid prices up higher.
From ‘window guidance’ to ‘market neutrality’
Historically central banks, including the Bank of England, have used ‘window guidance’ or ‘credit guidance’ to exercise control over the banking sector, taking advantage of their exclusive ability to create central bank reserves, which is the ‘high powered’ public money commercial banks need to settle payments with each other and with the state (i.e taxes). The term ‘window guidance’ is derived from the way this used to be done through the ‘discount window’ – a teller window at the central bank where private banks were able to swap assets at a discount for reserves.
The discount window gave the central bank a great degree of leverage over private banks, as they could set the terms on which they provided funds, and decide what kind of assets are ‘discountable’ and at what price. For instance, a bank which had made unproductive or speculative loans would then have a harder time using those assets to obtain the reserves they needed, discouraging such lending. Positive Money’s sovereign money system proposal included a similar mechanism for the central bank to act as lender of last resort, where banks would be able to obtain funds from the central bank, but they wouldn’t be able to use such funds for speculative lending.
The current central banking orthodoxy has seen the use of the discount window discarded in favour of more ‘market neutral’ open market operations, in which central banks buy government bonds off the open market to accommodate banks’ demand for reserves, with no strings attached. This means the central bank has little control over banks’ creation of credit, but is ultimately forced to stand behind them unconditionally regardless of the quality of their lending (as we saw most dramatically during the 2008 global financial crisis), to ensure the privately issued money in our bank accounts trades at par with public money issued by the state.
Moreover, banks in countries like the UK are currently sitting on far more reserves than they need, as a result of quantitative easing (QE), which has seen central banks inject a huge amount of new reserves into the banking system in exchange for other assets. The central bank’s ability to control private bank lending through the provision of reserves has therefore been drastically reduced, as there is currently little prospect of banks needing more reserves.
Despite this, the Bank of England has hinted at the need for a new discount window with its announcement of a new Short-Term Repo facility as part of its latest monetary policy decision. As the reversal of QE will see the central bank sucking back up the reserves it has injected, the Bank is worried reserves may eventually become scarce again, and the BoE would have to provide more to keep interest rates under control. This new facility again takes the form of an open market operation, and the fact that only government securities will be eligible for collateral means that it will give the central bank little influence over credit allocation. Furthermore, as the Bank recognises, the point at which reserves become scarce is “probably several years away”. Indeed, it seems doubtful whether QE will ever be reversed to the point where reserves are scarce, especially when a looming recession might make the Bank of England change course.
From paying banks to taxing them
For the foreseeable future it therefore seems we will still have a banking system flush with reserves. This not only has implications for influence over bank lending, but also the implementation of monetary policy. Since the introduction of QE central banks like the Bank of England have adopted a ‘floor’ system where they pay the base interest rate on banks’ excess reserves, to stop the interbank lending rate falling dramatically lower. As excellent recent research from the New Economics Foundation has shown, paying interest on reserves while rates rise provides huge income transfers to the banking sector (£57bn over the next three years, they forecast), prompting the authors to propose moves towards a tiered system of reserve remuneration, as practiced in the Eurozone and Japan. If we want to stop paying out interest to banks while preventing the interbank lending rate from falling towards zero (which could further turbocharge wealth inequality, all else equal), it may also be preferable to return to a system where reserves are not so abundant.
Perhaps the most obvious ways of making reserves more scarce is through selling more bonds to soak them up (essentially reversing QE), or reintroducing minimum reserve requirements. But there is also the question of whether instead of paying banks not to lend, as we are currently doing, it may be better to tax them for lending which is not backed by reserves.
In a recent presentation at the Levy Economics Institute, Eric Breon argued that rather than the central bank paying interest on reserves to stop interest rates falling to zero, demand for reserves could be maintained by charging banks for deposits they hold which aren’t backed by reserves through an ‘unreserved deposit tax’ (UDT). Switching from paying 2% interest on reserves to charging 2% on unreserved deposits could bring the US government $5tn in revenue, he estimates. But this increased demand for reserves means we could also be able to regain control over the banking system through the discount window.
As Breon recognised, a UDT could make banks less keen to take customer deposits if they would need to back them with reserves, and essential banking services (like current accounts) may need to be subsidised. This would however be less of an issue if there was a public banking option through a central bank digital currency (CBDC), as we at Positive Money have argued.
CBDC itself also offers another path towards a ‘new discount window’, as President Biden’s original pick for Comptroller of the Currency, Saule Omarova, and her colleague Robert Hockett have explored. If people no longer need to rely on accounts at commercial banks and deposits are converted into CBDC, these banks would no longer be able to rely on an abundant source of cheap funding, which allows them to freely create credit. Instead banks could borrow funds from the central bank, on the condition that they are used for investments which are aligned with democratically determined objectives. For instance, banks could obtain funds to invest in renewable energy, but not for new fossil fuel infrastructure. As in Hockett’s proposal to ‘spread the Fed’, this could complement a more decentralised central banking model that would see regional arms of the central bank using their power to support local economic strategies.
To find a way out of the dire economic situation we find ourselves in, we need to align private banks with public purpose, rather than relying on them to lead the way. Both the discount window of the past and the digital money of the future can help us build a financial system fit for the challenges of today.