This post argues that the new Governor of the Bank of England is wrong to address the Bank’s role in the crisis through the prism of traditional ‘price stability targeting’. Rather, the Bank’s duty and task is to support the government’s economic (including fiscal) policies, and in particular – and in so doing – to act to protect the financial stability of the whole system. Actions to support the Bank’s monetary and financial stability objectives need to be integrated.
On 5th April, the Financial Times published an article by the new Governor of the Bank of England, Andrew Bailey, entitled “Bank of England is not doing ‘monetary financing’”, and with the curious subtitle, “We will protect independence of inflation targeting”.
Now, the first – monetary financing – is indeed a matter of current debate; but as far as I am aware, no one is at this very moment seeking to attack (as a high priority) the Bank’s independence in inflation targeting.
Bailey is clearly aiming to send a message that the Bank is not open to simply financing the government in any direct means, and his only weapon to hand is the monetary policy priority objective of price stability. He writes:
“The Monetary Policy Committee voted last month to increase the bank’s bond holdings by £200bn to support the needs of the British people. Some external commentators are linking this move to fears that it that it may be using “monetary financing”, a permanent expansion of the central bank balance sheet with the aim of funding the government.
This type of reserve creation has been linked in other countries to runaway inflation. That is because it could undermine a central bank’s ability to control monetary conditions over the medium term… It would also ultimately result in an unsustainable central bank balance sheet and is incompatible with the pursuit of an inflation target by an independent central bank.”
At an FT webinar on the current crisis earlier in the week (which I listened to and watched) Adair Turner had made clear his view that the Bank was indeed necessarily going to undertake monetary financing, and would indeed end up with a permanently larger balance sheet. “We shan’t worry about where the money comes from”, Turner added.
Now it is hardly a state secret that Central Banks, including the Bank of England, have in recent years (since the Financial Crisis) done quite a lot of purchasing of government bonds, to support the economy and government policy, via QE and related policies. In the UK, the Bank has held around 24% of UK gilts (see the Treasury’s Debt Management Report 2019/20). This has neither destabilized the bond market – on the contrary – nor had any negative effect on inflation, which has been under- rather than over-shooting the 2% target for much of the time.
Clearly, these are matters in which a certain blurring of pure transparency is seen as beneficial – discreet financing of a reasonable but not excessive share of the government’s expenditure via purchases on the secondary market is seen as desirable and appropriate. And to date, there has been no shortage of willing private sector purchasers, who can take up government debt issued by the Debt Management Office, which may be sold on, in certain circumstances, to the Bank of England. It then becomes a matter of choice whether the government pays the coupon on the debt held by the bank, or whether this is waived or repaid by the Bank to the government. After all, these are merely transactions within the public/government sector, and have no wider impact.
Hyperinflation not the issue
The normally-expressed fear of direct monetary financing is that it can lead to hyperinflation, or at least to a situation in which the Bank is over longer periods unable to resist pressure from government to finance its expenditure directly, in particular in times when this is inappropriate. Most hyperinflations have occurred, however, in political situations in which there are many other factors at play, including wars and revolutions, as well as monstrous mismanagement of the economy. The UK has suffered strong annual inflation (20%+) – but not hyperinflation – in the First World War (but much less in WW2) and in the 1970s, but not the result of direct monetary financing from the Bank of England. Josh Ryan-Collins, in his 2015 paper “Is Monetary Financing Inflationary? A Case Study of the Canadian Economy, 1935–75” found “no support for a relationship between monetary financing and inflation” in that example of a long-term cooperation between government and Bank.
The urgent crisis situation in the UK (and many other countries) today is surely completely different from the general case – for essential public health reasons, the government has been obliged to crash the economy, sharply and suddenly. If it did too little on the fiscal side, the economic disaster would be unbearable for millions. Society would collapse. So government has to respond. The Bank has also to respond, using its monetary policy toolkit to the fullest.
Supporting government’s economic policy
But the issue is not so much one of monetary policy as one of social and financial stability. And here is the weakness in Governor Bailey’s argument; to discuss what needs to be done in terms of inflation in the medium term is frankly bizarre. Yet this is how he chose to express the genuine question for the bank – how far, and by what direct or indirect means, to support the government’s absolutely essential expenditure, in order to prevent systemic collapse.
Mr Bailey wrote this:
“The law requires the MPC [Monetary Policy Committee] to deliver price stability, which is defined through an annual inflation target of 2 per cent”.
But this is not so. The law does not require the MPC to deliver price stability. The 1998 Bank of England Act says this, at Section 11:
“In relation to monetary policy, the objectives of the Bank of England shall be—
(a) to maintain price stability, and
(b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.”
So while maintaining price stability is the first objective, there is and cannot be a duty to deliver it. The duty is to aim to deliver it. Now, if the system collapses, maintaining price stability will collapse along with the rest of our social and economic order. That is why part (b) of this section is what he should be looking at – supporting in the best way the government’s objectives for growth and employment – which at present may be translated to mean “preventing or at least mitigating the worst depression in modern history, and preventing or at least limiting mass unemployment”.
Addressing part (b) is thus the means of addressing part (a). It is only through such support that the Bank will ever be in a position to return to normality in policy-making.
The Treasury is required by the Act to set out its economic policy objectives; the latest I can find is dated October 2018 (did the Chancellor fail to do so in 2019?), in which the objectives are these:
The government’s economic policy objective is to achieve strong, sustainable and balanced growth. Price and financial stability are essential pre-requisites for [such] growth in all regions and sectors of the UK economy.
To achieve this objective, the government’s economic strategy consists of:
operationally independent monetary policy, responsible for maintaining price stability and supporting the economy;
credible fiscal policy, returning the public finances to health, while providing the flexibility to support the economy;
addressing long-term economic weaknesses in order to sustain high employment, raise productivity, and improve living standards for people across the UK; and
continuing to strengthen the financial system…
To achieve or support these, the starting-point is to prevent total collapse.
Financial stability of the system
But I argue that Bailey is wrong in a deeper way. As stated above, the matter is far more one of ensuring financial stability of our whole system than simply of conducting monetary policy. For financial stability, the Bank has a separate duty, set out in Section 2A:
(1) An objective of the Bank shall be to protect and enhance the stability of the financial system of the United Kingdom (the “Financial Stability Objective”).
(2) In pursuing the Financial Stability Objective the Bank shall aim to work with other relevant bodies (including the Treasury and the Financial Conduct Authority).
Now the Act’s provisions for implementing the Financial Stability Objective are admittedly rather clunky. The Bank’s Court of Directors must determine the Bank’s strategy, and revise it as necessary. They must in doing so consult the Financial Policy Committee and Treasury. The Financial Policy Committee may at any time make recommendations to the Court of Directors over the Bank’s strategy.
The most recent 3 year Strategy dates from June 2017, and must be reviewed by June this year. But in a nutshell, the Strategy provides
“The strategy has three broad elements:
(a) establishing a rigorous baseline level of resilience to protect the UK real economy;
(b) ensuring the level of resilience adapts to the possible shocks the system might face; and
(c) enabling the system to absorb shocks, if/when they occur, so it can continue to support the economy.”
If therefore the threat to the resilience of the “system” requires the government to be able to spend far more to keep it afloat (“absorb the shocks”), the Bank may and should lawfully do what is required, within its tools and powers, to enable that spending to take place.
Definitions of monetary financing
Now, Adair Turner (“The Case for Monetary Finance”, 16th Jacques Polak Annual Research Conference. Nov. 2015) has defined “monetary financing” in a broad way, with at least three modalities, which he maintains end up at the same point from an economic perspective:
The central bank directly credits the government current account (held either at the central bank itself or at a commercial bank) and records as an asset a non-interest bearing non-redeemable “due from government” receivable
The government issues interest-bearing debt which the central bank purchases and which is then converted to a non-interest-bearing non-redeemable “due from government” asset
The government issues interest-bearing debt, which the central bank purchases, holds and perpetually rolls over (buying new government debt whenever the government repays old debt), returning to the government as profit the interest income it receives from the government. In this case the central bank must also credibly commit in advance to this perpetual rollover.
Even if (which I am not convinced of) they would have the same economic result, they are likely to have different constitutional and governance consequences. His argument here is simplistic.
Turner’s formulation here is moreover unclear on one important matter – whether, in cases 2 and 3, the central bank ‘purchase’ is made directly from government, or whether it involves purchases in the secondary market, with the initial issue purchased via the private sector.
The principal risk of direct monetary financing, in whichever form, is not so much that of potential hyperinflation down the road’s slippery slope, as the confusion of roles between government and Central Bank. The art is for them to work together, but to retain some degree of operational separation of roles. It is not wholly inconceivable that circumstances become so dire that direct monetary financing becomes the only possibility, but this should be avoided so far as possible.
The Central Bank / Government relationship
The total separation of roles between Bank and government, via an excessive (Hayekian) concept of ‘independence’, represents a dangerous distortion of democracy, as well as risking a potentially catastrophic breakdown in financial stability (as with Governor Trichet’s handling of the initial Eurozone crisis). This lack of nexus, and thus of democracy, remains a vast weakness of the Eurozone structure, though thankfully the central bank eventually understood (under Draghi) that it needed to expand the legal interpretation of its role in order to avoid even greater damage. Back in the 1926s, Keynes set out his views on the relationship between Treasury and Bank:
“You can have two bodies which maintain their respective spheres of responsibility and of power and yet necessarily always work together. It is the fundamental question of the relation between any central bank and any Treasury. In a sense in any country it is quite unworkable that the two should be in antagonism. Therefore you might say, as a logical consequence of that, that one must be in subordination to the other, but I hope that is not true in practice, but that you can have two bodies neither of which is subordinate to the other but which must always act in co-operation with one another. It is a dilemma which you get in other spheres of government.”
[cited in “A Post Keynesian Perspective on the Rise of Central Bank Independence: A Dubious Success Story in Monetary Economics”, 2010, by Jörg Bibow, The Levy Economics Institute Working Paper Collection]
While the Bank/government relationship should not be one of “subordination”, Keynes made clear in 1932 (in a critique of a Labour Party pamphlet calling for direct control of the Governor) that “the management of the Bank should be ultimately subject to the Government of the day”, which should also set down the main lines of policy. The Bank, that is, is not a free-standing entity, while having its broad operational discretion. And lest it be forgotten Section 19 of the 1998 gives reserve powers to the Treasury to intervene in monetary policy:
(1) The Treasury, after consultation with the Governor of the Bank, may by order give the Bank directions with respect to monetary policy if they are satisfied that the directions are required in the public interest and by extreme economic circumstances. [My emphasis]
To conclude. The issue is patently not one of normal monetary policy focusing on control of inflation in the medium term. For the Governor to pretend that it is, in public debate such as in the FT, makes a mockery of proper discussion over roles and responsibilities.
In the current crisis, future inflation is the least of our problems at this stage. It is the total social and financial system that is at risk. The Central Bank has a legal duty to help the democratic government in delivering its economic goals – which in essence now means to save such parts of the economy as can be rescued, and try to avoid unemployment reaching terrible levels. If central government does not act fiscally, the disaster would be far greater. To do so, it is likely to need the practical support of the Bank. The issue is as much (or more) one of securing financial stability as it is one of monetary policy. The Bank of England should act to promote both duties – monetary policy and financial stability – in a joined-up way, and explain that this is what it is doing.
And of course the government’s necessary system-protecting expenditure needs to be managed and supported in the least problematic way. At present, despite everything, the traditional method of issuing bonds on the market is working, with Debt Management Office auction gilt issues still being well ‘subscribed’, and at low yields. Today (7th April) the DMO auction of £3,250 million of 0⅛% Treasury Gilt 2023 was ‘covered’ over three times, with bids of £9.9 billion for an issue of £3.25 billion, at a yield of around 0.2%. The Bank of England is then able to purchase a large quantity of this and other issues on an open-ended basis, if that is needed. By providing such financial assets for the private sector at this time, gilt issuance and BoE purchases can help to protect overall stability.
As we know, we have had some monetary financing for some time, to some degree. But it has gone through relatively traditional channels, and has not involved direct financing of government.
It would be wrong, however, to rule out all forms of more direct ‘monetary financing’ since we cannot know the situation to be faced in a few weeks’ or months’ time as the crisis (and the virus) evolves. Even then, it would be far preferable for the forms of bond issuance to be maintained, rather then to set the precedent of direct Central Bank credit into the government’s bank account. The FT’s editorial today (which I read after writing most of this post) bears the truly unhelpful title “Printing money is valid response to coronavirus crisis”. The metaphor of “printing money” carries serious dangers of undermining both government and Bank
What is just as important is that fiscal policy be always recognized as the responsibility of elected government, even if elements of it are delivered through the vehicle of the Central Bank.
Provision of Central Bank helicopter money (to use that other unhelpful metaphor) in any of its potential forms, without public decision and permission of central government, would be wrong and dangerous.
In sum, the Bank should be transparent in discussing and explaining its tasks and objectives, and ensure that it supports government in the best way that matches short-term economic needs and long-term systemic and functional resilience – including its own resilience.