When the latest round of quantitative easing was announced by the Bank of England in October, it was reasonable to expect that a positive rate of broad money growth would be recorded while the QE operations were taking place. (When the state purchases assets from non-banks, it increases their bank deposits which are nowadays the dominant element in the quantity of money.) However, that is not what has happened in the first three months of the exercise. In the third quarter of 2011, when QE was not in effect, the M4x money measure (i.e., broad money, excluding the money balances held by the awkward, semi-bank “intermediate other financial corporations”) rose at an annualised rate of 5.0%. But in the fourth quarter of 2011, when the latest QE operations had started, M4x declined at an annualised rate of 0.8%.
The latest credit counterparts data do show the imprint of QE. Particularly in October the Bank of England’s purchases of gilts led to a large positive “public sector contribution to M4 growth”. (However, in December QE operations seem to have been suspended for about three weeks over Christmas and the public sector’s financial transactions actually reduced M4, although not by much.) The main explanation for the failure of QE to increase M4 is that other transactions across banks’ balance sheets had the effect of destroying money. As has been true now for over three years, the destruction of money can be largely attributed to banks’ shrinkage of risk assets as they try to raise capital/asset ratios. Adam Posen, a member of the Monetary Policy Committee, has accused the banks of being “risk-averse jerks” because they are not lending enough. In fact, the latest round of asset shrinkage is partly – perhaps mostly – a response to the Vickers Commission report, which requires UK banks to hold more capital relative to their risk assets than their international competitors.
Quantity of money did not grow in Q4, despite QE operations
The purpose of the Bank of England’s quantitative easing programme is to increase the quantity of money, and thereby to boost asset prices, to ease balance-sheet strains and to promote recovery in an economy struggling to make a decent recovery from the Great Recession. In the three months to September M4x (i.e., the broad measure of money, excluding the money held by intermediate “other financial corporations” or quasi-banks) rose at an annualised rate of increase of 5.0%, a very satisfactory outturn. When the latest round of QE was announced in October, it seemed plausible to expect M4 growth to accelerate further and so to take an optimistic view of the UK demand outlook. However, in practice M4x has fallen slightly in the fourth quarter, with an annualised rate of fall of 0.8%. This is not a disaster, but it is a disappointment. The same question arises as in 2009. Why is the quantity of money not rising, despite highly expansionary open market operations by the Bank of England?
The first QE exercise – which ran for 11 months from March 2009 – was accompanied by a spectacular rebound in asset prices and the economy, and indeed in early 2010 there was some complacency that the Great Recession was over. But money growth was negligible, despite the massive gilt purchases by the Bank of England. The latest official thinking (see, again, the important Bridge and Thomas paper on QE, Bank of England Working Paper no. 442) is that QE caused broad money to be about 8% higher than it otherwise would have been, which makes sense to me. The trouble was that banks were raising vast amounts of capital (because of officialdom’s pressure on them to recapitalize) and shrinking their risk assets (partly because they had difficulty funding their assets, given that the Bank of England would not help them despite the closure of the global inter-bank market).
What is the problem now?
In early 2011 banks started to increase their lending to genuine non-banks (i.e., to households, companies and genuinely non-bank financial institutions, and excluding the awkward “intermediate other financial corporations”). Although the general macroeconomic environment had become difficult by the autumn, the main cause was the intensifying sovereign debt and banking crises in the Eurozone, and their feedback effect on UK exports. The Bank of England refrained from QE operations, but M4 was static rather than falling. UK domestic monetary trends did not signal a great boom, but they were not incompatible with continued UK recovery, particularly while Bank rate stayed at zero. Mortgage lending to households – which is quite volatile, but much less so than bank lending to companies – was stable or rising gently. Meanwhile mortgage approvals were edging up for much of 2011 and in December reached their highest level since the start of the Great Recession. (They remain at only a fraction of their values in 2006.) Moreover, the heavy bank capital raising of 2009 and 2010 seemed to be largely complete. So a fair verdict – assuming that QE would lead to a burst of additional money creation by the state – was that money growth would be healthy at least until early 2012.
But that has not been the pattern so far. As noted above, M4 was disappointing in late 2011. The muted impact of QE on M4 in the fourth quarter is partly due to an apparent three-week gap in QE operations – presumably related to holidays – in December. But far more fundamental is that bank lending to the private sector has taken another tumble. As ever, the official data require a little interpretation.
The bank lending numbers are prepared on two main bases. The first basis is the traditional one (i.e., for the M4 sector), where the lending figure is that by all banks and building societies to all non-banks, excluding inter-bank lending but including lending to “intermediate OFCs” (which are quasi-banks); the second basis is that which is now preferred, namely lending by all banks and building societies to non-banks, excluding inter-bank lending and lending to the intermediate OFCs. The justification is that intermediate OFCs are not bona fide business organizations separate from the banking organizations that have spawned them, and their balance sheet condition is not relevant to macroeconomic conditions. So we have M4 lending and M4x lending, with M4x lending the more meaningful in terms of monetary analysis.
The striking thing to appreciate is that since late 2008 new lending has been negative more often than it has been positive, for both M4 and M4x lending totals, and that no improvement is apparent towards the end of the period since. The date of the change in trends gives the game away. It was in September and October 2008 that UK officialdom demanded that banks accept large-scale recapitalization to cover past losses and operate with higher capital/asset ratios than before.
Although the weakness in late 2011 was much more a feature of bank lending to the intermediate OFCs than to genuine non-banks, the background remains troubled. UK banks have not expanded their lending to genuine non-banks at all over the last year. They have not expanded their loan portfolios even though interest rates are remarkably low by past standards.
The most plausible explanation for the recent pause is that the post-autumn 2008 retrenchment continues. Banks have still not reached the capital/asset ratios targeted for them by officialdom. Further, the demands that they hold more cash and liquidity imply – for any given balance-sheet total – that they reduce non-liquid assets, of which loans are the main example. Moreover, there is an argument that in the last few months UK banks have been responding to the Vickers Commission report, which wanted UK banks to operate with higher capital/asset ratios than their competitors overseas. The Vickers report was widely deemed to be a disaster for RBS, in particular. The newspapers have indeed carried reports of large asset disposals by RBS, which fits the wider story. (If RBS sells a loan portfolio to another bank, the total of all banks’ deposit liabilities – and hence the quantity of money – may be unchanged. But, if it sells a loan portfolio and/or securities to non-banks, the non-banks pay for the loans and securities by running down their deposits, and the quantity of money falls. So officialdom’s requirement that RBS trim its balance sheet and have less risk on it, in order that it have a safer balance sheet in future, can reduce the quantity of money.)
Are the banks “risk-averse jerks”?
Top officials at the Bank of England, including key figures on the Monetary Policy Committee, do now seem to be watching the money supply data. Some of them may even have come to accept that movements in broad money have powerful macroeconomic effects. (But I suspect MPC thinking is muddled and eclectic, as it has been ever since it was set up in 1997. For example, there is nothing in Martin Weale’s past career to suggest that he regards money data as of any interest whatsoever, while David Miles is a “creditist” in the Bernanke sense, not in any sense a monetarist. [For the meaning of “creditism”, see essays 17 and 18 in my book Money in a Free Society.])
If so, the MPC must be irritated that the latest QE programme has so far had such a feeble effect on M4. Adam Posen – who has been perhaps the most articulate advocate of QE in the last couple of years – has even denounced the banks as “risk-averse jerks” for their reluctance to expand risk assets on their balance sheets. As this note has shown, it is undoubtedly the weakness in bank lending that must take most of the blame for the failure of M4 to respond to QE so far.
To conclude with three points: first, the Posen insult (and “insult” is the only way to characterize a phrase like that) is surely misdirected. The change in the UK’s bank lending trends was sudden and abrupt in late 2008, inviting the conclusion that officialdom’s demands for stronger bank capitalization (and more liquidity and less dependence on wholesale funding) was the main cause of the collapse in lending. Indeed, it is baffling that the current Governor of the Bank of England can simultaneously urge banks to operate with higher capital/asset ratios and to increase their bank lending to the private sector (i.e., the principal kind of bank asset). If officialdom wants banks to lend more, it should reduce banks’ capital requirements, not increase them.
Secondly, the weakness in bank lending should not be exaggerated. In the last few months it is lending to the intermediate “other financial corporations” that has been particularly poor. Other kinds of bank lending have kept on growing, with mortgage lending – for example – chugging along at a rate consistent with a rise, admittedly only a slow rise, in banks’ mortgage portfolios. In the early months of 2012 we may well see better M4 figures, if QE is sustained and bank lending starts growing again.
Finally, if the quantity of money continues to stagnate, there may be a case for raising the QE total. As I have explained on several occasions, I would much prefer that the government (or at any rate the Debt Management Office on behalf of the government) tilts the gilt-selling programme, so that more shorts are issued at sufficiently favourable terms as to appeal to the banks. That would achieve the desired monetary expansion without the clumsy, awkward and controversial expansion of the Bank of England’s balance sheet that is now taking place.
Tim Congdon is the founder of International Monetary Research Ltd.