QE, UK banks and the economy

by Michael Roberts

This Monday is what used to be called a ‘bank holiday’ in the UK.  In the old parlance, this was a public holiday, banks were closed for business and capitalism took a break.  Well, just before this August bank holiday, the latest data on the how well British banks were doing in providing ‘basic banking services’ (namely taking deposits and making loans) were published.

The British Banking Association (BBA) is the organisation that has now come to public attention as the body that sets the infamous LIBOR (London Inter-Bank Offered Rate) charged for loans between banks.  We now know that during the banking crisis these rates were rigged by various banks in order to make their business look better (see my post, A Diamond standard, 28 June 2012).  And the BBA did not notice or did nothing about it.  The BBA is an industrial association, a public relations body for the big banks.  But it also releases data on Britain’s big five banks: the majority state-owned RBS, the partially state-owned Lloyds and the still ‘free’ HSBC, Barclays and Santander.

The BBA released figures on lending and deposits for the big five to July 2012.  The data show that the big five banks have $4.2trn in assets.  Of this £4.2trn in assets, only £297bn is held as a stock of loans to non-financial companies in the UK, or 7% of total assets.  Another £322bn has been lent to other financial institutions, while £800bn is held in mortgages and consumer credit.  Investment in government debt and financial securities (stock, bonds etc) stands at £1607bn, or more than five times the amount lent to the productive sectors of the UK economy.  So the ‘basic banking’ role of the big five remains a joke.  The banks are either engaged in ‘financial speculation’ or lending to government; and less than 25% of their assets are with households or businesses.

Indeed, while UK banks pile up deposits, they are reducing lending to industry at a near 6% annual rate.  The BBA puts it like this: “Companies are reluctant to borrow or invest new funds while domestic and international trading activities remain subdued or uncertain. With larger firms also using alternative funding from corporate bonds, bank borrowing levels are contracting”.

While it is obviously right that, in this Long Depression, the demand for new credit has fallen as both households and small businesses try to reduce their debt.  Large corporations are flush with cash and don’t need or want to borrow more.  But it also the case that the banks are reluctant to lend to the ‘productive’ sectors as there is little profit in it, relative to risk.  If they lowered their terms and rates of interest to small businesses to invest, it would be unprofitable.  And it also conflicts with the aim of the government to strengthen the capital base of private banks.  Thus we have the irony of the banks being castigated for not lending enough to productive sectors, but also told that they must avoid ‘excessive’ lending to bad borrowers – the apparent cause of the banking collapse in the first place.  It’s another reason why banking should be a public service, not privately-owned.  Public ownership would ensure basic banking as the objective with the control and backing of the state.

The lack of demand for credit is the flipside of the failure of the Keynesian/monetarist policy of ‘quantitative easing’.  This is where central banks like the US Federal Reserve, the Bank of England or the Bank of Japan decide to buy billions of government or corporate bonds in the open market from banks and other financial institutions.  With QE, the central banks do not reduce the cost of borrowing through cutting the basic interest rate but instead increase the supply of money by ‘printing’ more.  The commercial banks are then expected to use the cash from selling bonds to the central bank to lend onto productive sectors.  The increased supply of money should ensure that interest rates like LIBOR or mortgage rates can be kept low.

Well, the Bank of England has just published a report on the effectiveness of QE, entitled The distributional effects of asset purchases (http://www.bankofengland.co.uk/publications/Pages/news/2012/073.aspx).  The Bank claims that QE has been successful in helping the UK economy. The BoE found that “the Bank’s response to the financial crisis has been unprecedented, with Bank Rate cut to a historically low level and asset purchases totalling £375 billion to date.  Most people in the United Kingdom would have been worse off without this response, including savers and pensioners.  All assessments of the effect of QE must be seen in that light.  QE has caused the price of gilts (government bonds) to rise and yields to fall, in turn leading to an increase in demand for, and price of, a wide range of other assets, including corporate bonds and equities.  That has lowered borrowing costs for companies and households and increased the net wealth of asset holders, both of which have acted to stimulate spending.”

So the BoE argues that QE to the tune of nearly 20% of UK GDP has helped avoid a deep recession and kept incomes and wealth higher than otherwise.  Really!  The UK economy has just recorded yet another contraction in Q2’2012 of 0.5%, confirming that it is in a double-dip recession.  QE has failed to to stop a significant decline in average real earnings, now down nearly 6% in the last two years, when measured against UK retail price inflation (RPI) that includes those low mortgage rates that the BoE is so proud of. That compares to a decline of 4% when using the consumer price inflation (CPI) index that excludes mortgage rates.

Pensioners (both state and corporate) are getting the lowest possible return on their pension funds because government bond yields are at all-time lows, yet their pensions are now being inflation-indexed using the CPI, than the RPI previously.  The result is that pensions are contracting in real terms too.  And yet, the government is allowing its privatised rail companies to hike rail fares by RPI+3% next year.  So it’s RPI on rail fares and CPI on pensions.

If average incomes and pensions have lost from QE, are there any winners?  Yes: the BoE puts it rather modestly: “As with all changes in the stance of monetary policy, the recent period of loose monetary policy has had distributional consequences, and its benefits have not been shared equally across all individuals.” .  The BoE found that driving up the value of government and corporate bonds through QE purchases benefited the rich who hold most of these bonds.  The median income UK household holds only around an average of £1,500 of gross financial assets, while the top 5% of households hold an average of £175,000 of gross assets, or around 40% of the financial assets of the household sector as a whole.  That top 5% thus received the bulk of the gain in asset wealth through riding bond prices initiated by QE.

And what the BoE report does not show is that the biggest winners from QE were the banks themselves.  They were able to shift billions in government and bank bonds onto the BoE’s books at all-time high prices, getting rid of assets that paid very low interest.  With the proceeds, they could build up their capital base and renew investment in higher-yielding financial assets, like stocks and overseas assets. Thus QE has bolstered the banks and restored ‘business as usual’.

All this puts a less than rosy light on QE as a policy solution for the UK economy.  And yet many Keynesians want more of it, not less. Radical Keynesian Ann Pettifor tells us that “money is not a commodity. It is not like oil or diamonds. It can be created out of thin air. It is a public good, like clean air or water. But unlike clean water, there is no limit to its creation.”  (The Guardian).  So, apparently, the BoE could just print as much money as it thinks and the banks can then use it to boost the UK economy.

The BoE’s purchases of government and corporate bonds from the banks have expanded by about £300bn during the crisis and the Bank has added pretty much the same amount to the cash reserves of these banks deposited at the BoE – that’s how the money is printed.  It is not more notes and coins, but merely an accounting credit.  Money has been created out of thin air.

But, as I explained in previous posts, (Paul Krugman, Steve Keen and the mysticism of Keynesian economics, 21 April 2012), QE cannot kick-start the capitalist economy, however much money is created out of ‘thin air’.  This money either ends up in the banks and does not reach the real economy (i.e. caught in a ‘liquidity trap’) or it just reignites the credit bubble in financial markets.  If the capitalist economy remains weighed down by debt and unable to revive profitability, no amount of monetary stimulus will do the trick.  The evidence of the UK economy since QE began over three years ago confirms that.