The Economics Of Banking & Finance - The 99%

1 Contents Executive Summary 3 Transmission Channels of Monetary Policy 4 Monetary Policy and Macro-prudential Policy 14 Conclusion 15 References 18 2 Executive Summary In this paper I have analysed the functions of the Bank of England (BoE) to first build an understanding of how the central bank operates and it’s focuses as a central bank with a hierarchical mandate. I have then outlined the transmission channels that monetary policy operates through and explained how they have a wider impact on the aggregate economic activity of the UK economy. Following this, I have analysed the role of prudential regulation in maintaining the long-term stability and competitiveness of the UK banking system (and the UK economy as a whole); and considered both the areas of alignment and conflict between the BoE and the UK’s financial regulation system. Finally, I have outlined the limitations of monetary policy to impact the aggregate economic activity through it’s transmission channels due to primarily a number of critical issues that impact the effectiveness of the BoE, their monetary policy and their transmission channels; and the secondary and tertiary effects that need to be considered when analysing the effectiveness of the BoE’s transmission channels. Closing with my opinion and reasoning for why a wealth tax would be an effective fiscal policy to support the impact of the BoE to influence the aggregate economic activity via it’s transmission channels. 3 Transmission Channels of Monetary Policy The Bank of England’s (BoE, the UK’s central bank) hierarchical mandate is to ensure price stability of all products and services in the country. It does this by monitoring and actively implementing monetary policies to measure and control the inflation rate - the most effective nominal anchor for price stability. This is because of it’s measurability, controllability and predictable effect on goals. Although there are a number of inflation rate metrics that the Bank of England could (hypothetically) use to measure inflation, the Consumer Price Index (CPI) is the most widely used in their forward guidance to the public. For example, they could instead choose to use the Producer’s Price Index (PPI) which focuses on changes in prices of raw materials and the cost of producing assets. Instead, the BoE primarily uses CPI in their forward guidance because it relates more directly to the costs of everyday products and services. This is because CPI is measured through a selection/basket of mass-market products and services. Therefore, it is the most relevant inflation metric for the majority of the population. Alongside this, the reality is that by measuring CPI, they are more effectively able to measure consumer spending - a significant component of aggregate economic activity. Below their priority mandate of ensuring price stability, the BoE is also responsible for:  High employment and output stability  Economic growth  Stability of the financial system (further emphasised since the 2008 financial crisis)  Interest rate stability  Stability in of the British Pound (Sterling) in the foreign exchange (forex) markets These can be pursued after they ensure price stability. To achieve their mandates, the BoE has two (2) main monetary policy tools: 1. Discount Rate Adjustments (Conventional Tool): This involves increasing or decreasing the discount rate that they provide to private banks in discount loans, when they seek to increase their excess reserves (via increases to their borrowed reserves). 2. Open Market Asset/Securities Purchases (i.e., Quantitative Easing, QE Unconventional Tool): The BoE is able to create money (digitally or physically) to buy securities on the primary markets and/or the secondary markets. These may be government securities (e.g. government bonds, ‘gilts’) or they may be private securities (e.g. corporate bonds and/or stocks). 4 Beyond their two (2) main tools, they also have a wider range of conventional and unconventional monetary policy tools that they can implement. Their conventional monetary policy tools include:     Open Market Operations: These include the sale of securities into the primary and/or secondary markets, the issuing of Treasury bonds and other activities (excluding asset purchases). Discount Rates: The interest rates that the BoE charges private banks for discount loans that are made through the overnight accommodation window. Reserve Requirements: This is the liquidity/cash reserve ratio that is set by the BoE and monitored by the Prudential Regulatory Authority (PRA) Reserve Interest Rates: These are the interest rates paid to private banks on their reserves Their unconventional monetary policy tools include:     Asset Purchases: The purchase of assets on the primary and/or secondary markets provides additional liquidity to the financial sector. Liquidity Facilities: This is the creation of new money (either printed or digitally) with the objective of injecting it into the economy to drive stimulus within a portion of the economy. Forward Guidance: This is focused on reducing uncertainty in the market and with potential investors within the UK economy. As price stability is the BoE’s priority mandate, they utilise inflation targeting to focus attention on this issue when necessary. This includes public announcements of their medium term objectives to bring inflation (i.e, CPI) within an expected range; a publicly stated commitment to achieve this goal, allowing for accountability of their senior leadership team (SLT); increased transparency of their monetary policy strategy to reduce asymmetric information issues (i.e., adverse selection and moral hazard issues) with press releases and meeting minutes available on their website; and an information inclusive approach, where several relevant variables are used in making decisions about monetary policy. This actively helps to reduce the time inconsistency problem (i.e., reducing political pressure on the BoE to pursue effective monetary policy). Negative Interest Rates on Borrowed Reserves: This is when the central bank credits interest on the discount loans that it provides to private banks. Although this is not currently the case with the BoE it does occur in Japan (-0.01%), Denmark (-0.06%), and Switzerland (-0.08%) (World Population Review, 2023). 5 One of the core challenges of the BoE is ensuring that they strike the right balance with their monetary policy. Ensuring that its not too tight (excessive contractionary monetary policy) and not too loose (excessive expansionary monetary policy). To measure this they observe their monetary policy instruments, these include:   Reserve Aggregates: This is the monetary base (i.e., the total reserves and the currency in circulation) Short-Term Interest Rates: This is the bank rate / discount rate. They then utilise these tools to meet their intermediary targets (monetary aggregates and short/long-term interest rates); and their mandates (as noted above). To fully understand the transmission channels through which monetary policy is expected to influence aggregate demand, it’s essential to first outline the circular flow of income. [Circular Flow of Income, 1/9 - Song, W PhD] (2023, Graphic) 6 [Circular Flow of Income, 2/9 - Song, W PhD] (2023, Graphic) [Circular Flow of Income, 3/9 - Song, W PhD] (2023, Graphic) 7 [Circular Flow of Income, 4/9 - Song, W PhD] (2023, Graphic) [Circular Flow of Income, 5/9 - Song, W PhD] (2023, Graphic) 8 [Circular Flow of Income, 6/9 - Song, W PhD] (2023, Graphic) [Circular Flow of Income, 7/9 - Song, W PhD] (2023, Graphic) 9 [Circular Flow of Income, 8/9 - Song, W PhD] (2023, Graphic) 10 [Monetary Policy Transmission Mechanisms - Bvirindi, T PhD] (2023, Graphic) While considering the circular flow of income, the wider aggregate economic activity, and the various monetary policies, I have outlined six (6) of the nine (9) transmission channels in the diagram above: 1. Traditional Interest Rate Effects Lowering the discount rate to incentivise private banks to access discount loans through the overnight accommodation window and increase their borrowed reserves. Leading to an increase in their lending to businesses and households. Either for further investments (e.g. real estate and/or securities) or for household consumption. Increasing business investment (I) and consumer spending (Cd), which increases aggregate demand (AD). 2. Asset Price Effect: Exchange Rate Effects On Net Exports - Imports This is expansionary monetary policy aimed at increasing national income - via increases in national consumption and/or investment. This is achieved by increasing access to relatively affordable loans, however this can have the unexpected consequence of increasing net imports. Specifically, increased consumption of foreign products/services and/or investments into foreign companies. This would lead to an increase in demand for foreign securities and more foreign securities held in UK bank accounts. 11 To complete these transactions - whether consumption of foreign products/services and/or investments into foreign securities - it would be necessary for UK firms and households to withdraw cash from their checkable deposits, trade them for the respective currency and then complete the transaction in that local currency. Therefore, an increase in net imports (i.e. an increase in demand for foreign products/services/securities) would lead to an increase in the supply of British Pound (Sterling) that is available on the forex market. Alongside this an increased demand - with reduced supply - of the local currency that the foreign products/services/securities originate from. To complete these transactions, the bank would leverage its economies of scale, digital architecture and connections to the global financial system to: a) Withdraw the cash from the firms'/households' checkable deposits/cash reserves (i.e. currency in circulation). b) Traded on the forex market for the local currency. This is done at the real-time exchange rate, based on the supply/demand of each currency, and their currency pairing in the forex matrix. c) After the British Pound (Sterling) has been traded for the local currency, the purchase of the asset (products/services/securities) can be completed. However, in the case of importing overseas products/services, there are further considerations. Most notably the delivery charge and potential fees levied by the UK Government to either incentivise or dis-incentivise purchases of foreign products/services. Conversely, foreign investors wanting to purchase assets and/or invest into the UK would be required to withdraw their currency from their checkable deposits. Increase the amount of their local currency in circulation and trade for British Pound (Sterling). This would decrease the supply of British Pound (Sterling) in circulation and increase the price on the forex market, due to an increased demand for the currency. In regards to investing into securities, foreign investors would also be required to pay the UK Stamp Duty tax on securities. If there is greater demand for UK assets/securities there will be net exports. If there is greater demand for foreign assets/securities there will be net imports. 3. Asset Price Effect: Tobins (q) Theory Expansionary monetary policy that increases stock prices (e.g. open market purchases of securities) makes it possible for businesses to only need to sell a small number of their shares to raise their required capital, because their stock price is high. Increasing business investment (I) and aggregate demand (AD). Tobins (q) Theory is an effective metric because it is easy to understand and communicate. 4. Asset Price Effect: Wealth Effects Expansionary monetary policy that increases stock prices (e.g. open market purchases of securities) increases the wealth of households that own those securities. They can then leverage their financial securities to get a collateralised loan. Which can either be used for 12 personal investments or personal consumption - increasing aggregate demand through increased business investment (I) and consumer spending (Cd). 5. Credit View: Bank Lending Channel Expansionary monetary policy that prioritises increasing home ownership via lowering the discount rate, would allow private banks to increase their borrowed reserves, through overnight accommodation window. This makes it possible for them to provide lower cost long-term collateralised loans (i.e. 30-year mortgages) to more households and firms. This would increase personal and business investment (I). 6. Household Liquidity Effects Expansionary monetary policy of open market asset purchases increases stock prices through quantitative easing (QE). Since this transmission channel is specifically for 'household liquidity effects' the securities that are purchased through the open market asset purchases will like occur on the secondary market, not the primary market (which primarily contains institutional investors). The increase in the value of the securities on the secondary market will then lead to an increase in (primarily) household wealth, but also in the wealth of any firms who own assets in the secondary markets. This increase in the value of their securities will provide an extra layer of protection against economic shocks. This is because during periods of potential cash flow issues, they can either sell securities that are highly liquid (e.g. typically ‘AAA rated’ securities are considered to be 'near cash equivalents') (Davidson, A and Blumberg, A, et. al, 2008). Or more likely, they can leverage their securities to access a highly favourable collateralised personal loan. They can then use the low-cost collateralised short-term loan as a 'bridge loan' to deal with the cash flow issues, and repay the loan as they increase their income. Allowing them to retain the security for future leveraging opportunities, while dealing with their short-term cash flow issues. This will have the impact of primarily increasing consumer spending (Cd) since the aim of ‘household liquidity effects’ is to support personal incomes. The increase in household liquidity (either by making it feasible to sell securities) or through the channel mentioned above, will increase investments (I) as stock prices rise and ensure wealth isn’t destroyed (through the provision of the bridge loan or liquidity). 13 Monetary Policy and Macro-Prudential Policy Micro-prudential policy is a focus on the individual banks and ensuring that they are properly regulated. That the ‘financial services and products that we all rely on can be provided in a safe and sound way’ (Bailey, A, 2020). And macro-prudential policy is a focus on the entire banking system to ensure consumer protection, integrity in the UK financial system, and promote competition (Bailey, A, 2017). Prior to the 2008 global financial crisis, all of this was the responsibility of the Financial Services Authority (FSA). However in 2013, following the financial crisis, parliament separated responsibilities between the Prudential Regulatory Authority (PRA) [microprudential] and Financial Conduct Authority (FCA) [macro-prudential]. This is clearly effective fiscal policy to support the actions of the BoE, considering that the 2008 financial crisis led to a dire recession. A recession that the UK taxpayers had to pay for multiple times over, since the 2008 global financial crisis - to prevent the complete collapse of the UK economy (Reland, J, 2019): 1. Special Liquidity Scheme (SLS): The BoE facilitated the swap of £185B worth of UK Treasury bills for illiquid mortgage-backed securities (MBS). In fact, during ‘the nine months that the SLS was open, 32 banks and building societies, representing over 80% of the sterling balance sheets of eligible financial institutions, exchanged … eligible collateral for Treasury bills’ (Nygaard, K, 2020). 2. Open Market Asset Purchases (QE) of £137B worth of bonds on the secondary markets. 3. Providing £1T in guarantees (effectively insurance cover up to £1T) for the investors of private banks, should the bank’s fail and the investor’s require their money. While onerous this also creates a moral hazard problem, which could undermine previous efforts to reduce high risk behaviours of banking executives. 4. Over a decade of austerity to lower the budget deficit, due to the reduced tax revenue caused by the recession. This was certainly a positive step and although there are clear areas of alignment between the BoE and the regulatory authorities (i.e., ensuring the long-term stability and profitability of the UK banking system to ensure it can attract foreign investment). There is also a root area of conflict. This stems from the fact that discount loans are an asset to a central bank (BoE) but private bank’s required reserves - which provide short-term liquidity to protect against economic shocks - are a liability to a central bank (BoE), especially since it pays interest to private banks on those required reserves. Therefore, if the BoE focuses solely on maximising it’s own profits by Incentivising private banks to minimise their required reserves (i.e., setting an extremely low liquidity/cash reserve ratio) and maximise loans - they will maximise their own profits, while making the entire banking system vulnerable to economic shocks. 14 Conclusion Although the BoE’s monetary policy may consistently act to achieve it’s mandates, there are limitations to the impact that monetary policy can have on aggregate economic activity. Firstly, there are trade-offs. The BoE can target interest rates or the aggregate reserves (i,e., the money supply) - but not both. This is because they are interdependent variables, and by implementing monetary policy to affect one, the other is inevitably affected too. Secondly, it’s required to balance rules-based policies against discretionary-based policies. Although rules-based policies provide consistency - which is essential to achieve their longterm ambitions - they must also be prepared to respond to short-term critical issues. Actively considering the inevitable time lag in the impact of different monetary policies. Finally, for the transmission channels of the BoE’s monetary policy’s to work effectively, certain conditions are essential: 1. The BoE needs to be able to actively take action on the inflation rate while it’s still within a reasonable range. If it get to historic highs, it could make monetary policy less effective. 2. To effectively implement monetary policy, the BoE needs access to a variety of funding markets, with the scope to optimise for profitability. 3. The BoE needs to ensure that inflation expectations of the general public are well anchored. Beyond these critical issues that impact the effectiveness of the BoE, their monetary policy and their transmission channels; it’s also necessary to consider the secondary and tertiary impact of their monetary policy, to fully understand it’s long-term impact on economic aggregate demand (AD). As outlined by Mariana Mazzucato in her discussion on ‘Rethinking Value’ with the Long Now Foundation, the UK economy faces four (4) main challenges (Mazzucato, M PhD, 2019): 1. Excessive share repurchases by firm’s leads to a lack of reinvestment into ensuring longterm competitiveness. 2. A business sector that is not reinvesting it’s profits to maintain competitiveness, is then impacting the competitiveness of the wider UK economy. 3. Governments being limited in their activities as ‘market fixers’ has stifled their ability to support innovation as ‘market co-creators’. 4. Without the government being more involved in tackling the climate crisis as a ‘market co-creator’ it reduces the likelihood that the UK will achieve the UN’s Sustainable Development Goals (SDGs). As explained by Mariana Mazzucato: throughout history, technological innovation has occurred and this was typically not an issue. With consistent reinvestment of profits back into the economy to support innovation (R&D), maintenance, and employee development/retention initiatives, any potential job losses were recovered through the creation of new – or the improvement of existing – products and services. However, due to a 15 lack of profit reinvestment into innovation (R&D), maintenance, and employee development/retention initiatives, there is a warranted concern about this current technological development. How will the economy cope with the proliferation of artificial intelligence (AI)? If historical trends had continued, and reinvestment into the economy hadn’t been so severely cut, this would likely not be as much of an issue. There would likely be more opportunities for employees to re-skill and new types of jobs being created in the economy. [Circular Flow of Income, 9/9 - Song, W PhD] (2023, Graphic) As both explained and demonstrated (in the above graph) increased reinvestment would make firms more competitive and therefore allow them to operate closer to the full-capacity of their output. The macro-economics of this situation demonstrate that it will allow for a drastic increase in the productivity of the overall economy. Meaning that the UK’s GDP will be consistently higher and more resilient to global macro-economic shocks. The final point that I believe is worth making here, is simple. Without increased reinvestment of profits into the economy, what is the alternative solution to tackling our persistent socio-economic issues? Realistically, unfettered quantitative easing (QE) will only lead to unstable inflation which will lead to an uncontrolled increase in consumer prices, a corroding of long-term yields (due to the compounding impact of inflation on potential investments) and a substantial weakening of the British Pound (Sterling). Further reducing the purchasing power of UK taxpayers. Besides QE, the only other choice is an increase in taxes. 16 Considering that the root issue of the UK’s socio-economic problems stem from a persistent lack of reinvestment, which has inevitably led to a hoarding of profits. Considering that the UK taxpayer was forced into a position where they had to pay for the consequences of the 2008 global financial crisis multiple times over - or suffer most by having the entire UK economy collapse. Despite being the least responsible for the crisis. Considering the out-sized impact that stimulus to individuals who are on the lower end of the socio-economic ladder will have to generate tax revenue and close the budget deficit (due to them likely having MPC’s that are close to 1.0). Especially when compared to those at the high end of the socio-economic ladder (due to them likely having MPW’s that are close to 1.0). Considering the huge gap in average weekly earnings between the richest and poorest workers, the growing scale of inequality, and overwhelming impact of capital - a wealth tax seems like the most reasonable option. Especially if a core concern of policy-makers is to reduce the budget deficit, which would inevitably help to facilitate the international competitiveness of the UK economy and its growth in the medium to long-term. Once again, because of the impact of MPC, if the UK government did choose to pursue a wealth tax, a £1B increase in taxes would generate so much tax revenue, that it would lower the budget deficit more, than a £5B decrease in government spending (i.e., austerity). Although this is fiscal policy - and not monetary policy - it’s pertinent because without effective fiscal policy, the full benefits of effective monetary policy cannot be achieved. Mathematically and economically, a wealth tax is clearly the right decision. The only question is whether its the right decision - politically. 17 References World Population Review (2023), Negative Interest Rates Countries with Negative Interest Rates 2023 (worldpopulationreview.com) Bailey, A (2020), What is the Prudential Regulation Authority (PRA)?, Prudential Regulation Authority (PRA) [Bank of England, BoE] What is the Prudential Regulation Authority (PRA)? | Bank of England Bailey, A (2017), Our Mission 2017: How we regulate financial services, Financial Conduct Authority (FCA) [Bank of England, BoE] our-mission-2017.pdf (fca.org.uk) Reland, J (2019), £1 trillion was not spent on bailing out banks during the financial crisis, FullFact.org £1 trillion was not spent on bailing out banks during the financial crisis - Full Fact Nygaard, K (2020), UK Special Liquidity Scheme (SLS) (UK GFC), Yale (School of Management) The United Kingdom's Special Liquidity Scheme (SLS) (U.K. GFC) (yale.edu) Mazzucato, M PhD (2019), Rethinking Value, The Long Now Foundation [Video] Rethinking Value | Mariana Mazzucato - YouTube Song, W PhD (2023), Macro-economics: Circular Flow of Income [Graphic] [Full deck available through Coventry University] Bvirindi, T PhD (2023), Monetary Policy Transmission Mechanisms [Graphic] [Full deck available through Coventry University] Davidson, A and Blumberg, A, et. al (2008), 355: The Giant Pool of Money, This American Life 355: The Giant Pool of Money - This American Life 18