Quantitative Easing, Bank Lending & UK Government Borrowing

In my last blog, ‘The State of UK Banks& The Long Haul to Recovery’, I tried to show that even if there were sufficient demand in the UK economy to drag the country out of its present state of stagnation, the UK’s four largest banks currently have far less money available to lend than they had at the start of the financial crash in 2008 – an aggregate total of £1,622 billion less, to be precise – and that due to forthcoming legislation, which will require UK banks to retain stockholder capital equivalent to at least 7% of their lending, this position is not going to be greatly improved any time soon. I argued, therefore, that with UK businesses and consumers no longer having access to this now lost pool of finance, there is very little any government can do to overcome the current inertia, and that to suggest that a change in fiscal strategy would magically make this happen is wishful thinking to say the least, if not mischievously disingenuous.

Since then, a number of people have come back to me citing the very widely held belief that, through the Bank of England’s programme of quantitative easing, the banks in this country have actually been provided with ample amounts of cash for new lending – contrary to my assertion –  and that for reasons best known to the banks themselves – or their unalloyed wickedness, as some would have it – they have simply failed to use this additional finance to help fuel growth in the way that was intended, preferring instead to line their own pockets.

Despite hearing something to this effect almost every week on countless news and current affairs programmes, this is so far from the truth, however, that one can only assume it to be politically motivated. For although the BoE’s programme of quantitative easing – or asset purchase, as Mervin King prefers to call it – has provided some additional liquidity for the banks, not one penny of this was ever intended to go to the private sector, a fact which very quickly becomes apparent once one realises that the assets the BoE predominantly purchases are UK Treasury bonds, and that it has reasons for making these purchases which are far more critical and pressing than the ever-present need for economic growth. Put simply, they are:

a)      To ensure that the UK government can raise all the money it needs to finance its deficit, and;

b)      To keep the demand for UK Treasury bonds – and therefore their price – as high as possible, thus keeping their effective yield – and therefore UK interest rates – as low as possible.

To those uninitiated in some of the more arcane financial practices of governments and banks, this view of what the BoE has been doing may come as a bit of a surprise. What you have to remember, however, is that although government bonds are traded on an international market, the vast majority of new bond issues are initially taken up by the banks of the country in which the issue is made. It is this, for instance, that has led to a certain circularity in the debt crisis in Spain, where, in order to finance the bailout its banks, the Spanish government has made a number of new bond issues. The only problem has been that the only banks to have taken up these issues have been Spanish, thereby undermining the credibility of the exercise somewhat.

What you also have to remember is that, over the last four years, from April 2008 to March 2012, the British government borrowed a net total of £520 billion, most of it, as in the case of Spain, from its own banks. Given that during this same period, the four largest banks in the UK saw the total amount of money they had to lend fall by £1,622 billion, without the support of the BoE, lending an additional £520 billion to the government would therefore have been rather difficult. Indeed, I doubt whether it would have been possible at all. Without the BoE’s intervention, therefore, it is highly likely that the Treasury would not have been able to get all of its bond issues away. UK bond prices would then have fallen, yields and UK interest rates would have soared, and we could easily have found ourselves in the same position as Spain or Italy, in our case requiring a bailout from the IMF. By continually buying up UK Treasury bonds from UK banks – thereby providing these banks with enough additional cash to buy new bonds as and when the Treasury needed to issue them – the BoE thus prevented this worst-cast scenario from becoming a reality.

Of course, it is also true to say that, by taking this action, the BoE incidentally provided UK banks with a constant stream of additional liquidity. And indeed, without this, they would now have even less to lend than is currently the case. To say that, as a result of this largesse, they should now be lending more, however, is still a little harsh, especially when one realises that while our banks have lent the British government £520 billion over the last four years, during this period they have only received £325 billion back from the BoE in asset purchases. That is to say that in addition to lending the government the BoE’s £325 billion, they have also had to lend them another £195 billion of their own, leaving them, in fact, with £195 billion less to lend to businesses and would-be home-owners.

This also explains why the BoE’s QE programme has had far less effect upon the overall economy than was generally expected to be the case. For given that all this new money has gone to the government, which has used most of it to pay public sector salaries, pensions and welfare benefits, that part of it which has come back to the banks in the form of additional deposits and paid down mortgages and credit cards, has simply been used to finance that part of the loan to government not covered by the QE programme.

In fact, one can see this in the figures for bank lending between 2009 and 2011, where the overall increase of £191 billion is almost identical to the banks’ own internally financed lending to government (see Table 1). This would suggest, therefore, that all the additional money which the banks have been able to make available for lending during this period has been entirely vacuumed  up by the Treasury.

 Table 1: Bank Lending 2008 - 2011

Of course, these figures are for just four banks, and do not therefore give us a complete picture. There would have been additional contributions to government borrowing both from other international banks and from smaller UK banks. In that the banks in this sample are the UK’s four largest, however, and in that two of them are partially owned by the UK taxpayer, it is almost certainly the case that, throughout these last four years, it would have been these four banks that would have been working most closely with the BoE and the Treasury to ensure that the government’s deficit was covered. Simply as a reflection of their size, it will also have been these banks that will have done most of the heavy lifting.

What the above table more significantly tells us, however, is just how pernicious public sector borrowing to fund current expenditure truly is. For not only does it store up debt for future generations – generations, which, as a result this debt, may not be able to afford anything like the same level of salaries and benefits – competing, as it does, with the private sector for funds, it also drains the life-blood out of an economy, something which Keynesian economists of the left consistently fail to appreciate.

Combined with the uncertainty in the global economy, this also explains the general failure of the current government’s economic strategy, based as it has been on a gradualist approach to reducing public expenditure as a percentage of GDP. For despite what opposition politicians are constantly telling us – that the government is cutting ‘too far, too fast’ –  as I pointed out in ‘The Straightjacket of Economics & the Wriggle-room Left for Politicians’, the government is not actually cutting public expenditure at all. As can be seen from the budgetary forecasts shown in Table 2, public expenditure is, in fact, scheduled to rise every year throughout the current parliament. All the government has actually cut are Labour’s planned increases and thus the projected rate of growth in public expenditure as it stood in 2010.

 Table 2: Planned Public Expenditure 2010 -2015

The thinking behind the government’s strategy, I believe, was that by restricting the rate at which public expenditure was growing to something below that of the growth in GDP, the public sector would automatically shrink as a percentage of the overall economy in a way that was almost painless, thus allowing the governing parties to maintain some level of political popularity. By the same token they also assumed that, as tax revenues grew with growing GDP, the annual deficit would also simply disappear. What the Treasury clearly failed to take into account was the fact that by maintaining an annual deficit greater than the rate of growth in available bank lending, it would be starving the economy of the finance it needed to make this strategy work. The result has been that public expenditure is still rising as a percentage of GDP, and the government’s deficit reduction plan has effectively stalled. 

It is for this reason that many back-bench Conservative MPs are now calling for a more aggressive approach to deficit reduction. The irony is, however, that if, as seems increasingly likely, this tension within the coalition causes it to fall apart, the beneficiaries will be a party which is absolutely wedded to the public sector and which believes that increasing public expenditure is the answer to each and every problem. 

The difficulty for Labour will come when they get into office and discover – if they don’t already know this to be the case – that there is absolutely nothing they can do. They won’t be able to borrow any additional money – or not without very significant tranches of additional quantitative easing – and total taxation is already at a level where any significant increases in tax rates are likely to be counter-productive – actually reducing tax revenues. For the truth is, as I also pointed out in ‘The Straightjacket of Economics & the Wriggle-room Left for Politicians’, the economy is in such a state that, unless one is willing to take the very unpopular step of radically cutting public expenditure, the way Margaret Thatcher would have done, there is very little any government can do but walk the kind of tightrope the present coalition has attempted.

It’s why so much of the current economic debate is so trivial. The only substantive fiscal stimulus the Labour Party has so far proposed, for instance, is a cut of 2.5% in VAT, a measure which would put an extra £12 billion a year into the pockets of consumers, and which they propose to fund through an additional levy on the banks – the perennial scapegoats – and some additional borrowing. Against a backdrop of an economy which has lost £1.6 trillion in available finance, however, £12 billion is a mere drop in the ocean.

And it is this that is the real tragedy. For while our politicians belittle each other from the despatch box, while arguing over whether or not VAT should charged on hot Cornish pasties, the real problems go unaddressed. There is only so much time, however, before the elephant in the room makes its presence felt. And when that happens, as eventually it will, we’ll all wish we’d paid attention earlier.