Tuesday 24 January 2023

Should Quantitative Easing be reducing public services?


The Autumn Statement saw yet more cuts in public services planned for after the next election in order to get the debt/GDP ratio falling after 5 years. One item of spending that is expected to be higher after the next election compared to previous forecasts is debt interest. In part this is a result of the Bank of England’s Quantitative Easing (hereafter QE) programme. This created a large quantity of what are called bank reserves (explanations to follow), which currently earn interest for the commercial private banks that hold these reserves at the short term interest rate set by the Monetary Policy Committee of the Bank of England.

The Bank of England didn’t start paying interest on reserves until 2005-6. As long as interest rates were close to zero, or the quantity of bank reserves were much smaller than now, paying the short term interest rate on reserves didn’t cost very much. However after QE, and with short term interest rates climbing rapidly, they are costing not just the UK government, but all governments that undertook QE, serious sums of money. The money markets expect UK short term interest rates to stay reasonably high over the next few years, and as the OBR's forecast is based on these expectations this means that a significant amount of the austerity in the government’s current fiscal plan is a direct result of paying interest on reserves to commercial banks. The New Economics Foundation (NEF) calculate that the banking sector could receive over £50 billion of public money by mid-2025 because of interest paid on reserves. [1] Hence the title of this post.

If this all seems rather puzzling, it is because bank reserves are not well understood, and many of the explanations you will find just make things worse (see this from Frances Coppola who points to some all too common mistakes). To make things simpler I’m going to treat the Bank of England as part of the government (looking at what economists call the consolidated public sector). This is realistic, as any profits or losses the Bank makes end up being pocketed or paid for by the government. So I will talk about the government creating reserves and paying interest on them.

Why did the government create these reserves in the first place? After the Global Financial Crisis, short term interest rates hit their lower bound. Quantitative Easing (QE) was a programme where the government bought back some of its own debt with money the government created. The government has the ability to create money, either by issuing notes and coins (cash) or by creating reserves. I will not go into why they did QE, and how successful the QE programme was, because I and many others have written a lot about this already. Even if you think QE was a bad idea, as the Bank of England is understandably reluctant to sell all its holdings of government debt at once we are where we are.

Reserves are electronic money, in much the same way as your current account is electronic money that you use in, for example, online banking. Whereas you need to initially provide the bank with money, or get a loan from the bank, to create a current account, the government can just create that money. The amount of money created is the amount of the reserve held by the private bank. Private banks can only sell reserves to each other, so banks as a whole get no choice about how much reserves they collectively hold.

If reserves are like the government’s current account, why does it pay interest on them to individual banks? You and I don’t pay interest on our current accounts. The answer is that paying interest on reserves is a relatively recent innovation in most countries, and was designed to ensure the government can continue to set short term interest rates for the economy as a whole. When interest rates were very low that didn’t cost the government much, but now it does. For the private banks, getting today’s short term interest rate paid on its holdings of reserves is a bit of a windfall.

Do private banks deserve this windfall? The short answer is no. The reason they are getting paid interest on these reserves is because it helps the government set short term interest rates, and not in return for any kind of loan from the banks. So why isn’t the government finding some way to get this windfall back from banks, just as it (reluctantly) set up windfall taxes for energy producers? The answer is that this government cares rather more about bank profits than public services, which is an example of something I wrote about last week.

To be fair, a bank might argue that it is providing some services when it holds reserves. Your bank does not ask you to pay interest on your current account balance: indeed some banks pay you interest on your main current account. Banks compete for current accounts partly because they get to use the money provided when they are set up, but this isn’t the case for reserves. There is an argument, outlined by Paul Tucker here, that over some long period paying interest rates on reserves might happen to compensate banks for the use of any service the bank provides, but this seems very unlikely. There is also the question of the services the government provides to private banks that are not paid for, which I discuss here.

So if banks don't earn the interest they receive on reserves, how should the government get that money back? Some have suggested a tax to reclaim at least some of this windfall private banks are currently receiving. The windfall tax should be based on the income banks received from interest on reserves over the past year, and could be set at 100% of that income. However creating a tax to claim back what is a subsidy seems rather convoluted, and calling it a tax hands those that oppose it an immediate advantage.

The alternative is to change the way monetary policy works, so the government no longer needs to pay interest rates on all the reserves it has created. I have seen two quite similar proposals. The first is to move to what is called a tiered reserve system. Under this interest would only be paid on marginal reserves, with the majority receiving no interest, as suggested by Karl Whelan here or NEF here for example. The second is to insist that banks hold a large amount of ‘required reserves’ [2] that pay zero interest, as described by Paul De Grauwe and Yuemei Ji here. The two schemes sound very similar, and they illustrate that paying interest on reserves is not necessary for the operation of monetary policy.

As either a windfall tax, or changing the way monetary policy operates so that interest was not paid on most reserves, involves the banks losing a large amount of money while interest rates remain high, you will see a lot of misleading arguments about why this should not happen. The silliest is that not paying interest on reserves is a form of default: silly because most governments didn’t pay interest on reserves until quite recently, and governments not banks choose the quantity of reserves. Another argument is that not paying interest on reserves is a tax on banks, and taxes create inefficiency. But why not call paying interest on reserves a distorting subsidy?

Although changing the way monetary policy operates is a more elegant solution than a windfall tax on banks, political economy factors currently favour the latter. Here we have to disentangle the Bank of England from the rest of government. The government may feel that it is up to the Bank to suggest changing how it does monetary policy, because otherwise it would appear that the government is forcing the Bank’s hand just to save money. Unfortunately the Bank in turn may be too influenced by private banks to do this in a hurry. So changing how monetary policy operates is unlikely to happen soon.

Of course in the UK our current government is also unlikely to impose a windfall tax on banks. It was eventually forced to impose a windfall tax on energy producers, but that was because consumers were paying the higher prices that energy producers were benefiting from. If Labour wins the next election it should not feel so inhibited, and should be more interested in getting better public services than giving a subsidy to banks. This suggests a windfall tax on banks to recover recent interest paid on reserves should be an immediate priority for a new Labour government.

[1] That is not the only sense in which the QE programme may end up costing public money (or taxpayers money, as the media often likes to inaccurately call it). The bank reserves created as part of the QE programme were mainly used by the Bank of England to buy fixed interest government debt (gilts), during a period in which interest rates on gilts were very low, so the price of gilts was high. Now the Bank of England has begun selling those gilts, and because interest rates have risen the price of those gilts has fallen, leading to capital losses. (As the FT headline misleadingly put it, Treasury bails out Bank of England.) However it should never be forgotten that during the period when short term interest rates were low QE saved the government a lot of interest it would otherwise have paid on its debt.

[2] The phrase 'required reserves' is in itself confusing, as the banking sector as a whole gets no choice over the amount of reserves they hold.

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