The Bernanke Review of Bank of England Forecasting

 

My guess is that the world is divided into two groups of people: those who are really interested in the process by which central banks decide on monetary policy, and those who are largely disinterested. If I’m right, and you are part of the second group, it may be wise to skip this blog.

As the job of central banks is to set interest rates to keep inflation close to target, and inflation over the recent past has been well above target, then a typical reaction might be that central banks have slipped up in some way. The Bank of England is a typical central bank in this respect, and it commissioned Ben Bernanke - Nobel prize winner and former US central bank (the Fed) chair - to review their forecasting procedures. His published report is here. This post is informed by that report, but really just represents some of my own personal reactions.

My first point is rather fundamental and crucial. The fact that inflation got way above target last year does not necessarily imply the Monetary Policy Committee (MPC) of the Bank or the forecasters at the Bank made any avoidable mistakes, as Tony Yates has repeatedly pointed out. As we should all know by now, the burst of inflation we saw after the pandemic was led by higher commodity prices (helped by an unforecastable war) and was exacerbated by supply chain problems that were not a reflection of domestic overheating in the major economies, including the UK. To use the jargon, both represented short term supply shocks that would lead to only a temporary increase in inflation. Other things being equal, the best monetary policy reaction to such shocks might well be to do nothing, which is pretty well what central banks in the US, UK and EZ decided to do in 2021.

For those who understand this argument, please skip this paragraph. For those who don’t, imagine if central banks had instead raised rates aggressively through 2021. This would have had only a minor impact on oil and gas prices, or supply side bottlenecks, but might well have severely weakened the major economies as they recovered from the pandemic. In a nutshell an earlier central bank reaction would have had little impact on the upward path of inflation, but might have damaged the real economy at a very sensitive moment. It would have had no impact whatsoever on the cost of living squeeze, because wage inflation would have been lower. In some situations it is best for central bankers to do nothing, and 2021 was one of those situations.

By 2022 it became clear that wage inflation was also rising, reflecting a quite tight labour market, and this could threaten to lead to inflation being above target for more than a couple of years. As a result central banks did begin to increase rates pretty rapidly. Here the jury is still out on whether central banks were too slow, too fast or went too far in doing this, so it would be premature to say that central banks in general, and the Bank of England in particular, had a problem it needed to resolve.

Which all means that Bernanke was not looking for a smoking gun which would reveal why the Bank had got things so wrong over the last few years, because it is not obvious that the Bank (and other central banks) have got anything very wrong. Instead his review should be seen as a useful periodic check by an eminent outsider on what the Bank does. (Here is a short blog post based on an earlier review.) However there is a more subtle sense in which recent events do point to a weakness at the Bank, which I will come to at the end.

There is potentially a great deal to talk about from the Review, so here I want to limit myself to just three issues. The first issue, and one where I have some historical expertise, is the forecasting model the Bank uses. The second is about interest rate assumptions in the forecast, and the third is about openness.

Reading between the lines of the Bernanke Review, it is clear that the Bank’s core macromodel, called Compass, is increasingly unhelpful in producing the Bank’s forecast. Chris Giles asks “how on earth did the BoE’s management and governance arrangements allow its modelling to get into such a bad mess?” I think part of the answer reflects a problem with academic macroeconomics, about which I used to write a lot in this blog many years ago.

The current model, Compass, is a pretty basic DSGE model. For those unfamiliar with what that means, can I suggest my own taxonomy of macromodel types here. DSGE models are dominant within academia, and they put internal theoretical consistency above matching the data. An alternative style of model, which goes by many names and which Barnanke calls ‘semi-structural’, puts more emphasis on matching the past data and as a result sacrifices being certain about internal theoretical consistency.

The predecessor at the Bank to the Compass model, called BEQM, was an intriguing and ambitious attempt to combine a DSGE model with a type of semi-structural model. I was the external advisor on that project. I think it’s fair to say that this attempt failed because it was just too complex for the forecasters and decision makers to use and understand.

The Bank’s reaction, to resort to a simpler DSGE model, was in my view the wrong choice. Instead it should have built a modern semi-structural model. The problem with DSGE models is that they don’t help forecasters very much, and are more difficult to revise to take into account new data and issues, as I explain in detail here. I cannot say why they made the wrong choice, but the view that a lot of academic macroeconomists hold that DSGE models are the only way to do structural modelling may have been decisive. My own view, shared by Olivier Blanchard, is rather different, as I explain here. In short, the Bank needs to build a new semi-structural model to replace its current DSGE model, and ensure it devotes sufficient resources to continuously updating and improving this model.

The second issue is about what interest rate assumptions the Bank should use in its forecast. At present it uses both constant interest rates and market expectations, but both of these are unsatisfactory. It is, to put it simply, just daft that the Bank doesn’t forecast the one variable it actually sets. It should follow best practice elsewhere, as I and others have long advocated. It is a shame Bernanke dodged making this a strong recommendation.

What Bernanke did recommend is ditching fan charts showing forecast uncertainty, and instead look at alternative scenarios to the main forecast. How useful this will be remains to be seen, but I think it points to a more fundamental problem. Chris Giles talks about the need to examine past forecast errors, but I think an equally big gap is the lack of Bank analysis of the impact of monetary policy itself.

If you look at the Bank of England’s website you will find plenty of interesting research papers, many of which look at a particular aspect of the ‘transmission mechanism’ between monetary policy instruments and key economic variables. A few, like this, examine the whole thing. However there is a world of difference between a piece of research using a particular estimation method or theoretical approach and a considered Bank view based on looking at the totality of evidence. It is the latter which is missing.

For example I started this post by suggesting that the Bank couldn’t have done much to prevent recent inflation without harming the economy, but this should be something the Bank itself should address by looking at what the impact of alternative past interest rate profiles might have been, and publishing the results. More generally, the Bank should publish and regularly update its own assessment of how changes in interest rates impact the economy over time. The Bank must do such analysis internally, so why not make this public? Having a core model that it could trust would of course make this much easier.

Could governments finance deficits by creating money?

 

MMTers often say that financing government spending less taxes by issuing government debt is a policy choice, because they could instead create reserves (electronic money) at commercial banks. Of course only governments that have their own currency can do this, so this option is not available to Eurozone governments for example. If governments could finance deficits by creating money/reserves, would they want to do so?

The textbook answer (see here for example) is that monetary financing is inflationary, which is why most governments delegate reserve creation to independent central banks. This is not because of any crude monetarism: in mainstream macro the idea that there is a predictable and causal link between money creation and inflation died many decades ago, and today is believed by only a few. Instead the textbook story relies on the idea that governments creating money would undermine the ability of central banks to control the short term interest rate. Money financing would force interest rates to zero, and that would be inflationary.

However textbooks are nearly always out of date, and this explanation for why money financing would be inflationary became largely irrelevant when central banks started paying interest on reserves. Reserves are like electronic money held by commercial banks, the quantity of which is controlled by central banks. Today central banks control short term interest rates by paying that interest rate on reserves. As a result, it is possible to create large amounts of money/reserves without this ending in higher inflation.

We know this because of Quantitative Easing (QE), where central banks created large amounts of reserves in order to buy government debt. When they did this after the Global Financial Crisis (GFC) we didn’t get hyperinflation! The idea that recent inflation is a result of the new QE that took place during the pandemic is just silly. What recent experience shows us is that it is perfectly possible for central banks to control inflation even when there is a lot of money/reserves in the system.

So if central banks can create large quantities of money but still control inflation, why cannot governments finance their deficits by creating money? If interest is paid on that money/reserves, and it is clear that central banks have complete control over setting that interest rate, there is no reason to believe that money financing deficits rather than financing deficits by issuing bonds would be inflationary. This is what MMT means when it says bond financing is a policy choice.

Indeed we could go further and say that QE has been equivalent to the money financing of current and past deficits. The fact that this has happened because central banks wanted to put downward pressure on long term interest rates rather than governments choosing to money finance is just about motive. In practice we have ended up in much the same place as if governments since some past date had financed their deficits by creating reserves.

Of course none of this would matter if governments had no reason to be interested in money financing deficits. The obvious reason why they might be is if this form of financing was cheaper than selling debt to the bond market. Creating money/reserves incurs a cost equal to whatever the central bank sets the short interest rate to. Issuing debt could incur much the same cost if that debt was very short term. However governments have the option, which they normally take, of selling longer term debt. That may or may not be immediately cheaper than creating money/reserves, because long term interest rates may be above or below short rates. After the GFC short rates were below long rates, so money financing would have been cheaper and QE made a profit. Currently long rates are below short rates so bond financing would be cheaper at the moment. However over the long term whether the option of borrowing long is cheaper for governments remains questionable. Ellison and Scott found that the UK, which tends to borrow long, would have been better off if it had borrowed short.

The situation becomes much clearer if central banks only pay interest on reserves at the margin, rather than paying interest on all reserves. This would allow central banks to continue to control short term interest rates, but also to pay substantially less interest on the total stock of reserves. I discussed this possibility in detail here, in the context of reducing current losses from QE. An additional reason to pay interest only on some rather than all reserves is that there is no obvious reason why commercial banks should receive large sums of money for reserves when rates are high and virtually nothing when rates are low

If interest was only paid on marginal reserves, then it does clearly become attractive from a public finance point of view to finance deficits by creating money/reserves rather than issuing debt. So why are governments not exploring this possibility? I could equally well ask why mainstream economists are not talking more about this possibility. Maybe I’m missing something obvious here. If so please let me know.

One possible argument that I think doesn’t hold water is that cheaper financing of deficits would encourage governments to be fiscally profligate. The main deterrent to fiscal profligacy when there is an independent central bank is high interest rates, not high debt interest payments.

I want to end by making two additional points. The first is about markets and default. Money financing may appear attractive to those who believe that debt finance constrains government fiscal decisions. The idea is that bond markets could suddenly stop lending governments money, and this inhibits politicians from optimal fiscal policy choices. If politicians think this way they are mistaken, because as I have explained elsewhere the bond market is highly unlikely to stop lending the government money, and if it ever did the central bank would act as a last resort buyer of government debt. This is what happened as the pandemic hit, and after Truss’s infamous fiscal event. [1]

Because governments can create money they never need to worry about being forced to default as a result of a bond market strike. In addition governments having a magic money tree means that bondholders can always get paid interest and their money back. The only formal default [2] that bond markets need to worry about is when governments choose it, because the political cost of servicing government debt becomes too high. We are way away from such levels today, so the following paragraph is strictly of academic interest only.

If a government with an independent central bank that had financed all of its past deficits through money/reserve creation chose to default, how could it do so? Unlike government debt, reserves don’t have to be paid back at a set date. The only sense in which such a government could default is to instruct its central bank to no longer pay interest on reserves, which means that the central bank is no longer independent and loses control of inflation. In contrast, defaulting on government debt is possible while maintaining an independent central bank, and therefore maintaining control of inflation.

My second point is about safe assets. Because governments of advanced economies who issue debt in their own currency hardly ever choose to default, the debt they issue is far safer than any debt the private sector creates. [3] Such debt is invaluable to the financial sector. It allows pension funds greater certainty that they can pay future pensions, for example. This is a very good reason why governments should continue to issue at least some debt. Does that mean governments should always finance deficits using debt? No, because governments can issue debt to buy assets (through a sovereign wealth fund for example) rather than fund deficits.

[1] Politicians may worry about the impact of fiscal decisions on how the central bank sets interest rates, but it is absolutely right that they should.

[2] Bond markets do need to worry about inflation, which is sometimes considered as a form of default, but that gets reflected in interest rates through the actions of independent central banks and arbitrage.

[3] It can be disastrous when the private sector thinks they have created safe assets when in reality they haven’t, as we found out in the GFC.

The Anatomy and Reasons for UK relative Economic and Political decline over the last decade and a half

 

Nothing works anymore, the country is in a mess, worker’s living standards have remained stagnant, public services are at breaking point. Such statements are now commonplace, and are increasingly brought together in articles like this one by Sam Knight in the New Yorker. But is all this the result of 14 years of bad government, or can the blame be laid at the door of one or two specific events like austerity or Brexit?

Economic decline

I want to start with a post I wrote two years ago, where I was already talking about an unprecedented era of UK macroeconomic decline. I focused on comparisons with the US, and here is an updated chart of GDP per head in the two countries.

The divergence between the two countries has grown steadily since around 2010, it has become particularly dramatic since the pandemic. While real GDP per head in the UK has increased by only around 5% over the last 15 years, in the US it has increased by over 20%. As that earlier post showed, this divergence was not a feature of the previous three decades, but instead started around 2010. Between 1980 and 2010 UK GDP per head grew at least as fast as the US.

Comparisons with Europe are less dramatic, but partly for that reason may be more instructive.

If we compare the UK to the EU average (blue and green), the EU recovered more rapidly from the Global Financial Crisis (GFC) recession, but then fell back as the second Eurozone recession began to bite. However from 2016 onwards EU growth exceeded growth in the UK, leaving an 8% gap by 2023. A difference in growth of 8% over less than a decade is a lot. However over the last 15 years growth in France has been similar to the UK, and things have been worse in Italy (not shown above).

GDP per head does not tell the whole story about prosperity, because it doesn’t tell you about the purchasing power of incomes. Here is a comparison of real wage trends over roughly the same period from this source.

In this case the UK ends up well below France, with real wages in 2023 below 2008 levels. Part of the contrast between real wages and GDP per capita is distributional, with the UK government favouring pensioners in particular. However a large part is also about consumers buying many goods from abroad, and these becoming more expensive because sterling has depreciated. Here is the Sterling Euro rate over this period.

We had a large depreciation during the GFC, followed by a gradual appreciation until Brexit, when sterling depreciated again. A depreciation of 20% between 2007 and 2023 will reduce the purchasing power of UK nominal wages by a good few percent.

What does this tell us about why the UK has experienced a decade and a half of economic decline? These comparisons suggest austerity is important. The UK set out plans for large-scale and relentless austerity earlier than the EU, which is why our recovery was relatively slow, but the EU as a whole fell back to UK levels when it embarked on widespread austerity during the 2011-13 period. The US had an excellent recovery from the pandemic because, unlike the UK and Eurozone, it encouraged its recovery with fiscal expansion. As I argued here, deficit obsession, shared by the UK and EU but not (currently at least) by the US, appears to be bad for growth not just in the short term, but continuing into the medium term as well. Evidence also suggests cutting spending in a recession actually increases the debt to GDP ratio.

Brexit also clearly matters. I doubt that it accounts for all of the GDP per head gap that has opened up between the EU as a whole and the UK since 2016, but it almost certainly accounts for a good part. It is also responsible for the 2016 depreciation which reduced the purchasing power of UK incomes. [1]

To conclude, the relative decline of the UK economy since around 2010 is very real and substantial. It is not unique or the worst performance among major European economies thanks to Italy, although it is worth noting that in contrast to the UK Italian growth has been strong since the pandemic. Both austerity and Brexit have played a large part in producing the UK’s relative decline, but other factors (e,g, bad governance generally, poor pandemic management, encouragement of rent seeking from government) may also have played a part. As the New Yorker article notes, austerity itself probably played a key part in ensuring Brexit happened.

Political decline

Of course the current feeling that nothing works anymore isn’t just about a significant relative decline in living standards. It is also about political failure. There is no doubt that this became acute following Brexit. As I have noted many times, support for Brexit sorted those interested in evidence or even common sense from those who were not: some of the former got expelled from the party by Johnson and the latter got to be in his cabinet.

But 2010 austerity was also a failure of evidence based governance, in two crucial respects. First, we had known since WWII that cutting government spending during a recession, where interest rates were stuck at a lower bound, was a crazy idea. The fact that this was also advocated by the Republican party in the US, and a Germany dominated Europe spooked by the Eurozone crisis, should not lend it any respectability. 

Second, substantially shrinking the state without significantly altering thetasks the state is required to perform only makes sense if you believe that there are massive efficiency gains to be had, and again there was plenty of evidence in 2010 that this was untrue. The dire state of most public services today, which is so central to the current national feeling of despair, stems from this fundamental error that began in 2010.

I think it is important to recognise that so much of our current political malaise has deep roots of Conservative party strategy since the fall of the Major government, rather than being something that just happened with Brexit. The contrast with Labour in opposition is instructive. Whatever you might think of Labour’s embrace of some aspects of neoliberalism, it showed a party adapting to electoral failure. Where the subsequent Labour government did differ from Thatcher was in increasing spending on public services and particularly the NHS, and this was clearly popular with most of the public.

The Conservative opposition from 1997 to 2010 took none of this on board. Instead they saw themselves as leaving off where Thatcherism had ended, in an ideological rather than evidence based way. She had ignored the economists when raising taxes in the 1981 recession, so they would go further with austerity, not bothering to note that her fiscal contraction during a recession lasted for only one year and was then reversed. She had shrunk the state so they would do the same, but they ignored the fact that Thatcher mainly reduced what the state did through privatisation rather than starving it of money. Whereas some of Thatcher/Major’s economic policies were popular, those of their successors were not.

In simple terms the Conservatives in opposition moved further to the right on economic policy, rather than shifting left on public spending in a way that Blair/Brown had shown was popular. They understood that good public services were popular, but used the GFC as an excuse to cut spending. Conservative MPs today are much more right wing on economic issues than Conservative voters or members. [2]

Sunak’s strategy of focusing on tax cuts and culture war issues, that today seems so out of touch with the concerns of most voters, also stems from Conservative strategy after 1997. Of course Conservative party members have always been socially conservative, but Thatcher argued for her economic policies on their own terms. In opposition the Conservatives, like the Republicans in the US, saw their culture war as a means of winning despite their economic policies. With the help of the party in the media, they focused on immigration as a means of winning support from voters who were socially conservative but left leaning in economic terms, a strategy that was most successful with Brexit and Johnson’s victory in 2019, but which is now seen by many as the sham it always was.

One other feature of politics that we associate with Brexit and Johnson particularly, and which persists today, may also have its origins in the Conservative’s period in opposition from 1997 to 2010. One notable feature of the attitudes of the average Conservative MP (at least in 2020) is that they are slightly more socially liberal than the average voter, and therefore much more liberal than Tory party members. For most of these MPs the focus on social conservatism and culture wars has to represent a degree of deceit to win power rather than an expression of underlying beliefs or values.

For this reason, the tendency to deceive and lie to gain or retain political power, which reached its summit with the Brexit campaign and which continues today on issues like dealing with refugees, may represent the continuation of a trend that began in those opposition years. We don’t know how much of Cameron and Osborne’s rhetoric of deficit reduction they actually believed, but we do know that they started cutting taxes fairly quickly after 2010, which you wouldn’t do if deficit reduction was really your primary goal.

For these reasons I see the political decline of the last fourteen years as deeply rooted in the way the Conservative party developed since the Thatcher and Major years. One of the reasons for the current feeling of political despair is that the Conservatives under Sunak have almost stopped governing, and instead almost everything the government does seems aimed at trying to rescue some votes.

For completeness I would add two final, more minor, points. The first is that part of the current malaise also comes from an uninspiring opposition, but much of that stems from a First Past The Post electoral system where government typically alternates between the two major parties, and past Labour defeats. In most circumstances, including those today, it makes electoral sense for the opposition to appear ever so slightly more to the left in economic and social terms than the government. Labour too are in the business of winning votes, and in addition are inevitably very cautious of doing anything to lose them.

The second point that needs to be made is that the political decline over the last fourteen years in some part reflects a decline in the quality of our mainstream media. Some of this is obvious, such as the right wing press becoming a propaganda vehicle for Brexit, or the influence the Conservative party has had on the BBC. But it is also the case that the broadcast media, and particularly the BBC, has an increasing obsession with balance at the expense of informing viewers about facts or about the consensus of expert opinion. This has been an important factor in facilitating our political decline. It played a crucial part in the 2015 election, in the Brexit referendum and in the election of Johnson and it continues today. [3] More generally it allows particular members of the elite to present themselves as outsiders, championing ordinary people, and allows political deception and lying as a matter of routine.

When the Conservative led Coalition came to power in 2010, it suggested that cutting public spending rather than improving living standards should become the government’s economic priority. Today we are experiencing the inevitable result, a combination of dire public services and fourteen years of relative economic decline. In an attempt to appeal to voters that wanted functioning public services, they pretended immigration was a major problem. As a result we ended up with Brexit, trying to traffic asylum seekers to Rwanda and a government moving further to the right on social as well as economic issues. Today’s economic and political malaise is a direct consequence of a Conservative party strategy that was conceived after 1997 and implemented from 2010.

[1] The depreciation from 2008 to 2010 is generally put down to the fact that the GFC affected the UK more than most, because our banking sector was relatively large. However, having worked on equilibrium exchange rates, I have always found that justification for such a large depreciation unconvincing. In this respect it is also interesting that once the UK started growing again but the EU did not, sterling began appreciating, such that by 2015 it had regained most of the ground it lost during the GFC.

[2] The fact that taxes have increased as a share of GDP over their time in government is because spending on health has been rising as a share of GDP almost everywhere.

[3] On the few occasions the broadcast media ignored impartiality and took a clear side it backed the wrong cause, including its adoption of deficit obsession after 2010 and relentless pursuit of antisemitism within Labour while largely ignoring Tory Islamophobia and Johnson’s unsuitability to be PM. The latter, together with sections of the Labour right who preferred Johnson to Corbyn, helped ensure Brexit happened and led to many thousands of deaths in the subsequent pandemic.

Why Quantitative Easing is currently so costly

 

Unwinding Quantitative Easing (QE) is currently costing the public a great deal of money. Nearly £50 billion (almost 2% of UK GDP) has been transferred from the Treasury to the Bank of England to cover losses as the Bank unwinds QE (called Quantitative Tightening) since October 2022. That is real money that might otherwise have been spent on improving hospitals, schools etc. (Figures from the latest OBR forecast here, page 120.) It is true that before that QE made the government much bigger profits, but the OBR estimates that once all QE is unwound the net loss will be around £100 billion.

One of the reasons discussion of this has tended to be confined to pages in the Financial Times (see here for example) is that, as with most things finance related, the issue can often get needlessly complicated. In this post I’ll try and make things simpler, and ask whether these losses can be avoided and if not, who is to blame.

First, a reminder of what Quantitative Easing is and why it happened. It involves the Bank of England buying huge quantities of government debt, and paying for this by creating (electronic) money called ‘reserves’ which are held by the major banks. Most of this was done during the recession years after the financial crisis (GFC), but some happened during the pandemic.

Why did the Bank do this? After the GFC the main policy instrument of the Bank, the short term interest rate, was stuck at its lower bound, so instead the Bank was trying to stimulate the economy by putting downward pressure on longer term interest rates. By buying lots of longer term assets like government debt, it hoped it would push up the price of that debt. Most government debt when it is issued has a fixed nominal interest rate, so if the market price of that debt increases, that implies the effective interest rate falls for anyone buying it. [1] As I suggested here, for supply and demand to have any effect on the interest rate for government debt, the Bank needed to buy huge quantities.

As QE was always an emergency measure in a situation where short term interest rates were at their lower bound, it was never intended to be permanent. At some point the Bank would start selling the government debt it held, and using that money to reduce the money/reserves it had created to buy them in the first place. For the Bank the obvious time to start selling is when the economy needed cooling down rather than stimulating, which would also be when short term interest rates were well above their lower bound. That is why we have seen QE being reversed over the last few years.

So why did QE originally make a profit, but is now making a loss? There are two components here. The first is an interest component. The Bank pays the short term interest rate to the major banks on the reserves it created, but it receives the interest rate of the government debt it bought with that money. When short term interest rates were very low, longer term interest rates, including the interest rate on government debt, were higher so the Bank made money by holding this debt. However today the opposite can be true, so the bank could be paying more to the major banks than it’s getting from its holdings of government debt.

The second element involves capital gains and losses. Because the Bank bought government debt when rates were low and debt prices were high, and because it was likely to sell that debt when interest rates were much higher and prices lower, it was likely to sell its debt at a loss. This was understood at the time QE started, so making capital losses is no surprise.

Putting the interest rate and capital gains elements together, we can see why initially QE made the government money, but now it is losing it money. First, any profit or loss the Bank of England makes is picked up by the government. Second, when short term interest rates were low and the Bank was not selling government debt, it made a profit on the interest it received from the government debt. Essentially the government through the Bank was buying back its own debt and saving interest as a result, hardly any of which was going to commercial banks holding reserves because short term interest rates were almost zero.

However, once short term interest rates started rising in 2022, these interest gains started to disappear, because the rate of interest paid to commercial banks on the money created to buy the debt increased by substantially more than the interest the Bank was receiving on government debt. In addition, the Bank was now selling off some of its government debt at much lower prices than it paid for it, so it was making a capital loss. Because the quantities of government debt involved are very large, so is the size of these gains and losses.

Could current losses be avoided? The interest costs could be avoided if the Bank stopped paying the short term interest rate on all the reserves it created. I discussed this possibility here, including suggestions of how this could be done without the Bank losing control over short term rates. Alternatively the government could impose a windfall tax on the banks holding these reserves. How much of either measure would be passed on to bank customers or bank shareholders or bank employees is unclear.

What about the capital losses? I suggested earlier that these were almost baked in from the start, because the Bank would always be buying debt when its price was high and selling when its price was lower. While that is true, whether there is a net loss once interest gains or losses are added in depends on market expectations of future short term interest rates. Although the Bank was buying at a high price, it was receiving a relatively high interest rate in compensation (hence its initial profits). If market expectations about future interest rates when the debt was bought proved correct, then any capital loss would roughly equal the interest gain while the Bank held the debt. [2]

In terms of capital losses, therefore, the worst thing the Bank can do is sell its debt when short term interest rates are unexpectedly high. Interest rates today are indeed unexpectedly high, in the sense that few in 2019 would have expected interest rates at current levels. The problem here is institutional. The Bank has not been charged by the government to minimise its losses from reversing QE, but instead is concerned with meeting its inflation objective.

Who is to blame for these losses? Jo Michell put it nicely when he wrote that the original sin of QE was austerity. We had QE on the scale we did because in 2010 the government reversed Labour’s fiscal expansion. As an expansionary tool QE is undoubtedly inferior to fiscal expansion, which is why austerity was so costly in macroeconomic terms. Fiscal expansion also costs money, but the key difference here is who the money goes to. Most people benefit from higher public spending or a tax cut. In contrast those who gain from the government’s losses from QE are those buying, selling or holding government debt, and currently the commercial banks because they hold reserves.

Austerity from 2010 was enacted by the Coalition government, that rigidly stuck to their spending cuts even when the economy failed to recover. I suspect the politicians at the time ignored any potential future costs from QE because these costs were uncertain and, more importantly, would happen after the next election. As I said at the time, austerity was one of the major macroeconomic policy blunders since WWII, as well as having a devastating impact on public services.

However the Bank of England also oversold the benefits of QE to politicians only too willing to be convinced. Having been given responsibility for managing aggregate demand and inflation, the Bank was reluctant to admit that they couldn’t do this job effectively once short term interest rates hit their floor. This bias within central banks persists even today. As this ECB paper shows, estimates of the impact of QE tend to be much larger if done by researchers in central banks compared to academics.

With QE likely to cost an incoming Labour government large amounts of money that is desperately needed elsewhere, it is time the Treasury cast a more sceptical eye on the advice they receive from the Bank, particularly where that advice may reflect regulatory capture as much as sound monetary policy. Currently it is not clear that monetary policy considerations alone should govern when QE is reversed, and it is also far from clear why commercial banks should keep all the windfall they are receiving from their holdings of reserves. In any future demand led recession, the government should think very hard before agreeing to any request for large scale QE. QE was, and remains, a third best tool for fighting recessions [3], and a first best tool - fiscal stimulus - is easy to implement for any government that controls its own currency.

[1] Suppose the government issues 10 year debt at a fixed 5% interest rate. You buy £1,000 of that, and you get £50 a year for the next 10 years, and then your £1,000 back after 10 years. However, that debt is traded on the market. If after a year interest rates fall to 4%, say, and are expected to stay at 4%, traders will be prepared to buy that debt from you for more than the £1,000 you originally paid, because they will still get £50 a year.

[2] To the extent that the Bank was initially successful at pushing long term interest rates below the price implied by this arbitrage, it will still make a loss.

[3] The Bank should always have the ability to buy large quantities of government debt to resolve market failures (as it did after the Truss fiscal event).