The Stalinist Bank of England
On BBC Radio 4 on Saturday 24th August, Simon Rose from Save Our Savers said this:
"You can actually see the real price of money in other places. Now they’ve decided that it should just be 0.5%, but if you look at the peer-to-peer market for instance, which matches off people who want to borrow against people who want to lend money, well there the rate’s sort of 5% roughly. That is people coming together saying “I’m going to lend some money, what will you pay me”, or “I need to borrow money, how much does it cost”. That is free market capitalism operating, not the sort of crony capitalism with the sort of Stalinist control of the price of money that we get from the Bank of England. People never seem to challenge the idea that the Bank of England should set the price of money, but I find it very bizarre that they do, particularly when we’re seeing the cost of their decisions."
("How You Pay For The City", starting at 4min 20sec. I've transcribed it because BBC iplayer links are not available in all countries and are only up for a short time).
I really can't let this pass. I don't think Rose has the slightest idea what he is talking about.
Firstly, he is confusing the relationship between risk and return by comparing the base rate set by the Bank of England (which can be regarded as the "risk-free" rate for sterling) with the rates paid by peer-to-peer lenders. Peer-to-peer lenders are online platforms that bring together lenders and borrowers. They are currently unregulated, and although from 2014 they will be regulated by the FCA there are no plans for them to have central bank liquidity support or for lenders to have deposit insurance. Funds lent through a peer-to-peer lender are completely at risk. This is not in any way to criticise peer-to-peer lenders, many of whom do their best to mitigate risks to lenders: but arguing that the risk-free rate should be higher because peer-to-peer lenders pay more is comparing apples and pears. The base rate is lower than the rates paid by peer-to-peer lenders BECAUSE IT IS RISK-FREE.
Retail deposits are also risk-free up to the limit of FSCS deposit insurance. We would therefore expect retail deposit rates to be much closer to the base rate than to the rates paid by peer-to-peer lenders. Peer-to-peer lenders offer higher returns, but the lender carries the risk of loss. Save Our Savers seem to be recommending peer-to-peer lenders as higher-yielding alternatives to retail deposit accounts. This is fine, if they are making it clear that the lenders' money is at risk in a peer-to-peer loan, whereas it is not at risk in an insured deposit account. But if they are not making that clear - and I have yet to hear Simon Rose explain that, although I have heard him recommend peer-to-peer lending several times - then in my view they are as guilty of mis-selling as the banks that are now having to compensate people for PPI. The only difference is that depositors will have no claim for compensation if they lose their money because of bad advice from Save Our Savers.
Secondly, he is wrong about interest rates. Interest rates are set by the market. They really are.
The Bank of England's base rate is the rate at which it lends to banks. It lends overnight against pre-pledged good quality collateral (in effect, banks have standing lines of secured credit on which the interest rate is the Bank of England's base rate). The base rate is the lowest cost of secured funding for banks, and is the benchmark for LIBOR, the rate at which banks lend reserves to each other. It is also the rate that the Bank pays on agreed voluntary holdings of reserves by commercial banks. The base rate is used as a benchmark in market activities and some forms of retail lending, notably residential mortgages and commercial loans.
But the base rate is NOT the rate that banks pay to depositors, as Rose implies. The Bank of England does not "set" retail deposit rates. To lending banks, retail deposits are simply one of several sources of stable funding. Banks set retail deposit rates on a commercial basis, taking into account their general cost of funding, their desired credit spread, the competition for retail deposits and whether they have other stable sources of funding. If the cost of stable funding from capital markets falls, retail deposit rates will fall too. Banks are not going to pay retail depositors more than they would pay for comparable funding.
Rose and others claim that current very low rates on retail deposits are due to the Funding for Lending Scheme (FLS). They describe it as "cheap money from the Bank of England". This is incorrect. The FLS does not involve creation of new currency or bank reserves. It swaps illiquid assets on bank balance sheets (such as mortgages) for new short-term Government debt. This gives banks better collateral, which enables them to borrow more cheaply in the funding markets. It is quite possible that the FLS depresses deposit rates, but if so it is because it depresses bank funding rates generally. But the chart below shows that longer-term funding rates were already falling rapidly by the time the FLS was introduced, probably due to the ECB's OMT which reduced risks for banks operating in the European market. It is very hard to argue that the reduction in funding spreads, and therefore deposit rates, since mid-2012 is entirely due to the FLS. There is some correlation, but it certainly does not indicate causation.
(apologies for the poor quality of this image. The original is on p.12 of the Bank of England's Inflation Report for May 2013, pdf).
The truth is that retail deposit rates are low because market funding rates are low. And this is for many reasons, including - but certainly not limited to - intervention by central banks both in the UK and elsewhere. Indeed, some argue that interest rates would be even lower if central banks were not actively propping them up by, among other things, paying positive interest on excess reserves. Personally I think the main reason for low rates is the poor performance of Western economies. When economies are depressed, so are interest rates - not because central banks make them so, but because far too many people and businesses are saving (including paying off debt, which is equivalent to saving), which as Aziz points out, pushes down the returns on savings. If savers want interest rates to go up, they should spend some money.
Finally - and most fundamentally of all - Rose does not appear to understand the nature of the UK monetary system, and the implications for depositors of his suggestion that the Bank of England should be stripped of its right to "set the price of money", as he (incorrectly) puts it.
The Bank of England has been the monopoly provider of currency and bank reserves since the Bank Charter Act of 1844. This Act ended the right of banks in England and Wales to issue their own banknotes. Scottish and Northern Irish banks still issue their own banknotes, but in a separate Act in 1845 they were forced to back their banknotes one-for-one with Bank of England issued notes. The 1844 and 1845 Acts were introduced as an inflation control measure, because it was believed that banks creating their own banknotes without adequate reserve backing devalued the currency. They forced banks to ensure that all currency was backed by reserves at the Bank of England. Originally these reserves were in gold, but ever since the UK abandoned the gold standard in 1931 reserves have been central bank sterling liabilities. However, the Acts did not restrict the creation of new bank deposits. Banks could still create new deposits in the course of lending, provided they obtained sufficient reserves to settle the drawdown of the deposits created by lending. They could borrow those reserves from other banks, or as a last resort from the Bank of England.
In calling for the ending of the Bank of England's right to set the price of bank reserves, Rose is in effect calling for the ending of the Bank of England's currency issuance monopoly - though I'm not at all sure he understands this. Currency and bank reserves are the same thing - sovereign money. Together they make up the monetary base of the UK. The only difference between them is the form in which that money is created. The Bank of England could create bank reserves as physical currency, which banks would store in vaults, and indeed it does do this to some extent - after all, ATMs have to be filled. But in these days of instantaneous electronic communications, most reserves are created as computer records not physical currency. Therefore, since bank reserves are simply currency in electronic form, if the Bank of England stopped creating bank reserves it is very hard to see how it could continue creating currency. Banks would have to revert to the situation before 1844, when they printed their own banknotes and obtained their own reserves in the form of gold and government debt on the open market.
There is a school of thought that would like to restore this. Actually most supporters of Free Banking want to eliminate all government control of money, which would mean bank reserves would have to be a commodity such as gold or a fixed private sector monetary base such as Bitcoin, not government debt. However, let's assume for the moment that government debt remains acceptable as a reserve asset. Rose believes that the yields on government debt are being artificially depressed by central bank purchases, but the fact is that interest rates on gilts have been trending steadily downwards for over thirty years, and recent asset purchases seem to have made little difference to this trend:
(chart courtesy of John Aziz.)
Currently, unregulated financial institutions ("shadow banks") which don't have access to central bank reserves lend each other safe assets, mostly various forms of government debt, at rates not far above the current base rate. Ending commercial banks' dependence on the central bank would place them on the same footing as shadow banks. Unless the UK adopted a gold standard or some other kind of restricted monetary base, they would simply replace central bank reserves (safe asset) with short-term government debt (safe asset). I doubt if the rates would be any higher than they are now - in fact as this would increase demand for government debt, it might even depress rates further. But it would have a serious impact on banks' safety from depositors' point of view.
Ending the Bank of England's reserve creation monopoly would mean the end of its role as lender of last resort. After all, if the Bank of England can't create unlimited reserves, it can't lend them either. With no lender of last resort, if banks ran out of money and other financial institutions would not lend to them they would simply go bust, rather than being able to tap the central bank for funds as they did in the 2007/8 financial crisis. The Bank of England provided emergency liquidity assistance to Northern Rock for five months before its eventual nationalisation. Had it not done so, the Rock would have run out of money even before the retail run started - after all, it was the Rock's request for emergency funding from the Bank of England that triggered the retail run. Depositors - the "savers" that Rose thinks are so badly treated - would not have been able to withdraw their funds. They would eventually have got most of them back (although deposit insurance at the time did not cover 100% of small deposits), but the Rock being unable to pay its depositors would quite possibly have spooked depositors in other banks too, causing a spate of retail bank runs.
This is actually what happened in the US in the banking crisis of 1933 - a "domino effect" of bank runs which caused widespread chaos and was only ended by Franklin D. Roosevelt's famous "bank holiday". To this day, many people in the US remain terrified of bank runs. As I've written elsewhere, an effective lender of last resort is the best way of ensuring the stability of the banking system. In seeking to end this, Rose is in effect arguing for a much less stable banking system. I suppose forcing banks to have much more capital and bigger liquidity buffers would help, but in a systemic crisis would it be enough to compensate for the lack of unlimited lender-of-last-resort liquidity? I doubt it.
There is a further problem too. The central bank is the clearing house for electronic payments through systems such as BACS and CHAPS, and central bank reserves are the "money" that moves across those systems to enable funds to transfer from one bank to another. The central bank provides reserves as required to make payments: in effect, it carries the risk of banks being unable to make payments due to lack of liquidity. And it charges banks for this. Authorised borrowing of reserves against pre-pledged collateral is at the base rate, as I've already noted: but unauthorised borrowing (the banks' equivalent of an unauthorised overdraft) costs considerably more. It would in theory be possible for banks to make bilateral payments to each other without a central bank clearing house, but that would expose the system to payment failures. Payments could be seriously delayed, and funds in transit could even be lost, with potentially catastrophic effects for customers. The only alternative would be to allow commercial banks to create money at will to settle payments without obtaining additional safe asset reserves to back it. That is indeed what banks did prior to the 1844 Act. But the opportunity this would create for abuse, and the likely inflationary consequences, are surely obvious. Rose expresses considerable concern about inflation - yet he apparently wants to reintroduce a system that was abolished because it was inflationary.
Rose's accusation that the Bank of England is "Stalinist" appears to rest on his belief that the Bank of England is able to set interest rates, including those on gilts, independently of the market. It is fair to say that it influences them: after all, if it did not, monetary policy would have no traction. But Stalinist central control overriding market pricing? I don't think so. After all, even though the Bank of England has the power to buy up every gilt in existence, it can't set the price at which the market will sell to it. And if investors decided the UK was a bad bet, they would push up yields on gilts, forcing up interest rates on new issues. Indeed it is by no means clear that central bank asset purchases depress rates anyway: the chart above suggests otherwise, and if the market was determined to sell, knowing that the central bank stood ready to purchase would be likely to raise yields, not depress them. So it is questionable how much influence the Bank of England really has over market rates. Base rate and T-bill rates are usually similar, but which leads which is hard to say. That's why the Bank of England is now doing "forward guidance". It is telling the market where it wants rates to be in the hope that markets will cooperate. So far they haven't. It has not been a good start for Mark Carney.
But this really is a sorry episode for Simon Rose. His remarks are positively embarrassing. I am actually in agreement with his criticism of Help to Buy and Funding for Lending for inflating a housing bubble. But both are fiscal policy, not monetary - so he should be blaming the Chancellor, not the Bank of England. He seems to criticise both for everything. Maybe he doesn't understand that the Bank of England is supposedly independent, and it is only responsible for monetary policy, not fiscal? He really should do his homework on the UK's currency system and the way monetary policy works before he drops any more clangers.
How You Pay For The City - BBC Radio 4 (iplayer link)
Inflation Report May 2013 - Bank of England
Free Banking in Britain - Lawrence White, Institute of Economic Affairs
(also see Freebanking.org)
Why savers should put up or shut up - Azizonomics
Do savers need to be saved? Carola Conces Binder, Noahpinion
Money market funds series - FT Alphaville (h/t Left Outside)
Understanding the permanent floor - Scott Fullwiler
Anatomy of a bank run - Coppola Comment
Why did FDR's Bank Holiday succeed? - NY Fed
Peer to peer lending review - Which?
Lender, beware - Frances Coppola, Pieria
How do central banks set interest rates? - Benjamin Friedman & Kenneth Kuttner, NBER
The market reaction is definitely not what the Bank was looking for at all - Toby Nangle, Pieria
The illusory housing recovery - Coppola Comment
Many thanks to John Aziz, Carola Conces Binder, Left Outside and Trader Coach for their input to this post.