I've criticised the "green QE" proposal before. But this is a particular framing of it that raises some interesting issues about the nature of currency unions and the purpose of monetary policy.
Here's the heart of Richard's proposal:
It is worth explaining what I think the SNP is referring to when it mentions ‘innovative finance mechanisms’. It is my belief that they are referring to green infrastructure quantitative easing,which was the subject of a speech I made at the Convention of Scottish Local Authorities conference in March. In that speech I made clear that if the SNP wanted to do a service to Scotland, and to the rest of the UK, it would use its bargaining power after May 7 to demand that the UK government create a new form of quantitative easing that would be quite deliberately intended to provide the funding for new investment in infrastructure, housing, new energy systems, transport and the other essential underpinnings of growth in Scotland and throughout the UK.
This form of quantitative easing is entirely possible. As an example, the proposed Scottish Development Bank could, using this form of quantitative easing, issue bonds to the finance markets (because that is what EU law requires) that could then be repurchased by the Bank of England using funds specifically created by for this purpose.So, Richard's proposal has two parts:
- bond issuance by a government agency to fund infrastructure projects
- purchase of those bonds by the central bank using newly-created sovereign money.
The first part is eminently sensible. The UK has a desperate need for infrastructure development, while institutional investors such as insurance companies and pension funds have a desperate need for long-term investments giving low stable returns. There is clearly an opportunity for the next UK government to seize.
Furthermore, the crying need for regional rebalancing in the UK suggests that a network of regional development banks might be a better approach to the investment crisis than a single UK-wide institution. So it makes sense for the next UK government to create a network of regional Development Banks, of which the proposed Scottish Development Bank would be one. These regional Development Banks would issue their own bonds to fund infrastructure and other long-term developments in their regions.
So there is in principle no problem with the idea of a Scottish Development Bank issuing bonds to finance infrastructure, housing, renewable energy systems and transport improvements in Scotland, as Richard suggests. The framework would be similar to the EU's Juncker Plan: the Scottish government would provide capital to the Scottish Development Bank, which would then leverage that capital by issuing bonds to the private sector.
However, I would at this point issue a strong warning to a Scottish government interested in "innovative financing mechanisms". Innovative finance has a way of turning round and biting you if you don't pay attention to where the risk ends up. Juncker's plan is based entirely on public sector guarantees and leveraging of funds already committed to other enterprises. This is a recipe for disaster. State-owned banks can fail if they don't have enough real capital. And it isn't safe to assume that there will be no significant losses on long-term infrastructure projects. My uncle owned subordinated bonds issued by Eurotunnel in its very early days, some of which I inherited on his death. After years of losses they were eventually written down to zero. So a Scottish Development Bank must have sufficient REAL capital - i.e. Scottish taxpayers' money uncommitted elsewhere - to provide a reasonable cushion for leveraged infrastructure finance.
Part 2: Monetising the bonds
This is where the second part of Richard's proposal comes in. He envisages the creation of what we could describe as a "pump". The Development Bank would issue the bonds: the Bank of England would buy them: interest and repayments would be repatriated to the Government and effectively written off. It would, in short, be completely circular. The debt would be off the Government's books, any losses would be absorbed by the Bank of England and the new money would reflate the economy. What could possibly go wrong?
In a follow-up to my post about Juncker's synthetic CDO, I described such a "pump" mechanism involving the EIB and the ECB. And I suggested that the Juncker Plan had been concocted by Juncker and Draghi jointly with the intention of taking advantage of the ECB's forthcoming QE programme. There was no doubt at the time that the ECB planned to do QE, and EIB bonds are eminently suitable for ECB purchase because of their triple-A rating. Increasing EIB issuance to fund much-needed Eurozone infrastructure investment would be an effective way of channelling QE money directly to where it is needed. It's a very clever scheme.
But Richard's plan, although apparently similar to Draghi's Machiavellian scheme, is in fact fundamentally different. And it carries huge risks.
Let's suppose that the SNP does succeed in persuading the Westminster government to instruct the Bank of England to buy infrastructure bonds. To keep it simple, I'm going to assume that only bonds issued by a single UK Development Bank can be bought. This is in fact how the Juncker-Draghi Plan works, since the ECB and EIB are both pan-EU institutions backed by the taxpayers of all countries in the union. Why would instructing the Bank of England to buy bonds issued by a UK Development Bank be a problem?
The key difference is that the Juncker-Draghi Plan does not involve "instructing" the ECB to do anything. Indeed no fiscal authority in the EU has the authority to do so. Rather, the fiscal plan is created to take advantage of the ECB's existing monetary policy plans. This is "monetary dominance"; the fiscal authority responds to the monetary authority. In contrast, Richard's plan would force the Bank of England to CHANGE its monetary policy stance in order to do the bidding of the fiscal authority. This is "fiscal dominance", and it would mean the end of operational independence for the Bank of England. It's quite a problem, considering that the UK is a member of the EU, which enshrines the independence of central banks in treaty directives, and the Bank of England is a member of the Eurosystem and therefore (in theory) answerable to no-one.
To be sure, I have pointed out before that "independence" for a central bank is an illusion: central banks are only as independent as politicians allow them to be. So the loss of independence is perhaps not the main problem. Far more important is the fact that if the fiscal authority forces the central bank to purchase bonds without regard to the monetary conditions in the economy, the central bank can no longer control inflation. This was demonstrated by Sargeant & Wallace in one of my favourite academic papers, "Some Unpleasant Monetarist Arithmetic".
Richard recognises the potentially inflationary impact of such a programme:
So long as e-printing money to pay for investment is kept at sensible levels to prevent the risk of serious inflation this process of green quantitative easing could be used to fund the investment Scotland wants and badly needs without risk.But this means that responsibility for controlling inflation would no longer rest with the central bank. It would rest with the government agency issuing the bonds. As long as the Bank of England was expected to underwrite infrastructure bond issuance, the path of inflation would be determined not by short-term interest rates but by the nominal value of bonds issued. This would be a fundamental change in the conduct of monetary policy. Indeed it would be hard to see how there could be any such thing as "monetary policy". Monetary conditions would be principally determined by the political imperative to invest in infrastructure.
And this creates a further problem. QE is done on the basis that it can be reversed, so that the effect of the monetary expansion is - at least in theory - temporary. Richard's proposal, however, envisages that purchased bonds would be cancelled. This would therefore be permanent expansion of the money supply. Some consideration needs to be given to how monetary conditions could be tightened if inflation started to rise, since the Bank of England would lack the means or the authority to sell the bonds it had purchased.
Currently, the Bank of England has no plans to do more QE, so it is not possible to construct anything remotely like the Juncker-Draghi plan. Richard thinks the Bank of England is wrong:
And let’s be clear: we printed £375 billion to pay for quantitative easing to bail out the financial markets in the three years from 2009 to 2012 and the outcome is that we now have zero per cent inflation, which is less than anyone thinks economically desirable. So we do in fact need new quantitative easing now to create the new money the economy badly needs to create the moderate inflation that keeps the economy on an even keel.But sorry, Richard, if this is what you think then you need to influence the views of those on the MPC, not try to end the Bank of England's responsibility for monetary policy.
In short, Richard's proposal is for outright monetisation of sovereign debt. I have argued that monetisation of existing debt when growth is stagnant and both inflation and interest rates are negative and expected to remain so carries little inflationary risk. But the UK is not Japan, and this proposal monetises new debt, not existing debt. I'm worried about the replacement of the nominal interest rate anchor with a "quantity of bonds" constraint that is subject to fiscal dominance, and the lack of any mechanism for tightening monetary conditions if inflation started to rise. Maybe it's just me, but I can't help thinking this would not end well.