Monetary policy under the Coalition

In this piece David Cobham assesses the contribution of monetary policy to the economic recovery. He argues that once the basic choice of fiscal austerity had been made the authorities searched, largely in vain, for ways to make monetary policy boost demand in compensation. No doubt the recession would have been even worse without the monetary expansion that was implemented, but there is no sense in which normal operations have been restored.

Cobham’s paper on monetary policy under the last Labour government is free to view until the election, via the Labour government page. See also this short piece on common misconceptions about the crisis:

The role of monetary policy over this period was determined from the start by the government’s basic choice of ‘austerity’ in the sense of fiscal consolidation: with the economy in a deep recession (though it had been recovering before the election) and fiscal policy affecting aggregate demand negatively, monetary policy needed to be made more expansionary even though the policy interest rate was already (since March 2009) at its effective lower bound of 0.5%.

The government therefore sought a significant increase in ‘monetary policy activism’. In the short term the Bank of England embarked on further rounds of quantitative easing, while the Treasury offered credit subsidies in the form of Funding for Lending and Help to Buy, and the government appointed a new governor from June 2013 who was known to support ‘forward guidance’ and duly introduced it in the UK.

1.  Quantitative easing (QE) and monetary growth

When interest rates cannot be reduced further, monetary expansion can be delivered most obviously by expanding the money supply through the process called quantitative easing. In the first round of QE before the election, between March 2009 and January 2010, the Bank of England had bought £200 bn of financial assets (mostly UK government bonds). Two further rounds of QE, referred to as QE2 and QE3, involved another £175 bn of asset purchases between October 2011 and November 2012.

Such purchases lead to increases in the bank deposits of the non-bank private sector (initially the deposits of the non-bank financial institutions that sell their gilts to the Bank of England, mainly pension funds and life assurance companies). These deposits are part of the broad money supply. At the same time the asset purchases bring about increases in the deposits of the banks at the Bank of England.

Figure 1 shows the four-quarter growth of the Bank of England’s preferred measure of broad money, M4ex, and its two principal ‘credit counterparts’, bank lending to the non-bank private sector and the public sector’s contribution to monetary growth (the budget deficit minus borrowing from the non-bank private sector), in each case as a percentage of the outstanding stock of M4ex.

Three things stand out from this graph. First, in the period before the crisis the growth of M4ex closely reflected the growth of M4ex lending (bank lending to non-banks), but that collapsed in the crisis. Second, the public sector’s contribution, which had been minimal before the crisis, became very large in 2009-10 and large again in 2012 (as the result of QE), offsetting the negative or very low levels of bank lending and ensuring that the money supply did not fall. And third, bank lending has still not returned to anywhere near the level it maintained throughout the pre-crisis ‘Great Moderation’ period.

There is considerable agreement that QE1 had a positive effect on GDP growth. Initial studies from within the Bank identified significant effects of QE on long-term bond yields, but the Bank’s later studies of the wider macro effects estimated that QE raised GDP, relative to what it would otherwise have been, by 1½ to 2% and inflation by ¾ to 1½% (Joyce et al., 2011). Some other studies found larger effects: Cobham and Kang (2012) estimated that in the absence of QE nominal GDP in 2010 Q1 might have been between 3% and 11% lower, while Baumeister and Benati (2013) thought that without QE inflation could have fallen to minus 4% and real GDP growth to minus 12% at an annual rate.

However, non-Bank of England observers were less convinced of the effectiveness of the asset purchases in QE2 and QE3 (Goodhart and Ashworth, 2012; Martin and Milas, 2012): yields seemed less affected, the rise in corporate issuance of equity and bonds during QE1 was not repeated, and the international climate (the eurozone crisis) made it harder to isolate the effects of UK QE. In addition, while the large depreciation of sterling in 2007-8 may have contributed to the higher growth ascribed to QE1, it did not recur in a way that would have affected the outcome for QE2 and QE3.

At intervals from late 2012 there was speculation about a further round of QE, and three of the nine members of the MPC voted for (smallish) additional asset purchases in each of the meetings between February and June 2013. But there was never a majority for this, and after June 2013 the issue was dropped. On the other hand, there has been little discussion so far of unwinding the asset purchases, that is, selling off the gilts the Bank had acquired. It is generally understood that interest rates would be raised first, and assets resold only later, in a controlled and orderly process.

2. Funding for Lending and Help to Buy

In July 2012 the Bank of England and the Treasury launched the new Funding for Lending Scheme (FLS) which provides banks with a source of funds other than that obtained from retail deposits or wholesale markets. These funds would be made available more cheaply, and in larger amounts, to banks which increased their lending to households for mortgages, to companies and to buy-to-let landlords: banks were given an incentive to lend more. The scheme was extended in 2013 and again in 2014.

The Help to Buy (HB) scheme was started in April 2013 (in England but later schemes covered the rest of the UK too). At that time it offered equity loans of up to 20% to first-time buyers and people buying new-build homes, but the scheme was extended to provide mortgage guarantees of up to 15% to lenders where buyers put down deposits of 5%, so that lenders could offer better terms.

Both these schemes are essentially subsidies to particular types of credit, and their likely effect on house prices – if borrowers can borrow more easily, then they can bid more for the properties they seek to buy – was widely criticised. While it is not possible to be sure of the causes, house prices began to rise more strongly in 2013 and especially 2014, with a peak in 12-month growth of 12.1% in September 2014 (UK, all dwellings, ONS data).

House price growth was higher in London, the East and the South East of England, but much lower in Wales and the North West, with other regions in between. Concerns about a fresh house price bubble led to mortgage lending being made no longer eligible under the FLS in the autumn of 2014.

Bank lending, on the other hand, remained (in total) well below the period before the crisis, as is clear from Figure 1: as a percentage of M4ex, bank lending to the non-bank private sector (four quarter change), which had fluctuated around 15% between 2000 and 2007 and collapsed in 2009-10, became positive again in late 2011 and 2012 (with a peak of only 1.7%), but went negative again in 2013 before returning to the positive in the second half of 2014. While we cannot be sure how much banks would have lent in the absence of FLS and HB, it is clear that there has not been a significant revival of lending.

Figure 1: Growth of money supply and its main credit counterparts (growth since four quarters earlier, %)

cobhamfig1Source: Bank of England statistics

3. Forward Guidance

Mervyn (now Lord) King’s second term of office as governor of the Bank of England came to an end in June 2013, and he was succeeded by Mark Carney, who was appointed in November 2012 while he was still governor of the Bank of Canada. Carney was known for pioneering ‘forward guidance’ at the Bank of Canada and for his position as chair of the international Financial Stability Board, and from his appointment it was expected that he would introduce some forward guidance in the UK. The MPC unveiled its forward guidance policy in August 2013.

The MPC said that interest rates would not be raised until the unemployment rate came down to 7%, unless (a) its inflation forecast for 18-24 months ahead was 0.5 or more above its 2% target, and/or (b) inflation expectations were no longer ‘well anchored’, and/or (c) the Financial Policy Committee decided that the current interest rate level was posing a threat to financial stability which could not be dealt with by other (macroprudential) means.

Technically this is a ‘state-contingent’ rather than open-ended or time-contingent type of forward guidance, that is one where a rise in interest rates would depend on the state of the economy. The policy was justified by the MPC in three ways: (1) it would give greater clarity about the trade-off between the speed at which inflation should be returned to target and the speed with which economic growth recovered, (ii) it would reduce uncertainty about the future path of monetary policy, and (iii) it would allow the MPC to explore the scope for expansion without jeopardising price and financial stability.

However, it should be noted that the 7% was a threshold not an automatic trigger, that inflation expectations would be monitored via a range of indicators (survey data, extrapolations from financial market data), and that MPC members would make up their own minds as to whether the ‘knockout clauses’ had been breached. Thus the information conveyed in the guidance was hardly clear-cut or precise, in which case its contributions to controlling inflation expectations and reducing uncertainty could be expected to be limited. [I have suggested elsewhere that the initial guidance was so opaque because it emerged from a policy disagreement between a Treasury pushing for the Bank to introduce the policy and MPC members trying to formulate an intellectually respectable version of it. See Cobham (2013).]

In the event the unemployment rate fell more quickly than expected, going below the 7% threshold in the period December 2013-February 2014, but by then the MPC had issued fresh guidance which emphasised the continuing spare capacity in the economy, to be assessed by a range of indicators including the growth of wages. As of March 2015, the unemployment rate was well below 6% and expectations were for interest rates to rise only some time in 2016. However, the initial confusion over the meaning of the guidance and the subsequent changes to that guidance make it difficult to regard the policy as coherent or, given the speed and quality of the recovery, successful.

4. Alternatives and debates

The crisis and the difficulties of the recovery period have stimulated debate on possible alternative frameworks for monetary policy, other than the inflation targeting which the UK has pursued since the 1990s. There has been discussion of price-level targeting and nominal income targeting (growth and level), but these alternatives each have their disadvantages (Goodhart et al., 2013) and no consensus has developed.

A general problem with each of these is that a higher rate of monetary expansion might be required in order to attain the new targets, but – with the effects of QE waning, credit subsidies having failed to revive bank lending and forward guidance largely incoherent – the monetary authorities lack adequate instruments to bring that about. There have also been calls for modifications of current arrangements in the form of a rise in the inflation target (Ball, 2014), the continued use of the central bank balance sheet as an extra instrument (Friedman, 2015) and the formal adoption by the Bank of England of a secondary concern with asset prices (e.g. Cobham, 2015).

The only area on which the Bank of England has concurred and progress has been made is in the introduction of new ‘macroprudential’ instruments by which the new Financial Policy Committee of the Bank of England might try to head off various possible sources of financial instability. These instruments include the ability to vary the amounts of own capital the banks are required to have relative to their outstanding loans, and the ability to limit loan to value and debt to income ratios in the mortgage market.

While such measures seem eminently desirable, there are open questions about how the Financial Policy Committee will interact with the Monetary Policy Committee (Shakir and Tong, 2014), and since the effects of these instruments are likely to vary with the state of the economy (Harlmohan and Nelson, 2014) it is arguable that monetary policy will need to be kept as a backstop policy for financial stability (in addition to its role as principal instrument for price stability).

5. Outcomes

Figures 2 and 3 show the outcomes for the level of GDP and the rate of inflation in the UK, the Eurozone and the US. Figure 2 makes clear that the UK had a much deeper fall in GDP from the crisis than the Eurozone (as a whole – individual countries had different trajectories) or the US, which moved remarkably closely together until the end of 2011 when the US began to recover strongly while the Eurozone stagnated. The UK recovered somewhat in 2010 but between late 2010 and late 2012 its recovery was meagre, and it was only in 2013 that a more substantial recovery got under way.

This pattern is consistent with the view that the Coalition’s choice of austerity in the early years reduced UK growth in 2010-11 and 2011-12 (see Simon Wren-Lewis’s piece in this collection), while the resumption of growth from 2013 is consistent with the view that austerity had been quietly put on hold from 2012, together with the slow and partial bounce-back that can be expected of squeezed market economies.

Figure 2: GDP levels, UK, US and Eurozone


Source: International Financial Statistics (IMF)

Figure 3 shows that the UK experienced much the worst inflation over these years of the three currency areas shown, with a sharp peak in late 2008 and a more long-lasting rise in late 2011, which may have reflected the sterling depreciation of late 2007 and 2008 as well as fluctuations in world commodity prices (and the January 2011 rise in VAT). The recent further sharp fall in UK inflation, which has enabled a limited recovery in living standards after years of decline, is also heavily international in origin.

Figure 3: Consumer price inflation UK, US and Eurozone


Source: International Financial Statistics (IMF)

6. Conclusions

The monetary history of this period is a history of a search for ways to make monetary policy more expansionary, to overcome the drag on growth due to fiscal austerity measures which, as Wren-Lewis points out, were not required by the Coalition government’s new fiscal rules and are hard to explain. The search included further quantitative easing, the credit subsidies of FLS and HB, and forward guidance (facilitated by the appointment of a new governor), but there remains a shortage of effective monetary instruments.

The overall framework for monetary and financial policy was changed by the establishment of the Financial Policy Committee at the Bank, whose new macroprudential focus had its first test in trying to head off a nascent house price bubble caused, at least in part, by the credit subsidies. The monetary policy developments were mostly responses to short term problems, and not very successful ones at that, but the changes to the framework are likely to outlast the Coalition.



  • Ball, L. (2014), ‘The Case for a Long-Run Inflation Target of Four Percent’, IMF Working Papers 14/92
  • Baumeister, C., and Benati, L. (2013), ‘Unconventional Monetary Policy and the Great Recession: Estimating the Macroeconomic Effects of a Spread Compression at the Zero Lower Bound’, International Journal of Central Banking, 9(2), 165-212
  • Cobham, D. (2013), ‘Forward guidance in the UK: holding rates down till something happens’, in W. Den Haan (ed.), Forward Guidance, VoxEU ebook
  • Cobham, D. (2015), ‘Multiple objectives in monetary policy: a de facto analysis for ‘advanced’ countries’, forthcoming in Manchester School
  • Cobham, D., and Kang, Y. (2012), ‘Financial crisis and quantitative easing: can broad money tell us anything?’  Manchester School, 80 (s1), 54-76
  • Friedman, B. (2015), ‘Has the financial crisis permanently changed the practice of monetary policy? Has it changed the theory of monetary policy?’, forthcoming, Manchester School
  • Goodhart, C., and Ashworth, J. (2012), ‘QE: a successful start may be running into diminishing returns’, Oxford Review of Economic Policy, 28(4), 640-70
  • Goodhart, C., Baker, M., and Ashworth, J. (2013), ‘Monetary targetry: possible changes under Carney’, Morgan Stanley Research Europe
  • Harlmohan, R., and Nelson, B. (2014), ‘How might macroprudential capital policy affect credit conditions?’, Bank of England Quarterly Bulletin, Q3, 287-303
  • Martin, C., and Milas, C. (2012), ‘Quantitative easing: a sceptical survey’, Oxford Review of Economic Policy,28(4), 750-64
  • Shakir, T., and Tong, M. (2014), ‘The interaction of the FPC and the MPC’, Bank of England Quarterly Bulletin, Q4, 396-408

Financial regulation under the coalition government

In this, the third article on Coalition Economics, Arup Daripa and Sandeep Kapur (Birkbeck, University of London) examine the changes to financial regulation made since 2010. They argue the Coalition has improved the overall regulatory architecture with respect to systemic risk, but made little progress on either the regulation of shadow banking activities or the introduction of methods of resolving (winding down) large banks that get into trouble. Daripa and Kapur’s earlier assessment of financial regulation under the Labour government, 1997-2010, is included in the special journal edition which is free to download until the election.

  1. Introduction

The Coalition government came to power in 2010 in the wake of a financial crisis that had exposed significant weaknesses in the UK’s financial regulatory structure. The new government’s early attempts to repair these weaknesses had two elements: to the extent the financial crisis was seen as a banking crisis, it set up an Independent Commission for Banking (ICB) to identify the fault-lines. But it also launched an overhaul of the institutional architecture of financial regulation in the UK, leading to the Financial Services Act 2012. This note assesses the Coalition’s record and achievements in the area of financial regulation.

While the financial crisis focused attention on the failures and near-failures of some of the UK’s largest retail banks, to a large extent the underlying problems had emerged from the so-called shadow banking sector. This sector comprises a variety of non-deposit-taking financial institutions which engage in maturity transformation like retail banks but lack any protection for their creditors. Without protection, this sector is particularly vulnerable to wholesale ‘runs’, if short-term lenders decide en masse not to roll over their debt or demand large ‘haircuts’ to do so. In the recent crisis, problems arose initially in markets for securities backed by subprime mortgages, but metastasised into a broader crisis of illiquidity, and eventually came to stress the balance sheets of retail banks.

Once market turmoil sets in, any fragility of financial intermediaries is vulnerable to endogenous amplification mechanisms. A bank that wants to repair its stressed balance sheet may choose to deleverage by selling some of its assets. While optimal from the standpoint of a single bank, when many financial institutions make similar adjustments simultaneously, asset prices fall; this triggers further adjustment of leverage by additional sale of assets. This ‘fire-sale externality’ may be exacerbated by a ‘haircut spiral’ as lenders in repo markets demand larger discounts to lend against collateral. In the recent crisis, the combination of falling asset prices and large haircuts created a downward spiral that threatened systemic stability.

The principal lessons from the crisis are clear. One, in order to manage systemic risk, we must regulate all institutions deemed systemic, whether they are conventional banks, investment banks or shadow banks. Two, microprudential regulation of individual institutions does not per se guarantee systemic safety, and additional tools must be employed for macroprudential regulation. Three, when a crisis sets in, some form of liquidity provision facility is essential to guard against a sudden loss of investor confidence. Finally, large, complex, systemically-important financial institutions should have relatively transparent resolution mechanisms in place. Let us consider the structure and content of regulation proposed by the Coalition government against this background.

  1. The Independent Commission on Banking

As the crisis revealed many UK banks to be quite fragile, the new government established an Independent Commission on Banking in 2010 to explore structural reforms of the UK banking sector to promote its systemic stability. It sought to assess UK banks’ traditional model of ‘universal banking’ which combines both retail and investment banking. It also examined the relatively concentrated structure that had emerged, with a handful of large banks dominating the industry.

The Commission’s report, released in 2011, put forward a proposal to limit the interaction between the retail and investment banking functions in UK banks. It called for the assets and liabilities of the retail and investment banking functions to be separated, and the retail arm to be ‘ring fenced’. The retail arm must carry capital in excess of Basel III regulatory requirements, and only capital above this enhanced level can be transferred to the investment banking part. The purpose of this restriction is to limit the risk that an investment arm that runs into trouble might drain capital from the retail operation. The Coalition government agreed to implement this proposal, but under pressure from the City decided that the restriction would be imposed only after 2019.

In our opinion, the ring-fencing policy addresses the wrong problem. The crisis arose not within the traditional banking sector, but largely from the shadow banking sector. Unlike banks that had some depositor protection, this sector was particularly vulnerable to runs once doubts emerged about certain classes of securities. Ring-fencing, had it been in place, could hardly have prevented such runs in repo markets. More generally, systemic stability requires that all systemically important financial institutions be subject to macroprudential capital requirements. Subjecting only banks, or only retail parts of banks, to capital restrictions simply creates distortions without much gain in systemic stability. Indeed such ring-fencing can even increase systemic risk. If the investment banking part is in trouble, a universal bank may have an incentive to shrink its retail balance sheet so that excess capital can be released to support its investment banking arm. Such asset sales can trigger fire-sale externalities.

Further, the ring-fencing proposal seems to implicitly assume that the main problem in a crisis is that of solvency. In the recent crisis many financial intermediaries who required central bank support were solvent but illiquid. A ring-fence would, once again, have made this problem worse. The liquidity from depositor funds is typically unaffected in a crisis because such funds are backed by depositor insurance (which, when designed properly, eliminates depositor runs). If the crisis is primarily one of liquidity, access to depositor funds can help investment banking activities in a crisis. Overall, in our opinion, the implementation of the ring-fencing proposal would be a step in the wrong direction.

  1. A new structure for prudential regulation

In the tripartite regulatory structure created by the Labour government, the Bank of England, the Treasury and the Financial Services Authority (FSA) were collectively responsible for financial regulation. This arrangement had transferred microprudential regulation of banks, and also regulation of their conduct, to the FSA, while financial stability and lender-of-last resort functions remained a responsibility of the Bank of England. This tripartite structure was seriously tested by the crisis: with insufficient communication between the various parties as events unfolded, and poorly assigned responsibilities, this arrangement was found to have a ‘regulatory underlap’.

The Coalition government remedied this by reforming the institutional structure of financial regulation, specifically to improve macroprudential oversight. A new Financial Services Act 2012, which came into force in April 2013, abolished the FSA and divided its tasks across different bodies. Conduct regulation was transferred to a new body, called the Financial Conduct Authority (FCA). A Prudential Regulation Authority (PRA) was set up under the Bank of England to return microprudential regulation to the Bank of England, while a Financial Policy Committee (FPC) was established in the Bank to maintain systemic oversight. The FPC is tasked with monitoring overall levels of leverage and credit growth in the financial system and makes policy recommendations to the PRA and FCA as well as to the Treasury. Along with the existing Monetary Policy Committee, the FPC and PRA together puts the Bank of England in charge of monetary policy, prudential bank solvency as well as systemic financial stability, making it one of the most powerful central banks in the world.

The new arrangement enables better macroprudential oversight and, as such, is a move in the right direction. However, the arrangements fall short when it comes to regulating shadow banks. In the US, the Dodd-Frank act of 2010 includes a number of measures to achieve precisely such control. The lack of any comparable attempt at gaining control over the shadow sector remains a significant weakness of the current UK regime.

  1. Regulation of conduct and practice

The Financial Services Act 2012 hived off the regulation of financial services to a new Financial Conduct Authority (FCA). Consumer protection is its key remit, but the FCA is also responsible for some broader regulatory functions, notably preventing market abuse (such as insider dealing or market manipulation) and for promoting competition and innovation. Its mandate covers all firms providing retail or wholesale financial services (for instance, banks, building societies, insurance companies); its enforcement powers come from its ability to exclude individuals and firms from financial markets, to investigate financial crime and to seek criminal penalties through the legal system.

Pre-crisis conduct regulation in the UK had been celebrated as ‘light touch’. Given the extent of corporate excess and malfeasance revealed in the wake of the financial crisis, some regulatory tightening was inevitable. Indeed regulatory tightening had commenced while the FSA was still in charge, and the FCA has largely continued that task using institutional assets and personnel it inherited from the FSA. In recent years, the FCA has led the investigations into the manipulation of LIBOR and foreign exchange markets by UK banks. The value of financial penalties has risen from about £34 million in 2009-10 to £425 million in 2013-14, and the FCA has also resorted to issuing public warning notices as a deterrent.

However the choice of regulatory intensity presents a familiar dilemma for the Coalition. The financial services industry continues to be a very substantial part of the UK economy and continues to lobby against ‘excessive regulation’ that might damage London’s position as a leading global financial centre. But stronger enforcement may be critical for restoring public trust in financial institutions tainted by scandals. The on-going debate over excessive personal remuneration in the financial sector offers a case in point: despite the public hostility to a culture of large bonuses, the UK government has lobbied aggressively against EU attempts to restrain high performance-related pay in banks, and even sought legal challenges against European directives that aim to do so. Given the Coalition’s reflexive preference for laissez faire policy wherever feasible, there is the risk that choice of regulatory intensity may be distorted by ideological considerations.

  1. Private debt restructuring

Recent research has thrown light on the importance of private-sector debt, especially housing debt, in determining the severity of crises as well as the duration of the recessions that follow. Jorda et al. (2014), drawing on data from banks’ balance sheets for 17 advanced economies since 1870, show that mortgage lending by banks has been the driving force behind the rise of the financial sector. Mortgage credit accounts for the bulk of the episodes of credit expansion and these episodes tend to be followed by deeper recessions and slower recoveries. This research programme puts housing finance at the centre of the economy, with significant responsibility for financial instability.

A related research programme by Mian and Sufi has examined disaggregated data on credit and spending from the US. Using a rich variety of sources, they establish that, after the collapse of the housing bubble destroyed the net worth of indebted individuals, the withdrawal of their private demand, more than any credit crunch, has prolonged the recent recession. If so, restructuring of housing debt must form a crucial element of any financial policy reform to enable faster recovery. The ‘Help to Buy’ programme in the UK, which involves provision of public equity to support investment in housing (the government puts up 20% of the purchase price thus absorbing 20% of any subsequent capital gains or losses), is a step in this direction.

  1. Conclusion

Financial regulation is not easy. Regulated entities tend to devote far more resources to avoiding any regulatory burden than those available to the regulator in enforcing regulation. This reduces the information content of the measures that the regulator depends on. Further, regulation gives rise to a boundary problem: regulated entities have the incentive to try to locate economic activity just outside the purview of the regulatory authorities, as evident from the rise of shadow banking. It follows that any regulatory regime is bound to be imperfect and future crises cannot be ruled out. Casting the regulatory net as widely as possible to contain systemic risk, and planning for a soft landing should therefore form crucial parts of any regime of financial regulation.

Since 2010, the Coalition government has improved the regulatory architecture to better manage systemic risk, but the lack of any progress towards regulating shadow activities remains a significant weakness in the UK regime. The ICB proposal adds little in this regard. As for containing future crises, there remains the crucial task of designing transparent resolution mechanisms for large financial intermediaries, so that debt holders are prevented from free-riding on the public purse. A debt-restructuring regime for distressed mortgage holders would help in the event of any collapse in real estate prices. However, very little progress has been made on either front so far.



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