Is it time to ditch Monetary Policy?

Currently Monetary Policy attempts to control inflation and steer the economy through interest rate changes. The proposal of MMT advocates, on the other hand, is that interest rates should stay low permanently. Any inflation should be controlled through changes in taxes. (MMT actually says it will not even come to inflation, see Scott Fullwiler’s note here). Let us examine the two systems:

What happens at the moment? About  once a month the Monetary Policy Committee of the Bank of England decides by majority vote which way the main reference lending rate should go, it implements it through monetary operations within the banking system. High rates dampen economic growth, low rates will lead to more investment. That is the theory.

Let’s say the Bank of England increases the rate. Many other interest rates will adjust upwards, based on the decisions of the lenders in commercial banks, which follow the lead of the Bank of England. What does an increase in rates mean?

Anybody in the economy borrowing money will have to pay more interest, reducing the amount available for consumption or investment. So people or companies who borrow a lot will be worse off.

As a general rule, it is the poorer people who have the largest borrowing (relatively to their income). So if rates are raised, the poor and businesses lose spending power, while the rich (they have the most savings) will gain, as interest on their savings go up. But rich people will not necessarily spend more if they have extra savings income (they have a higher propensity to save), so consumption on the whole stays lower.

Here is a graph who borrows by income decile.



Equally, investments by businesses will not be undertaken because (a) the economic outlook might be worse and (b) borrowing for new business activities will now be too expensive, due to higher interest rates.

Also, it will be mainly the relatively young of the working population with huge borrowings who will be affected. Older folks who have already paid off their mortgages will not be effected.


So any increase in interest rates is a transfer of the young and productive part of society, and business, to the older generation of savers.

Clearly, extreme increases in interest rates have very bad effects. People forget that the worst happened under the Tories, with recessions which were entirely caused by high interest rates. In the early 1980s it was particularly brutal, leading to the permanent closure of many industries and destroying a huge chunk of British manufacturing capacity.

Businesses were not only affected by the extreme high interest rates, but they were equally affected by the rise in the value of the pound which made exports uncompetitive.

The recession in the early 1990s led to record numbers of home repossessions as mortgage holders failed to cope with higher mortgage rates. Both times Britain had record levels of unemployment, much worse than following the most recent recession 2008/09.


Can Monetary Policy considered to be a success?

In my view it has been an abject failure. Inflation was crushed in the early 1980s and 1990s recession, yes, but at a very high cost of destroying industry and throwing millions of people out of work.

In addition, the Bank of England could not prevent nor predict the 2008/09 recession. Interest rates therefore were clearly not the only determinant of economic performance. The risk to the economy from the financial sector,  due to lax supervision, partly by the Bank of England, and insufficient equity capital in banks, turned out to be the main determinant of the crisis.

After the economic shock in 2008 became apparent, reducing rates quickly helped borrowers (the poor). On the other hand, the Quantitative Easing (QE) measures helped mainly the rich again, who benefited, as the main asset holders (property, shares, bonds), from these measures which prevented a slump in asset prices.

Central Banks will argue that QE helped the poorer sections of society too, as huge unemployment was avoided and the slump was less bad than it could have been. They are certainly right. Here is the ECB making these claims (ludicrously stating that the poor were helped more through QE), and here the Bank of England.


However, the richer households were, in monetary terms, much better off than the poorer ones.



What could have been?

What it fiscal measures (extra taxes) had been used in early 1980s and 1990s?

Undoubtedly that would have been a better way to deal with high inflation. Raise taxes to take demand out of the economy, why not? The pain of adjustments could have been spread over the whole of society (all taxpayers) and would have avoided the destruction of British manufacturing to a large degree and had kept Britain more competitive internationally with a lower exchange rate.

Is Monetary Policy completely useless – it helped in 2008, right?

Reducing rates from 5% to 0.5% after 2008 certainly helped. But these rates have been stuck at that low level pretty much for 10 years. And about £450bn has been pumped into supporting asset prices through QE, amounting to about a fifth of total government debt.

So extreme high interest rates certainly help to crush inflation (and the economy) whereas extremely low rates reduce the impact of recessions. The evidence of any changes in between (say, from 4% to 5% over the cause of a year) is less conclusive.

And the next recession?

Everybody worried about MMT seems to worry about inflation rising. However, the more likely event is surely another recession. The Monetary Policy cupboard is pretty empty. That is also the view of a former vice-president of the European Central Bank. Rates cannot be cut back much further from the current level of 0.75%, and that will have only a marginal effect. Equally, more QE might suffer from the same problems as the previous round. The asset rich will benefit, everyone else less so.

So that leaves fiscal policy. The government should spend more money into the economy. There are challenges out there which need to be tackled, like climate change, insufficient affordable housing, inequality. If £450bn were spent directly into the economy, that would allow the UK to increase spending by 20% each year over current expenditure over 5 years. We could have done that, of course, in 2008, in which case we would be further advanced in our aims for housing, climate mitigation, or inequality. We wasted it.

It is time to take this on board, keep our low interest rates and tackle the challenges ahead. Let us get ready for the next recession, lets plan for it. In the unlikely event that inflation will become a problem, it is of course possible to tackle it equitably and early with tax changes.

Given the inadequacy of interest rate changes to steer the economy, avoid recessions, cause unemployment, harm industry and cause an increase in inequality it is time for Monetary Policy to be scrapped. It would be replaced by government spending which is only restricted once inflation becomes a problem.

Fiscal spending and taxes is vastly superior to manage demand, especially compared to damaging and regressive changes in interest rates and QE.



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