Both QE and FLS are in a mess

George Osborne’s nanny state policy responses are failing our banks and perverting our markets. In the midst of the political rhetoric on welfare and debt, there is one economic policy that the chancellor has implemented which has a genuinely significant impact: Quantitative Easing (QE).

This has had a profound impact on the economy.

The normal way for the money to be supplied into the economy is for banks to provide loans. If ten £1k loans are made for every deposit of £1k, then £9k of new money has been put into circulation. The banks are liable for it if it isn’t paid back, so they have become expert at judging risk. The supply of money makes a good demonstration of the private sector achieving a public good, normally.

The problem is that lending is too slow. As a result there is a lack of new money going into the economy but people are continuing to repay the loans they previously took out. The net effect is less and less money in the economy. If money is the oil on the cogs, then without it, the machinery will grind to a halt.

As a policy response, we’ve had QE. The Bank of England is creating money on a grand scale. Under Quantitative Easing they have so far produced an extra £375billion. In this respect it is the largest nationalisation of private sector service since the 1945 Labour government. I wonder if George Osborne realises that.

For a long time the banks have been receiving contradictory instructions from government. They must lend more, but they must increase their capital reserves. It’s like telling a schoolboy to spend his pocket money then scolding him for not saving it.

As a result, innovative policies are not only proving expensive but also potentially counter-productive. The government driven Funding for Lending Scheme (FLS) aims to subsidise bank lending for small businesses.

It is bad economics. It has lowered the interest paid to savers, but achieved little increase to the loans given to small businesses. With the state competing with savers, the banks no longer need to attract deposits as they have cheaper source with government cash.

This acts as a disincentive to savers to place their capital on deposit, making the banks dependent on future state handouts. Further to this, by reducing the return on savings, the policy reduces consumer spending. By the way, for every SME loan, that state gives the bank x10 of capital under FLS. As a taxpayer you should be aware of that.

This is not just a mess, it is also a hypocrisy. We constantly hear from George Osborne that the state is bad and the market is good. Feel free to shake your head in disbelief.

However, there is a solution. The £375 billion of QE gilts are currently on deposit at the Bank of England. They are just sitting there. If we put them on deposit with the high street banks, then at a stroke the capital ratios of those banks would be bolstered. The conflict for the banks between building their reserves and increasing lending would be resolved.

If the banks continue not to lend, then we would know that SMEs are not passing the bare minimum requirements to qualify for loans. At least then we would have clarity.

Sometimes it can be better to follow the simple policy responses that support the market, rather than the complex ones that attempt to replace it with state interference. Let’s put the gilts where they have a purpose and mandate the Bank of England to make future asset purchases in non-financial sectors.

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