Christopher Martin is a Professor in the Department of Economics at the University of Bath.
When the history of the COVID-19 pandemic is written, there will be many heroes. In the UK, some of these will enter our national mythology, honoured for their sacrifice and dedication. Central bankers are not heroes. But they will deserve an honourable mention for responding quickly to the developing crisis with large scale and imaginative policy measures.
Unlike some other parts of the UK state, central bankers were well prepared for the pandemic. In response to the 2008 financial crisis, central banks developed a range of innovative tools and ideas that could quickly be deployed as the COVID crisis began to impact the economy.
Central bankers have three main objectives. The first, familiar from 2008, is to stabilise the banking system. Central banks are able to create money, in the form of bank reserves, the safest and most liquid asset there is. They can also lend to commercial banks at preferential rate. Their willingness to do this on a very large scale seems to have reassured financial markets and prevented a public health and economic crisis from also becoming a financial crisis. Achieving this at an early stage is essential for any plan to “restart” the economy once the pandemic has passed.
The second is to maintain lending to firms and households, at low interest rates. The idea here is that large scale borrowing by commercial banks at low rates from the central bank should translate into large scale lending at similarly low rates by commercial banks to households and firms. Here, similar to 2008, the Bank of England has been less successful, despite the Treasury underwriting 80% of losses, through the Coronavirus Business Interruption Loan Scheme. Loans have been slow to reach firms. And interest rates on unsecured lending such as credit cards have increased.
The third, and most important, objective is to finance Government spending. Post-2008, many economists argued that the response of the Bank of England to the financial crisis, although welcome, was not sufficient on its own. This is because central banks can only affect the wider economy via the banking system and via the Government. Since banks were reluctant to increase lending on a significant scale, and since the Government sought to reduce rather than increase expenditure, the economy never had the boost to demand that was required to bring us back up to pre-crisis levels of wages and incomes.
This has all changed. Governments now recognise their leading role in the economic response to the COVID-19 pandemic. There are two aspects to this. The public health emergency requires that large numbers of workers step away from production until the pandemic has passed; currently only around 50% of workers are still at work, while around 16% of workers are furloughed. Two thirds of private sector firms have used the furlough scheme, so that redundancies have remained low (for now), despite 1.4 million additional claims for Universal Credit. But the Government will also need to support demand once the lockdown ends, to ensure that there is demand for the output of newly returned workers, since understandably nervous households are unlikely to increase spending to pre-Coronavirus levels for some time.
This is necessary but expensive. The Resolution Foundation has estimated that a 6-month pandemic would require Government borrowing equivalent to 22% of GDP, a level that has only been seen in wartime; a 12-month pandemic would require borrowing at the unprecedented level of 38% of GDP. The Bank of England has a central role in financing this. With taxes sharply down, this expenditure requires a very large increase in borrowing. The interest rate on this debt has to be low, to prevent the cost of debt service squeezing out more useful types of government expenditure in the coming years. The rate of a 10-year UK Government bonds is currently very low, around 0.3%. This is in part due to the Bank of England restarting quantitative easing by purchasing £435 billion of assets, mainly Government debt, a larger sum than all the QE purchases post-2008. Although the bank will not purchase bonds directly from the Government, these purchases will increase the price of government debt and enable the Government to borrow the £50-60 million per month that will be required at continuing low rates.
Finally, the Bank of England has moved towards financing of government expenditure, so-called Helicopter Money. Advocated by some on the left and long seen as heretical by central bankers, Helicopter Money occurs if the central bank “creates money” by increasing the size of the account that the Government holds at the central bank, enabling the Government to increase spending without recourse to the bond markets.
At present, there is no Helicopter Money in the UK as the Bank of England has only created a credit facility for the Government. This facility has yet to be used and if it is, the intention is that any borrowing “will be repaid as soon as possible before the end of the year.” But if the pandemic persists, repayments can be postponed indefinitely and so Helicopter Money can arise. In the current circumstances, that would be a sensible move.
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All articles posted on this blog give the views of the author(s), and not the position of the IPR, nor of the University of Bath.