A Spot of Monetary Trickery

This was not a U-turn.

The British press is darn sure it is—and taking Prime Minister David Cameron to task for it due to an unfortunate outburst in Parliament last month (more on this in a bit)—but the Bank of England and British Treasury’s new plan to boost the economy is, in fact, in keeping with existing plans.

Now let’s rewind.

On May 23, answering a question on his economic record, Cameron told Parliament, “What we need to do both in Britain and Europe is to combine deficit reduction, which has given us the low interest rates, with an active monetary policy, with structural reforms to make us competitive, and with innovative ways of using our hard-won credibility, which we wouldn’t have if we listened to the muttering idiots sitting opposite me.”

(Cue a scolding from the Speaker and a media frenzy.)

Those “sitting opposite” are, of course, the opposition Labour Party, whose finance spokesman, Ed Balls, has repeatedly (and a bit unfairly, in my view) lambasted Cameron and Chancellor George Osborne for not doing enough to prop up the UK’s economy. With falling eurozone demand impacting British exports and severe fiscal consolidation biting at home, Britain entered recession (by one common definition) last quarter, and Q2 economic data have been mixed. Like many in his political party, Balls believes goading demand through fiscal stimulus is the best fix, and he’s called for a “Plan B” of spending to replace the government’s “Plan A” of cuts and economic reform.

Thus, when Osborne and BOE Governor Sir Mervyn King announced on June 14 a scheme aimed at boosting bank lending, many assumed Cameron decided Balls was perhaps not so idiotic after all—surely, having the Treasury help the BOE provide cheap funding for banks to lend to households and small businesses was Cameron’s Plan B. B-minus, at least.

Only, it’s not. The new program isn’t fiscal stimulus—it’s monetary stimulus, keeping with Cameron’s assertion that “active monetary policy” is the best prescription for Britain. The Treasury’s not pumping money into the British economy through infrastructure spending and the like—it’s underwriting the £80 billion “funding for lending” scheme, through which banks will swap assets with the BOE at monthly auctions, borrow below current market rates for four years and lend the funds to British non-financial firms. Since the Treasury’s backing the loans, collateral requirements are high to limit taxpayer risk—banks can’t dump toxic assets on Her Majesty’s doorstep. But if the program works as intended, it could help banks boost lending to households and small businesses, easing one of Britain’s stronger economic headwinds.

Due to the Treasury’s involvement, some might call this fiscal stimulus dressed as monetary, but to me, that overlooks a critical point: If this were proper fiscal stimulus, the money would flow straight from the government to hand-picked projects (and probably not very efficiently). Now, I don’t think Balls is a “muttering idiot” for suggesting this—he and Osborne seem equally intelligent, and I’ve no preference for either. But the Exchequer’s budget is a touch stretched—Osborne likely can’t boost public spending and meet his deficit reduction target, and there’s no guarantee fiscal stimulus would promote enough near-term growth (and tax revenue) to offset the expense. Taking the monetary route—having the BOE provide private firms with £80 billion to deploy as they see fit—seems more sensible at this point (and likely more efficient).

To improve the program’s chance of success in the face of the eurozone’s ongoing issues, King and Osborne also outlined a new BOE lending facility to give British banks a bit of breathing room should banking troubles cross the Channel. Under the Extended Collateral Term Repo (ECTR) Facility—created last December but not yet used—the BOE will auction six-month liquidity to banks in monthly tranches of at least £5 billion. Banks can use a wide range of collateral—anything eligible at the BOE’s discount window—and for now, the cost is 0.75% (.25 percentage points above the 0.5% bank rate). The first auction takes place Wednesday, and they’ll continue until further notice. It’s unclear how much demand there will be though, considering the plan’s aimed at pre-empting a European disaster—unlikely when the plan was announced last Thursday, and even unlikelier now after Greece’s decidedly less-chaotic-than-anticipated election on Sunday. Still, the firewall’s sheer existence seems positive.

But, here’s the million-pound question: Will these measures kick-start small-business lending, succeeding where previous efforts like Project Merlin and the National Loan Guarantee Scheme (NLGS) didn’t?

Well, thanks to a key policy change announced the following day, there’s a realistic chance this might just work a bit. Project Merlin and the NLGS didn't fail for lack of available liquidity—regulatory uncertainty was likely the primary culprit. In early 2010, the Independent Commission on Banking (ICB) launched a 15-month review of Britain's banking system, culminating in a massive regulatory overhaul recommendation last September. Facing the prospect of ever-stricter capital requirements, banks weren't keen to lend—why take on the additional risk now if there's a chance they'll have to shore up significant capital later to compensate?

But after months of deliberating while banks took a wait-and-see approach, Osborne finally introduced banking reform legislation Friday, and the package is significantly watered down from the ICB's proposal. Banks must hold capital of only 3% of total assets—more than one percentage point lower than the ICB's recommendation and in line with Basel III. The Tier 1 capital requirement is only 17%, at the low end of the ICB’s recommendation. Also key, smaller banks are exempt from strict deposit protection rules, retail banks can execute simple hedging strategies, and full implementation won’t occur until 2019. With these big question marks now erased, banks may find lending far more enticing. That's not to say the floodgates open—this measure has a long journey through Parliament, and Britain’s capital rules are the world’s strictest outside Switzerland—but a lending uptick wouldn't surprise.

Now, none of this is to say British equities or the UK’s economy skyrocket from here, but easing regulatory overhang and improving small firms’ access to credit—while keeping the private sector in the driver’s seat—are important steps forward. And if a spot of monetary trickery is what’s needed to achieve that, well, hear, hear!