Critiques of Monetary Policy
Within this document I state how I believe how monetary works as suppose to the traditional process of the transmission mechanism. We are told that when monetary policy becomes expansionary, households increase their consumption levels and businesses increase their investments via reduced borrowing costs. However, I don’t believe this is the case, especially in the perspective of households. I believe that households have a lack of power to increase their consumption levels, in the UK.
One reason for this is interest rates. Interest rates have completely disincentivized individuals to save. To explain this, let’s look at a simple equation:
REAL INTEREST RATE = NOMINAL INTEREST RATE - INFLATION
When viewing this equation, one thinks that the nominal interest rate must be larger than the rate of inflation for individuals to see a good return on their savings in real terms. However, when assessing the UK economy over the last decade this is far from the truth. Ever since the financial crisis, the Bank of England have slashed UK nominal interest rates from a level of 6% to 0.5%, then a further 0.25% in 2013 making the nominal rate of interest near to nothing for households. Now considering the fact that the Bank of England have an inflation target of 2%, we can deduce that inflation has been outstripping nominal interest rates leading to negative real interest rates. This should ultimately encourage business and households to engage in more vigorous economic activity because in real terms, households make back less on their savings and businesses pay back less for their borrowing but liquidity trap, liquidity trap, liquidity trap! It doesn’t take a genius to figure out that households and business have been less engaged towards the economy than pre-financial crisis levels so have not responded to this signal for increased consumption and investment. What’s most noticeable about real interest rates is the difference in attitudes it has induced amongst individuals. When I was younger, I remember my friends and I being encouraged to save the money we received to put in a bank one day to gain interest. That sounded like a brilliant idea because more money equals more toys and games. Now the idea of saving money is far from me because of the minimal interest rates bank offer on saving accounts. At most, one can only receive interest of 1.25% annually. Such a low interest rate would lead me to do the only other thing money. Spend it. I believe that unconsciously this is what many households think and feel which is why the savings ratio has fallen from its average of 9.25 to 5% in 2019. Households have no other choice but to spend. Spend on their needs and wants… or not. That power to spend has greatly fallen due to ever increasing debt. As of 2019, the average household debt in the UK is twice as much as their average income. This disparity between debt and income compels households to think more about their needs rather than their wants and so doesn’t induce the spending that expansionary monetary policy requires. This is something that the Bank of England need to address because if households cannot induce the spending they wish, businesses the investments they seek, then monetary policy fails.
Note that in my analysis of households changing attitudes towards saving, I don’t talk about investing. This is because in my own experience I have realised that this has been one of the major failings of society, let alone the Bank of England. I have learnt a lot about investment options in a couple of weeks during lockdown, then I have my entire life, and this has been through the means of social media, doing research and exploring different information sources about investing. Basic market failure tells us that when there is asymmetric information residing within a market, marginal private benefits and marginal social benefits are not equal, but rather diverge. In this instance of market failure, the failure of the central bank to provide institutions, other than banks, the means to improve knowledge on financial literacy has been (in my opinion) the downfall of the bank. Not solely, but majorly. Individuals are not well placed to make good decisions regarding finance and spending, which is why the majority end up having large debts in the future. This represses an individuals’ marginal private benefit quite simply because individuals don’t have enough information to make the thoughtful decision of what to do with one’s money. Therefore, the marginal social benefit that the Bank of England have in mind when making their policy decisions can never be reached. Some may argue that learning such things requires the desire of the individual to seek out the information, but in a system whereby the time someone turns 18 they have been flooded with unnecessary information only to project them into a life of debt, majority of individuals will be desensitized to learn these things just leaving a minority with better financial equipment to respond effectively to monetary policy. Since the central bank mainly has short term policy tools, I believe policies like these can become favourable long-term instruments to enhance the aggregate demand potential within the UK.
Secondly, monetary policy fails because it favours asset owners and those with majority stakes in private sector ownership because of asset purchasing programmes like quantitative easing, which drive up the value of assets, and makes financial and private institutions the main benefactors of monetary policy. When the central bank conduct QE (purchasing assets//bonds), they expect owners of assets, bonds, capital to have a moderate marginal propensity to consume or invest. However, this is not the case. Marginal propensity to consume and invest has been significantly low evident to the indications of both business and consumer confidence. In the last decade, business confidence has fluctuated between indexes of 30 and -80 - most notably dipping at the start of 2020. Due to volatile businesses sentiments, their propensity to invest has greatly fallen leading to directors of companies holding onto their earnings and spending less on employees. Consumer confidence has fluctuated between an index of 8 and -40. Remarkable to note that consumer confidence has been in the negative range for majority of the period, only being positive for the period 2015. This clear consumer pessimism has resulted in declining demand growth for services and goods which has then reduced demand for labour. Both business and consumer factors have contributed to weak growth in labours wages. Furthermore, publishing’s by HMRC found that out of 1,501 unlisted companies, 70% of large sized firms retained their profits and 53% of medium sized firms retained theirs instead of paying to dividends to their shareholders. Ultimately meaning that open market operations inducing the purchasing of assets from business done by the central bank doesn’t filter throughout an economy but rather, the liquidity stays trapped at the top in the hands of business owners, executives and directors of companies. This causes income inequality to grow wider which seriously needs to be addressed considering the current climate of the economy.
To conclude, “Instead of the problem of too little money, we have the problem of too much money”. Though Friedman was commenting on failings of the federal reserve during the Great Depression, I believe the concept can still be applied in today’s situation of constant liquidity injections into the economy; with all this money floating about in an economy with consumer and business pessimism. All monetary policy seems to do is increase the price level and rapidly increase the value of a minority of people’s wealth whilst majority of households struggle to live competent lives whereby, they can express their economic freedoms by spending on their wants and needs. Households cannot respond to interest rates the way they should because they do not have the ability to. Monetary policy needs a serious rethink on how it can be used effectively to stimulate economic activity, because I believe that very soon monetary policy will run out of tools to encourage aggregate consumption. It will become a tool that very few economic agents will respond to, hindering its objective of stimulating economic activity. Lastly, I believe it is rather weird that a policy that depends upon the behaviours and attitudes of economic agents merely includes behavioural instruments in its policy implementation. In order for the bank to expand their range of tools I believe they must go into the territory of behavioural economics, to bring about greater impact of monetary policy.
By Dillon Oppon-Ferguson