The Bank of England does not need a tiered reserve system for the Government to avoid austerity

There is an interesting debate going on in the UK at present about the concept of tiered bank reserves. The concept is now being used by commentators to argue that the new British government does not need to inflict the austerity that the Chancellor has now announced (even though she is denying that is what the government is up to) because the government can simply reduce outlays to the commercial banks in order to meet the fiscal rules. The discussion is rather asinine really and features all the missteps that commentators make when trying to appear progressive but falling into the usual mainstream macroeconomic fictions.

I read a UK Guardian article yesterday (August 5, 2024) – A simple solution to Rachel Reeves’ spending cuts? Stop subsidising the banks – which characterises this dilemma.

The journalist, Larry Elliot is no neoliberal and often has interesting ideas.

But in this article he just reinforces the ‘sound finance’ framing while trying to oppose the austerity that the new government is clearly going to pursue.

In many ways, I find it more disturbing when progressive commentators fall into mainstream framing fictions than I do when the usual suspects just follow their normal predilections.

The UK Guardian article is summarised as follows:

1. The British government now wants to eliminate the so-called “£22bn ‘black hole’” that it has suddenly discovered upon assuming office.

I wrote about that fiction in this recent blog post – British Chancellor fails the basic test – language is meant to impart meaning (August 1, 2024).

The UK Guardian article does not contest the ‘black hole’ framing, which is its first misstep.

I thought his contextual comment on Rachel Reeves’ (mindless) austerity plans was good though:

Her definition of what can and can’t be afforded is determined by whether or not arbitrary rules governing the conduct of the state’s finances are met or not.

The arbitrariness of the fiscal rules is something that is often lost in the public debate.

In my 2015 book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale (published May 2015) – I documented in some detail the arbitrary way the fiscal rules that formed the basis of the Stability and Growth Pact in the Eurozone were formulated.

When Mitterand turned neo-liberal in 1983, his government had invoked a stricter fiscal regime – that deficits could not exceed 3 per cent of GDP, which it subsequently pushed at the pre-Maastricht conferences in 1990.

The development of this rule in 1983 was comedic.

The person who came up with the rule admitted in 2010 that economists in the French Ministry of Finance were told that Mitterrand wanted a simple, practical deficit rule which carried the semblance of authority by being endorsed by economists and would provide an image of fiscal discipline so that he could resist the demands for more funds from his government ministers.

A ‘back of the envelope’ calculation was produced in a few minutes which had had no theoretical basis in economics.

France proposed the rule in the negotiations leading up to Maastricht to outdo the German’s ‘golden rule’ in terms of ‘fiscal toughness’.

The rule stuck and it is now used to enforce policies that have lead to millions losing their jobs.

The rules that the British government is now claiming have to be followed, similarly, have no foundation in economic theory.

They also make no sense because the government is not the final determinant in what the fiscal data generates each measuring period.

The non-government spending and saving decisions significantly determine what the fiscal position will be at any point in time as a result of the effect of those decisions on economic activity and subsequent tax revenue and government welfare payments.

The UK Guardian article is correct though in emphasising that by using the fiscal rules as a sort of benchmark for adjudicating whether a government program should be cut:

… favour short-term decisions over longer-term assessments of what might be good for the economy, and make no distinction between capital spending and current spending on the day-to-day running of the state.

It is always politically easier for a government to cut capital programs because the negative impacts of the cuts will usually not manifest within the current political cycle.

Cutting recurrent programs – such as cash handouts to people and the like – show up immediately and generate immediate political damage, not to mention the personal damage that austerity inflicts on well-being.

Larry Elliot then proposes his solution to the Government’s supposed problem – cut spending on things that will not be as damaging in the long-term.

He earlier had noted that the austerity program proposed by the new government was likely to cut into capital spending on AI, which will undermine future productivity growth.

At this point the article reinforces the frame that the British government should protect one spending destination by cutting another.

His specific solution is to cut the support payments that the Bank of England pays the commercial banks for the excess reserve holdings the banks have accumulated.

As background, the Bank of England purchased a substantial portfolio of government bonds under its quantitative easing program, first, during the GFC and then again during the COVID-19 pandemic.

The Bank of England writes that (Source):

QE involves us buying bonds to push up their prices and bring down long-term interest rates. In turn, that increases how much people spend overall which puts upward pressure on the prices of goods and services.

In total, we bought £895 billion worth of bonds. Most of those (£875 billion) were UK government bonds. The remaining £20 billion were UK corporate bonds.

Further, the Bank details how the transactions occurred:

The money we used to buy bonds when we were doing QE did not come from government taxation or borrowing. Instead, like other central banks, we can create money digitally in the form of ‘central bank reserves’.

We use these reserves to buy bonds. Bonds are essentially IOUs issued by the government and businesses as a means of borrowing money.

Just keep that explanation in the back of your minds because it is important for a point I will make towards the end of this blog post.

When we talk about bank reserves we are referring to, as the current governor of the Bank of England explains in this speech – The importance of central bank reserves by Andrew Bailey (May 21, 2024):

… the central bank balance sheet plays a crucial role in everyday economic life. Its main liabilities – central bank reserves, the deposits that commercial banks hold at the central bank – serve as the ultimate means of settlement for transactions in the economy. Central bank reserves, in other words, are the most liquid and ultimate form of money …

… whenever money has to be transferred from an account at one commercial bank to an account at another commercial bank, that transaction has to be settled between them. That is where the central bank’s balance sheet comes in. Commercial banks hold reserves at the central bank. So transactions can be settled by moving these reserves – claims on the central bank – across the central bank balance sheet by debiting one commercial bank’s reserve account and crediting another’s …

This does not imply that banks need to hold reserves for all eventualities. They can borrow liquidity from each other in the so-called money market, for example, to smooth out demands. And central banks stand ready to provide additional liquidity, in the form of central bank reserves, as needed for the system to operate smoothly. Effectively, banks can borrow the reserves they need from the central bank, by pledging other assets as collateral for the loan.

However, the commercial banks only desire to hold sufficient reserves for the daily transactions that they anticipate.

Excess reserves are typically eschewed because, in the absence of the central bank paying a competitive interest rate on them, the commercial banks lose returns.

Since the GFC, most central banks decided to pay a support rate on reserves held with them by the commercial bank.

There is some logic to this.

If there are excess reserves in the system overall and the central bank does nothing, then the banks with excess reserve balances will seek to loan them to other banks and in doing so, will drive the overnight rate (in the ‘money market’) towards zero – some rate is better than none!

This process, however, cannot eliminate the overall excess – it just shuffles it between the banks.

In this situation, if the central bank is targetting a non-zero policy rate, then the behaviour of the banks will undermine that aspiration because the overnight rate will dominate the target and the central bank, effectively, loses control of its monetary policy.

In the past, central banks would then sell government bonds to the banks with excess reserves, thus draining the excess from the system, which would then maintain the interest rate target as desired.

In more recent times, many central banks have paid a return on reserves at some rate close to its target rate which serves the same purpose – precludes the commercial banks from trying to get rid of their excess reserves.

In the UK, the “central bank reserves are remunerated at the official policy rate and as such they provide an essential anchor for the implementation of monetary policy.”

Which is just a reflection on what I have written.

These payments are what Larry Elliot focuses on:

Between December 2021 and August 2023 the Bank of England raised interest rates 14 times, taking them to 5.25%. Threadneedle Street is now paying 5% interest on £700bn of bank reserves at cost to the exchequer of £35bn a year.

The point he is making is that there is a massive income flow to the commercial banks from what is effectively government spending which if cut could – in his erroneous mainstream framing – allow other spending to be saved from the austerity.

He says:

… if Reeves decided to pay interest on only one-third of the reserves it would save her just over £22bn a year and fill the “black hole” in the government’s finances without the need for spending cuts or tax rises. She could also reduce the national debt by about £400bn at a stroke.

So the framing here is all mainstream.

He doesn’t question the ‘black hole’ fiction or language and by implication is inviting his readers to think that reducing the ‘national debt’ is a desirable goal.

While he does not really explain the “one-third of the reserves” point, what he is referring to here is the so-called tiering of reserves, which is a practice used by the ECB (a two-tier system), the Bank of Japan (a three-tier system) and the Swiss National Bank (exemption scheme) among other central banks to manage payments on excess reserves.

By way of explanation, the central bank categorises the total bank reserves into tranches or tiers which then attract different support rates.

One tier would be excluded from support rates while higher tiers then would receive some scale of rate support.

At present, the Bank of England applies a uniform rate to all reserves.

The mainstream monetary economists claim a tiered system would ‘save’ the government money because the central bank would have higher profits to distribute to the treasury.

Left pocket-right pocket of government sort of stuff.

Would this tiered system still allow the central bank to maintain a non-zero interest rate target in the context of excess reserves.

Yes.

It can scale the payments within the tiers to ensure the banks do not engage in competitive loans in the overnight market which would undermine the target.

It would however reduce the profitability of the commercial banks and they would certainly resist the loss of the corporate welfare flowing from the central bank.

From an Modern Monetary Theory (MMT) perspective, Larry Elliot’s scheme would not be supported.

The preferred monetary policy position is to maintain a zero short-term target rate maintained by the presence of (unrewarded excess reserves).

The banks would obviously cry poor claiming that the absence of a support rate would represent a ‘tax’ on the banks and consumers would pay the price.

Mostly that is just special pleading from the banks.

In terms of evaluating well-being of the general population, the support rates do nothing.

The last point to make in terms of how this article just reinforces mainstream framing relates to Larry Elliot’s claim that the government will likely do nothing because it fears “upsetting the City of London” and as a result:

… the banks are likely to continue to get their colossal handouts from the taxpayer.

Think about that.

There are actually two points here.

First, implicit in the journalist’s claim is the inference that the central bank is part of government, which means the concept of central bank independence is a furphy.

Second, recall the Bank of England governor (cited above) making it clear that just “like other central banks, we can create money digitally in the form of ‘central bank reserves’.”

Where is the colossal handout from the taxpayer?

I suppose Larry Elliot might claim that the accounting profits of the Bank of England are now lower as a result of these ‘digital’ payments which means it passes less back to H.M. Treasury.

But if you think about that the whole idea of the ‘taxpayer’ being compensated by the Bank of England profits is ridiculous.

If the central bank can type any number into any account that it chooses then the idea of government spending being limited by or funded by taxpayers becomes inapplicable.

I am not sure Larry Elliot sees the inconsistency in his own proposal.

Conclusion

Here we have seen a classic example of mainstream framing being advanced by a progressive journalist.

That is an on-going problem that we have yet to prevent.

That is enough for today!

(c) Copyright 2024 William Mitchell. All Rights Reserved.