The Bank of England must not pump money into the UK economy due to Brexit
|Date:||15 May 2017|
No sooner had the United Kingdom voted to leave the European Union than calls began for the Bank of England to pump money into the economy to avoid deflation.
Mario Draghi urged central banks to coordinate to tackle low inflation in his first major speech after the vote. Bank of England Deputy Governor Nemat Shafik said “more easing would probably be needed for the U.K. following the Brexit vote”.
The Bank of England must not fall into this trap. Inflating the economy with paper money distorts inflation, leading to problematic expectations by entrepreneurs and households.
To understand why, imagine the Bank of England has two choices: to intervene in the economy or not. For the sake of simplicity, imagine all business environment factors (e.g. level of infrastructures, competition, efficiency of labor markets) are stable.
In a scenario of intervention, households, entrepreneurs, and banks see lower interest rates. Households have artificial incentives to buy products, services and houses. This leads to inflation, decrease in savings, and a potential bubble in the mortgage market.
Entrepreneurs have artificial incentives to over-invest in apparently profitable investments driven by an artificially increased demand. As shown by Smith and van Egteren, the level and the variance of inflation distorts corporate investment decisions, and reduces the level and efficiency of such decisions.
Banks face lower interest rates, and thus get lower profits from “normal” operations. In this way, banks are incentivized to either give mortgages to subprime borrowers because of increasing housing prices, or invest in risky derivatives covering themselves from potential losses.
Why does this matter? Just look at the case of the UK bank Northern Rock. In 2007 it announced a drop in corporate profits of about 500 million pounds, and its stock fell 32 percent. The day after, bank account holders withdrew 2 billion pounds -- 8 percent of overall bank deposits. The Bank of England bailed out Northern Rock, even though the then-governor of the Bank of England Mervyn King had announced there would be no intervention.
What is the very simple takeaway? If bank managers expect a central bank intervention, they have incentives to over-risk and over-invest, because their bank will be “rescued” by the central bank. This example makes clear how central banks can distort free market mechanisms with negative consequences for taxpayers and personal savings.
If the Bank of England intervenes heavily in the British economy after Brexit we could be in the same scenario of the US subprime crisis that started in 2004 and materialized in 2007.
The worrying fact is that central banking intervention is not only the cause of the crisis, but also the consequence. Central banks in the US and in the European Union have responded to the subprime crisis with even more loose unconventional monetary policies, starting with the Troubled Asset Relief Program in the US up to Europe’s quantitative easing. These lead to higher bank reserves with no stimulus at all on the real economy.
I would argue that a central bank can create a systemic crisis, but is not likely to solve it. The other negative effects are the decreasing value of the national currency, the erosion of personal savings, and the future negative shock on the previously-inflated demand. The effects on ordinary people echo the conditions that drove Brexit in the first place.
Samuele Murtinu is associate professor in the Department of Innovation, Management & Strategy at the Faculty of Economics and Business, the University of Groningen.