The real challenge – on a global scale – is to rebalance the world economy so that very low interest rates are not required to exhort deficit countries to spend in order to absorb the surpluses elsewhere. Monetary policy cannot provide the answer. It can only buy time to bring about the necessary structural changes in investment, trade and capital flows. Whether they involve changes in currency values or restructuring of debt is a political choice, but a failure to deal with global imbalances will not only retard the recovery in the world as a whole, but worsen the scale of the adjustment ultimately needed. It will inevitably be a bumpy ride. The other obstacle to a return to normality is our banking system where, despite the generous provision of liquidity and funding from the State, lending remains lacklustre, and risk premia high. Although the combined balance sheet of our largest banks has shrunk since the height of the crisis in 2008, it is still 400% of annual GDP. Leverage ratios have fallen, but all our major banks remain highly leveraged. And of course the two biggest lenders to the domestic economy remain largely in state ownership. It is difficult to imagine a banking sector like that making a real contribution to any economic recovery. It must be time for decisive action. Chancellor, you have made clear tonight that you embrace that view.
But monetary policy can not – and should not – seek to prevent those adjustments. They are necessary for the long-run stability of our economy. Rather the job of monetary policy – and of public policy more generally – is to ensure that these adjustments occur in an orderly manner and within an economic environment which is consistent with hitting the 2% inflation target. Because it is new and untested, there is understandably considerable nervousness about the Monetary Policy Committee’s asset purchase programme – a.k.a. quantitative easing. How is it supposed to work? Will it work? The essence of the asset purchase programme is to increase the supply of money and credit in the economy. An important point to stress is that the success of the programme does not depend on banks returning to a position in which they are able to lend normally. The policy works by supplying money directly into the economy, not through the banks. Much of the money is being injected by purchasing government bonds from institutional investors, such as insurance companies and pension funds. These purchases encourage investors to switch their portfolios away from gilts into corporate bonds and equities, so improving the supply of credit to businesses. Companies’ access to credit is further enhanced by the Bank’s purchases of commercial paper and corporate bonds, which improve the functioning of these markets. But is it working? The objective of the asset purchases is to increase the growth of nominal spending.