UCL News


Comment: Central banks must change course if they are to lead us out of the coronavirus crisis

26 May 2020

Dr Josh Ryan-Collins (UCL Institute for Innovation & Public Purpose) discusses how central banks must do more to support economies after the Covid-19 pandemic.

Josh Ryan-Collins

The financial sector was the cause of the last major economic downturn of 2008. This time round we need it to help aid a strong recovery following the economic shock caused by coronavirus. As they did during the last crisis, central banks have prevented financial sector collapse, with the G7 nations injecting $2.5tn of new money into financial markets in March and April through quantitative easing and related liquidity programmes.

In the face of demand-and-supply shocks causing some industries to contract and widespread unemployment, we now need banks, asset managers and stock markets to take advantage of this liquidity by lending to productive and job-creating sectors of the economy. These jobs need to be sustainable so we also need patient finance – long term, committed, high-risk investment – to create the green infrastructure and innovation needed to rapidly transition to a zero-carbon economy.

Currently in the UK, only about £1 in every £10 lent by British banks goes to non-financial firms. Most credit flows into existing property and supports financial trading of one kind or another. Similar patterns are evident in many other advanced economies. As yet, there is little sign of industrial strategy being linked to coronavirus finance.

The good news is we can look to the post-second world war period for a playbook on how to do it. After 1945, advanced economies faced an epic recovery challenge, with public debts even higher than those predicted to arise this year (the UK’s debt-to-GDP ratio reached almost 250% in 1947). Finance played a key role in the recovery and “golden age” that followed. But central banks did not just create new money. They worked closely with governments to ensure the money was directed to the right parts of the economy.

“Credit guidance” policies were employed to steer bank lending into priority sectors – including exports, manufacturing, housing and transport infrastructure – and away from more speculative sectors. State-owned development banks channelled both government and household savings into infrastructure and innovative high-growth sectors. Financial rents – profits from interest, speculation and capital gains – were minimised via the imposition of capital controls which restricted speculative foreign inflows and the maintenance of low rates of interest on government debt. These low rates enabled aggressive government spending programmes, which enabled full employment.

In western economies, these policies supported job growth, corporate investment, industrial transformation and modernisation to such an extent that the period become known as the “golden age” of capitalism. By keeping nominal growth (ie, GDP plus inflation) above the rate of interest on government debts, such policies also effectively deflated away the public and private debt piles that had built up.

However, in the 1970s the strategy changed. High inflation in advanced economies was blamed on too much government interference in the economy and spurred a shift in economic thinking. A new consensus emerged that credit-guidance policies distorted the efficient allocation of capital by market forces. The term “financial repression”, invented by Stanford economists Edward Shaw and Ronald McKinnon, was used to disparage the policy. By the 1980s, financial repression policies were abandoned and prohibited as part of the liberalisation and deregulation of finance.

Today, in response to the economic crash caused by the pandemic, some central banks are again embracing aspects of financial repression, offering ultra-low interest rates and financing government debt. But, so far, directing credit to support industrial policy objectives appears to be a step too far.

Instead, central banks have focused on propping up new areas of the financial system that were previously outside their regulatory purview, in particular capital markets. The Federal Reserve has created programmes to purchase corporate assets in sectors that arguably make little contribution to sustainable economic growth. These include various speculative asset markets, such as private equity and exchange-traded funds, which invest in risky corporate sector markets to feed investors’ thirst for high-yielding assets. Such activity props up stock markets but doesn’t guarantee any investment in the real economy.

Meanwhile, some central banks and governments are supporting key sectors that require structural change to transition to a zero-carbon economy, such as aviation, oil and mining, with few conditionalities attached. A large state investment bank could take equity stakes in such firms and support them to transition their business models while saving jobs. But the UK doesn’t have one, and there is little public discussion about creating one. This is despite Britain losing access to the sizeable spending of the European Investment Bank due to Brexit.

The bottom line: central banks need to return to the credit-allocation and investment-led growth policies that reignited the economy after the second world war. The classic central bank defence of maintaining “market neutrality” or independence is looking increasingly weak. When, as in the US, 38 million people have filed for unemployment yet stock markets enjoy record rallies, you know something has fundamentally gone wrong. Rather than financial repression, we have financial dominance.

Financial repression needs a rebrand. Let’s call it financial guidance. Without it, advanced economies will face another anaemic recovery. With it, governments and central banks can get their countries back to economic health.

This article was first published in the The Guardian on 26 May.