A Comparative Case Study of the Quantitative Easing Undertaken by Central Banks in the UK and Europe

Extraordinary times call for extraordinary methods (Hannoun, 2012). The global financial crisis of 2008 led to the usage of unconventional monetary policy across major central banks (Pattipeilohy et.al., 2013). Monetary policy is a complex system, run Britain by the Bank of England (BoE) and in the EU by the European Central Bank (ECB). Both central banks have a wide range of policy levers to control (White, 2012), allowing them to effectively respond to crisis such as the financial crash. One such form of unconventional monetary policy used was quantitative easing, a policy first introduced prior to the financial crash by the Bank of Japan (Fawley and Neely, 2013) to combat sluggish economic growth. The objective of quantitative easing undertaken in by the Eurozone and the UK in 2008 was to help to ‘reflate’ the economy and ‘revive nominal spending’ (Benford et.al., 2009), with a secondary aim of ‘reviving bank lending’ (Fatouh. Markose. and Giansante, 2021). Within the realms of quantitative easing, the ECB and the BoE differed considerably in terms of which form of quantitative easing they implemented most prominently (Fawley and Neely, 2013). The primary form of quantitative easing is split into two channels, the portfolio substitution channel (favoured by BoE), and the bank lending channel (favoured by ECB). The bank lending channel focuses on gilt and securities purchases from commercial banks, with the aim being to increase liquidity within commercial banks with the view to increasing commercial bank lending to households and businesses. Alternatively, the portfolio substitution channel is the purchase of gilts and securities on the secondary market from investors and non-bank firms, with the aim of reducing long term interest rates (as most of the assets purchased are government bonds), as well as increasing liquidity and encouraging investors and firms to invest more in either government or corporate bonds.

This essay will examine the cause of the differentiation of policy in terms of why different central banks enacted different policies for different states whilst facing the same financial crisis, and which variables caused this outcome to occur. Therefore, the central question this essay will be answering is: Why was quantitative easing undertaken by the EU focused on a different channel to that of the UK?

Whilst it is important to note that both the UK and the EU saw both forms of quantitative easing, we will examine why each state preferred to use differing forms whilst being in the same crisis with similar economic conditions. I will begin to answer this by segmenting this essay into a literature review; exploring key analysis of the usage of each form of quantitative easing by both the ECB and the BoE, by secondly using Mill’s Most Similar System Design (MSSD) to determine the control variables and the cause of policy differentiation. These variables will be intrinsically economically based, examining the differences seen between the two economies at the time of the initial round of quantitative easing after the financial crash. Finally, I will conclude the reasoning behind the differing variables, and explain how this led to a policy differentiation on quantitative easing channels between the EU and the UK. It should be noted that this essay is focusing on the first round of quantitative easing undertaken by both the ECB and BoE, directly after the financial crash, as opposed to latter rounds.

Literature Review

Quantitative easing was viewed predominantly as an ‘unconventional form of monetary policy’ (Pattipeilohy et.al., 2013), and was widely viewed with a degree of scepticism as the Bank of Japan attempted to use quantitative easing to boost their sluggish growth and kickstart their economy. However, amidst the financial crash beginning in the end of 2007 moving into 2008, quantitative easing quickly became a central form of monetary policy (Pattipeilohy et.al., 2013) for four of the worlds largest central banks, the Bank of Japan, Bank of England, Federal Reserve and the European Central Bank (Fawley and Neely, 2013). Alistair Darling’s 2011 memoirs provide a useful backdrop to the macroeconomic environment within which quantitative easing took place, with a good account of the condition British banks were in, an important factor to consider when analysing the UK’s relationship with the bank lending channel. Much of the literature around quantitative easing examines the effectiveness at which different channels worked in terms of passing on intended effects to the wider economy, with economists ‘rarely reaching a consensus so quickly’ (Gagnon, 2016) as to the effects of quantitative easing via each channel. Martin and Milas (2012) do shed doubt upon the effectiveness of quantitative easing, as does Joyce et.al., (2012) although they do highlight the lack of literature and research done on the topic at the time of writing, as well as the need to study subsequent rounds of quantitative easing taking place in 2012. There is a strong consensus amongst the literature that the BoE and Fed strongly focused on quantitative easing via the portfolio substation channel, with the ECB and the BoJ channelling most of their quantitative easing into the bank lending channel (Fawley and Neely, 2013), (Gern et.al.,2015), (Butt et.al., 2015). This illustrates the clear distinction between the focus of quantitative easing undertaken by the UK and the Eurozone on which the basis of this essay is formed, forming a niche for us to examine why this was the case using Mill’s MSSD analysis.

Additionally, regarding the first round of quantitative easing, there is a relative agreement from economists in the lack of effectiveness in the bank lending channel in terms of increasing commercial bank lending to consumers in the UK, as observed by Fawley and Neely (2013), Butt et.al., (2015), and (Deleidi and Mazzucato 2018). Whilst Gagnon (2016) highlights the overall success in quantitative easing in the UK, there are considerable question marks as to the success of the bank lending channel in comparison to the portfolio balancing channel in the UK. ECB working papers produced by Gräb and Żochowski (2017) and Albertazzi, Becker and Boucinha (2018) provide a reasoned analysis of quantitative easing undertaken by the ECB for the Eurozone, strongly illustrating the effects on both the bank lending channel and the portfolio substitution channel, detailing comparatively the effectiveness of each channel.

Mill’s MSSD was chosen to complete this analysis due to the extreme likeness of the macroeconomic environment surrounding the UK and the Eurozone at the time of the implementation of quantitative easing policies in 2008/9. Both economic areas were strong, medium growth economies which were significantly damaged during the crash, with both also having similar, if not identical institutional frameworks surrounding monetary policy decision making. The similarities seen in external environments, and internal institutions leads us to towards the use of MSSD, with only intricate details leading to the Eurozone focusing on the bank lending channel as opposed to the UK focusing on the portfolio substitution channel.

Central bank independence allows the autonomy of central banks over monetary policy (Berger, De Haan and Eijffinger, 2001) providing the institutional ability to pursue policies such as quantitative easing. This is an example of a control variable which is institutionally identical between the UK and the European Union, providing comparable institutional economic environments for central banks make decisions on which quantitative easing channel to favour. Additionally, another control variable shared by both the UK and the

Eurozone is that both places had strong levels of economic growth in the year previous to the financial crash and initial rounds of quantitative easing. The UK posted a 2.2% growth in 2007 (World Bank, 2022a), with the Eurozone slightly higher at 3% (World Bank, 2022b). This is important as it shows that both economies were in comparably robust states before the financial crash hit, with investor confidence high in both economic areas.

One of the primary causes of the crash, and a control variable observed within both the UK and the Eurozone’s commercial banks is the abundance of ‘bad debt’ held. The financing of bad debt is a primary cause for the dwindling reserves seen within both minor and major banks across Europe, with banks ‘destroying themselves’ with bad debt (Thompson, 2013)

Similarly, some of the largest banks in both the Eurozone and the UK embarked on acquisitions of smaller banks during the financial crash. Most of the smaller banks acquired were ‘stuffed full of junk’, as described by the British chancellor at the time Alistair Darling in his 2011 memoirs. Referring to the acquisition of ABN AMRO by RBS, which was at the time Britain’s largest ban, Darling (2011) explains how damaging this ultimately was to RBS, taking on swathes of ‘bad debt’ and in the end crippling RBS and its reserves. This is an important control variable to consider. With large banks such as RBS taking on the bad debt of smaller banks, it has an extremely negative effect on the reserves held by the purchasing banks. A Eurozone example bringing ‘great relief’ to Darling (2011) is the Spanish bank Santander acquiring Alliance & Leicester, a struggling British bank. The importance of this is rooted within the possible effects of quantitative easing via the bank lending channel. The below diagram highlights the issue effectively.

Figure 1

(Skidelsky, 2018)

As Skidelsky illustrates, when undertaking quantitative easing via the bank lending channel, multiple outcomes may occur. Initially, when QE is undertaken by either the BoE or the ECB, commercial banks see an expansion of their balance sheets, with greater reserves, liquidity and deposits, and a lesser cost for funding. There are now three possible outcomes which determine the effectiveness of quantitative easing, with it being important to remember that the aim of quantitative easing is to pass down liquidity to the real economy, increase bank lending (Fatouh. Markose. and Giansante, 2021) and increase general spending. This being said, the least effective outcome is banks absorb the gilt sales made to the central bank during quantitative easing, and use this revenue to shore up reserves, as observed considerably within the UK commercial banking sector (Butt et.al., 2015). As aforementioned, large banks in both the UK and Eurozone acquired smaller banks with bad debt causing a drain on their reserves. This shows the importance of bad debt acquisition by large banks as a critical shared control variable between the UK and Eurozone. This completes our analysis of the control variables shared by both the UK and the Eurozone, highlighting the intrinsic macroeconomic and institutional similarities seen by both economic areas.

Independent Variable Analysis and Outcome Reasoning

The independent variables, potentially causational towards our outcome are twofold. Firstly, as mentioned, Britain undertook a larger programme of bank recapitalisation and part nationalisation for struggling small to medium sized banks, including that of some large banks such as RBS. However, other large banks such as Barclays, Natwest and HSBC were able to maintain a relatively strong level of reserves throughout the crisis (Darling, 2011) and were in a lesser need for government intervention. This is in direct opposition to Eurozone banks, which required a higher level of support in terms of bolstering reserves (Mazier and Petit, 2013), with it being important to note the scale of the commercial banking sector being larger in the Eurozone than in the UK due to the number of nations functioning within the Eurozone.. This is a potential cause for our outcome. With European commercial banks requiring a greater level of liquidity in order to sure up reserves, it would be logical for the ECB to embark on a greater range of quantitative easing aimed at the bank lending channel. Similarly, with British banks more secure due to either government assistance in the case of RBS, or due to stronger reserves (HSBC), it is logical for the UK and BoE to focus on other avenues of quantitative easing, such as the portfolio rebalancing channel (Fawley and Neely, 2013). However, whilst this is a strong independent variable, it can be dismissed as the cause of our outcome. This is due to the fact that, as demonstrated in our independent variable, Eurozone commercial banks had a higher propensity pass on this extra liquidity in the form of loans to households and firms (Gräb and Żochowski 2017), (Albertazzi, Becker and Boucinha, 2018). This means that we can dismiss the argument that the ECB chose the bank lending channel with the aim of initially securing commercial bank reserves, as this outcome was not observed throughout the programme of quantitative easing, or in the aftermath. Conversely, this is unlikely to be the cause of the BoE’s decision to focus on the portfolio substitution channel, with the cause likely to lie in the fact that the UK economy is more bond focused (Fawley and Neely, 2013) or due to the fact that British commercial banks did not increase lending as a result of the scheme (Butt et.al., 2015), (Deleidi and Mazzucato 2018).

Secondly British commercial banks were more likely to absorb quantitative easing financing and hold this newfound liquidity as reserves (Butt et.al., 2015) in comparison to European commercial banks which were more likely pass this liquidity on in the form of loans to households and firms (as outlined on the figure 1), as demonstrated by Gräb and Żochowski in 2017, as well as Albertazzi, Becker and Boucinha (2018). This demonstrates the Eurozone bank lending channel to be more effective at achieving the traditional aims of quantitative easing in line with the objectives outlined by Fatouh, Markose, and Giansante, (2021). Deleidi and Mazzucato (2018) provide further weight to this argument, postulating that the effect of quantitative easing on loans to firms and households has been ‘disappointing in comparison to the relative increase in reserve holdings’ seen in commercial banks, boldly also stating that ‘QE did not increase business loans’ in their study of UK monetary policy. This provides an initial explanation for why the BoE and UK may have chosen to focus quantitative easing on the portfolio substitution channel, which had a more tangible effect on the British economy. With so much of quantitative easing seemingly remaining within the reserves of the commercial banking sector, it would be futile for the BoE to have continued to supplement these reserves when other channels such as the portfolio substitution channel seemingly promise a greater return with regards to achieving the objectives behind quantitative easing. Finally, Fawley and Neely (2013) explain that the UK financial economy is far more bond based in comparison to the banking heavy Eurozone. This therefore means it makes more sense for the BoE to focus quantitative easing on the portfolio substitution channel, in which bond purchases on the secondary market make up a large proportion of transactions, meaning a greater spill over effect into the wider economy as a result of quantitative easing (Fawley and Neely, 2013), (Neil et.al., 2015).

On the other hand, as aforementioned, the ECB and the Eurozone saw comparatively more success in the ability of the bank lending channel to provide the economy with more capital via loans and mortgages from commercial banks. In essence, whilst British banks hoarded the liquidity from their central banks and used it to increase their reserves, Eurozone banks did not do so, instead providing the Eurozone economy with greater liquidity and increasing lending as intended. Leroy (2014) demonstrates that this is due in part to the fact that there is greater competition amongst Eurozone commercial banks to sell gilts as part of quantitative easing. The British government embarked on a large programme of bank nationalisation and recapitalisation (Buchholtz, 2021), reducing the firms competing for the sale of gilts a form of quantitative easing, whereas the Eurozone saw comparatively lesser bank recapitalisation. With Eurozone banks lending more, helping to revive the Eurozone economy, it makes perfect sense for the Eurozone to focus on this channel of quantitative easing.

Conclusion

To conclude, as demonstrated using Mill’s MSSD, the UK and the Eurozone had differing focuses in regards to the channels used for quantitative easing. We have exhibited that the UK chose to focus on the portfolio substitution channel, whilst the Eurozone opted to focus their quantitative easing programme on the bank lending channel. This is in spite of the fact that both the UK and the Eurozone had similar economic conditions both leading up to the crash and during the crash itself, both macroeconomically and institutionally. Both areas have independent central banks with monetary policy autonomy, providing a similar institutional framework. Additionally, both areas also saw similar effects on commercial banks during the financial crash, with banks becoming saddled with bad debt. Furthermore, larger banks in both the UK and Eurozone also saw the crash as an opportunity to expand and acquire smaller banks, overlooking the bad debt held by these banks, causing a fall in their own reserves and in subsequently part nationalisation as a result of this in the case of RBS. Thus the situations facing monetary policymakers were rather similar in the UK and in the Eurozone in 2008, yet as explained, both central banks focused on different channels for quantitative easing. Using Mill’s MSSD, our central finding is that the EU chose to focus their quantitative easing on the bank lending channel because of the high levels effectiveness demonstrated in the initial months of conducting this policy. With increasing levels of bank lending as a result of the quantitative easing (Gräb and Żochowski 2017), (Albertazzi, Becker and Boucinha, 2018) seen in the EU, the ECB chose to continue this policy, and increase the levels of quantitative easing seen in the bank lending channel in comparison to the portfolio substitution channel because of the initial success. Furthermore, Fawley and Neely’s (2013) argument that the ECB initially focused on the bank lending channel due to the comparatively larger bank focus of the Eurozone economy in comparison to that of the British economy adds weight to the argument, explaining the initial and latter focus on the bank lending channel. Whilst larger UK banks such as Barclays and HSBC had sufficient capital and reserves to weather the storm (Darling, 2011), with the banks struggling receiving government help in the form of nationalisation or recapitalisation. Eurozone banks had comparably fewer reserves, in part due to the wide ranging nature of the Eurozone banking system spanning multiple countries, with Greece for example having very low reserves observed within its commercial banks (Febrero, Uxo and Bermejo, 2018). However, the idea that this is the primary cause of the ECB’s focus on using the bank lending channel for quantitively easing is negated by the fact that the Eurozone’s commercial banks increased lending as a result of quantitative easing comparatively more than the UK’s commercial banks. Using Mill’s MSSD, we have been able to determine the control variables shared by both the Eurozone and the UK determining the environment in which the corresponding central banks are involved in to make their necessary policy decisions, and subsequently, the independent variables leading us to the outcome with the UK and Eurozone each preferring a different quantitative easing channel. Our findings are that the ECB fand the Eurozone focused on the usage of the bank lending channel as a means of conducting quantitative easing due to its increased effectiveness compared to the portfolio substitution channel. On the other hand, the BoE and the UK focused on the portfolio substitution channel due to the lack of need for the UK’s largest banks to increase reserves, as well as the reluctance of UK banks to lend, meaning the bond focused portfolio substitution channel was preferred due to its increased effectiveness for the British economy.

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