Why the New Funding For Lending Scheme Won’t Work Either

By Greg Fisher

If the managers of UK banks believe a recession is imminent then they will be cautious about lending.  Similarly, if these same managers think the future state of the economy is highly uncertain, they will also be cautious in making lending decisions.  Either way, prudent lending is not conducive to an economic recovery.

Unfortunately, the new Funding For Lending scheme, which was announced by the Treasury and the Bank of England two months ago, is very unlikely to influence bankers’ expectations of – nor their certainty about – the future state of the economy, so it is unlikely to be effective.

If policy makers wished to entice bankers to lend more – to help stimulate the economy – then they must first get to grips with how consensus views of the economy emerge in the real world.  Conventional economics is a gazillion miles away from doing this well.  But that need not concern us here because I think all we need do is employ common sense.

Fortunately, this common sense approach is also backed up by some really cool theory.

Common Sense

People form their views of the current and future state of the economy through conversations with other people and by reading, seeing, and listening to others’ views via different forms of media.  This obvious society-wide interaction involves the use of simple narratives that combine the past, present and future in to a coherent way.  Each of us influences – and is influenced by – other people.

For example, Joseph Blogs might say, “the financial crisis was where it all started, we’ve been through one dip so far, and it looks like we’re in for a second”.  By contrast, Joanna Blogs might say, “yes the crisis was bad but things always bottom out, so the economy will probably recover from here.”  Often, a consensus view emerges among a group of people – however vague or precise – which we commonly refer to as public sentiment.

This interaction, involving simple narratives about the economy, describes how it works in the real world.  Most people do not collect data which is then put in to accurate models which allow them to predict the future state of the economy.  And “most people” make up most of the economy, so how they form their views is important.  Moreover, my own experience with senior bankers and their economists leads me to believe that bankers also form their views in the same sort of way, often paying little attention to the professional economists they employ (or only listening to them if they agree), some of whom might use formal models.

Theory

At the risk of sounding like a pleb, there are two bits of cool theory we can point to which support this common sense view.  The first is the new study of dynamic networks, which help us to understand how these consensus views can arise within a network of interacting agents.  The conversation process described above enables what looks a lot like the concept of emergence in complex systems of interacting agents.  In these types of network, system-wide phenomena can emerge in a way that is not reducible to the parts of the system.  Things can and do simply emerge.

The second bit of theory describes the role of narratives in human cognition and psychology.  The human brain is a pattern-recognition machine par excellence and we can describe most of the dynamic patterns we experience and imagine as narratives.  Most of this sense-making goes on in our deep sub-conscious and we are hardly ever aware of it.  A useful book that described this process well is Professor David Tuckett’s Minding the Markets.

Most people will relate to my common sense description of expectations formation.  The economy is far more complex, and the future far more uncertain, than our brains could ever hope to handle; and we form our views in large part in conversation with others.

But the economics on which most government policy is based, including the new lending scheme, takes a different approach.  In that theory, bankers’ decision making is much more deterministic.  Bankers are seen to react positively to incentives such as those contained in the lending scheme, which induces them to lend more.  There is a second effect: a positive change in expectations about the future state of the economy, which results from the first effect.  Overall, bankers are expected to react to policy as if they were automatons, allowing policy makers to launch the economy in to some recovered state.

The main problem with this conventional approach is the process through which bankers are thought to form their expectations and make decisions is too detached for reality.  If bankers agree with public sentiment, which is – let us suppose – pessimistic, then no amount of goading by policy makers will make them lend.  Put another way, if the consensus narrative among the public suggests a recession then bankers will be obstinate in the face of any public policy trying to make them act otherwise.  Bankers tend to swim with the tide, not against it.

Different words and concepts have been used here but this is consistent with John Maynard Keynes’ reference to monetary policy “pushing on a string”.  Moreover, it also explains why the Enterprise Finance Guarantee Scheme didn’t get the economy moving, and why Quantitative Easing doesn’t really work either.

It’s all pretty obvious once we employ common sense rather than conventional economic models.  If we really wanted to, we could use some fancy words like “public sentiment is a time-consistency transient attractor subject to bifurcation” (which is my view) but, at the end the day, bankers make decisions in a way as described above, not so much like standard economic theory.

But if I’m right, why has there been a £60bn uptake of the Funding For Lending Scheme, a number recently announced by the Bank of England?  Well, the scheme offers banks cheaper funding so it’s a no-brainer for the banks.  But the money will not necessarily get passed on to would-be borrowers.  If bankers’ confidence in the economy remains flat, the scheme will probably just help them make a higher margin on lending they would have made in any case, helping them to recapitalise or to pay out higher dividends to their owners, or both.

Conclusion

So what are the policy implications of this common sense?  A good first step would be for the chancellor to sack all the economists around him whose advice defies such common sense.  That would create a good platform on which to proceed.

A second step would be for the Chancellor to recognise that he has much less control over the economy than is commonly believed.  He cannot control the emergent properties of social system, such as public sentiment; he can only influence them.  The Chancellor is probably experiencing that in spades right now.  He should not only accept this, he should also incorporate it in to his analysis to help form better policy.

A third step would be to contemplate policies which constructively influenced people’s expectations – and impressions – of the future economy.  An essential part of this would be to place the UK’s economy on a much more resilient footing than it currently is.  Young army officers are often told that respect is not granted by rank, it has to be earned.  Likewise, confidence cannot be imposed on people; it too must be earned, and also inspired.

 

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2 Responses to “Why the New Funding For Lending Scheme Won’t Work Either”

  1. Peter Richmond says:

    Nice commentary. Concepts from physics really do need to be built into the teaching of economics. Entropy is a vital key for the development of a sensible theory of macroeconomics. We really have to stop teaching the subject as it is. It is doing a disservice to young people now entering the economics profession.

  2. David Hales says:

    From Plebs to Proles?

    I think one aspect that Agent-Based Modelling (ABM) can bring to this is the ability to use them to create new narratives that incorporate common sense assumptions. This is particularly true of models that do not aim to predict some specific existing target phenomena but aim to explore “possible worlds” based on some common sense assumptions of given stakeholders.

    I am increasingly viewing work in “artificial societies” – an area I have worked in – as producing models that capture “narrative sets”, that is stories about possible worlds in the language of a particular community. One could call this “Narrative Technology”.

    The value of this is that since the models are formally specified they can be formally compared and shared with others.

    Put in it’s simplest form ABM’s become a method of specifying and sharing not just single narratives but whole sets of narratives which can be explored in new ways. i.e. one can search an ABM to find the contingent conditions in which a given narrative is supported.

    Put another way, one could envisage machines that can help to produce specific narratives for specific policy purposes.

    However, this does worry me too because it starts to sound like Orwell’s idea of automatic machines that generate the pulp novels “prole feed” to keep the underclass happy.

    Hence it seems one should be very clear if using these techniques as to what the basic assumptions (the common sense) built into the models is and how it has been sourced.

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