6.3.1. Linking fiscal policy to increased credit creation It is possible, however, to increase the impact of fiscal policy by linking it to credit creation. This can be done in a number of ways. The easiest would be for the central bank to purchase, indirectly, through the secondary market, the Government bonds newly issued to fund fiscal expansion, while not counteracting these purchases through any of its other transactions. In other words, when the Bank of England purchases ÂŁ1 billion of existing gilts in the secondary market, the Government could take the opportunity to raise the same amount of funds by selling new gilts. Government spending would increase or taxation would fall, but the total stock of gilts owned by the private sector would remain unchanged. When it cannot be sure of the long-term co-operation of the central bank, the Government can easily implement an alternative by ceasing the issuance of government bonds and borrowing instead directly from commercial banks in the form of long-term loan contracts.* This has the advantage of increasing bank credit creation, as well as strengthening the banking system by improving the quality of its loan book. Such a policy is a potential solution to many of the problems faced by countries such as Spain and Ireland presently: the prime rate, i.e. the interest rate banks charge borrowers with the best credit risk, is often far lower in Spain, Ireland, Portugal and Greece, than the sovereign bond yield of similar maturity. The reason is that bank credit is not tradable and hence not susceptible to speculative attacks, or downgrades by rating agencies â€“ while being eligible as collateral with the ECB, not required to be marked to market and not requiring new capital from banks, according to the Basel rules.20, 21 As we saw in Section 3.6.2, a similar mechanism of the Government borrowing directly from banks was last adopted in the UK during World War II, when the Treasury forced banks to buy Treasury Deposit Receipts (TDRs) at 1.125% interest to help fund the war. 22 TDRs were valid for six months and therefore less liquid than Treasury bills but paid 0.125% higher interest than the Treasury Bills at the time.23 In response to the UK banking crisis, the Government chose to do the opposite: it borrowed money from the markets to finance a bailout of the banking system.* This has now been partially counteracted, however, by the central bank buying back government bonds through the programme of QE.
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