The podcast is almost exclusively based on two articles, written by Michael McLeay, Amar Radia, and Ryland Thomas of the Bank of England’s Monetary Analysis Directorate. They were published in the Bank of England’s Quarterly Bulletin, Q1, 2014 (PDFs):
The hubbub about these articles, the sense that they were a critical “admission” and a breaking of ground by the Bank of England, is reflected in David Graeber’s Guardian article, written at the time of their publication; and in Ann Pettifor’s book, The Production of Money (Verso).
My interview of Guido Preparata, mentioned early in the podcast, can be found on this site.
The intent in this podcast is to set out, purely descriptively, how money is created in our time, and how the quantity of money in an economy is determined. I will admit briefly that my interest in these questions has sprung from a much broader hunch – and it’s only a hunch, that I wouldn’t be able necessarily to defend in front of massed ranks of experts – but a hunch anyway that a failure to think clearly about money has exacerbated lots of social problems. The cost of housing, for example, which may be more than simply a matter of supply and demand, but instead be bound up with how money works. So in the end, how money happens will probably turn out to be much more than an academic question.
But as I say, my focus this time is narrow and descriptive: how is money created these days, and how is the quantity of money, the money supply, determined?
“Doesn’t it come from the mint?”
The reason it’s worth making a podcast on something so fundamental is that many people who are in most respects sharper and more clued-in than me often don’t know how it happens. When I’ve talked about making this podcast, I’ve had the response, “doesn’t it comes from the mint?” But the mint only makes notes and coins, and they only accounted for 3% of the money held by the public in the UK in 2013, and it’s a similarly small percentage in all wealthy countries.
I talked to someone who said that a bank creates money by lending a multiple of the money they already have, which has been put into the bank by a depositor, while keeping some of it for depositors who might want funds from their accounts immediately. This is the famous idea that a bank is “an intermediary of loanable funds.” But it leaves the question, where did they get that money they already have? One answer to that, from a friend of mine, was that some money belonging to commercial banks is held by the government-owned central bank, the amount of this money being determined by the central bank, and these funds are “multiplied up” to a given percentage at any time by the commercial banks to make up the money we all use. So that way, money begins with funds held by the central bank, and the amount of money the central bank holds, has a determining effect on the amount of money in the economy. This is called the “money multiplier effect.”
When I heard this, I replied that my understanding is that in fact commercial banks create money, and that the amount of money in the economy is not determined by the amount of money the central bank is holding, by what are called the central bank’s reserves, but by commercial banks’ willingness to make and by consumers’ willingness to take loans. And that yes, the central bank can have an influence on the amount of money in the economy through the central bank interest rate and its monetary policy, but not a determining influence. My friend said that this is not what he had learned in university.
I can believe that, because, amazingly enough, it does seem to be the case that university economics textbooks do not reflect what actually goes on in the world of money and banking.
For example, an article in 2014 from the Bank of England, that is the UK’s central bank, said, quote, “While the money multiplier effect can be a useful way of introducing money and banking in economics textbooks, it is not an accurate description of how money is created in reality.” End quote. And a number of economists have been saying more or less the same thing.
So the confusion about money creation that I’ve been giving examples of is not just a matter of non-experts’ being hazy about an academic question, even about something so fundamental to most people’s daily lives as money. Thinking about where money comes from, after all, is not usually going to get you any more of it. Instead, the confusion about money creation is also to do with teaching that is abstract, outdated, academic, and does not reflect the present reality of money creation. Banks – by the way, the word comes from bench, it was where the banker sat while dealing with customers – banks did in the old days have to hold on to a certain amount of gold, so people could cash out their deposits, while lending a multiple of the value of that gold. But that’s not how it happens any more.
Obviously I’m not saying that everyone is going around clueless about how the banks and money work. What I am saying is just that people not paying close attention, in a way that’s still quite surprising, given how important the topic is, do fall back into those textbook ways of looking at the topic. But equally, many other economists do have their finger on the pulse.
In explaining how money creation does happen, I will be effectively exclusively reporting on that 2014 Bank of England article I mentioned, and a companion article that was published with it. They are titled “Money in the modern economy: an introduction” and “Money creation in the modern economy” and they were written by Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate. The two articles were published in March of that year in the Bank of England’s Quarterly Bulletin.
Coincidentally, while I was preparing this podcast, I got some very gratifying love from a couple of people for an interview I did last year with the economist Guido Preparata, who was for a time himself a central banker at the Bank of Italy, but who is very heterodox, and questions things, rightly in my view, that the Bank of England is never going to question in a million years, like “Why do we pay interest at all?” and has a very sharp take on, for example, quantitative easing. If you haven’t, it’s definitely worth listening to, because Preparata is so stimulating, thought it’s probably better to do it after listening to this one. In comparison, this podcast is a bit of a civics lesson, a bit square, a little unquestioning even: it’s about how things are supposed to work, and kind of do, in the good sense, about the mechanics of things, like how a bill becomes a law in Parliament, without telling you why they’re making that law in the first place. My response to that kind of criticism, if anyone wants to make it, is that you might at least learn, as I did, lots of technical and important facts about money creation, which can then be looked at more critically if you think that’s indicated. And that I hope this podcast will introduce some conceptual clarity. After all, I’m only learning too. Even in that Preparata podcast I referred pejoratively and naively to some money as “printed, out-of-nowhere dollars”.
Well, from doing this research, I have a firmer grasp on what I should have known all along: that all money is printed and out of nowhere. So the learning goes on. Also, as I’ll point out at the end of the podcast, some radical implications in the Bank of England articles have been picked up by various commentators. The articles actually had a substantial impact on publication, in that many campaigners who opposed the Coalition government in power in UK at that time felt vindicated, felt that the articles undermined many of the justifications for the spending cuts that Coalition was engaged in. I did hear about these articles through the excitement of one of those campaigners. But as I say, we can leave all that aside: the job right now is to describe money creation now.
We need first of all to go over the very basics. By the way, one of the virtues of the Bank of England articles is that, as it says in one of them, “It does not assume any prior knowledge of economics before reading”. By the same token, one of their vices is the slightly toe-curling hackneyed examples it gives to take you from that point of no prior knowledge. Trust me, though, it’s worth it. So let me introduce, the farmer and the fisherman.
By trading, a farmer, in the Bank of England’s example, is able to give a fisherman berries, and receive fish for those berries. But if the farmer has a berry surplus in the summer, and the fisherman has no fish until autumn, the fisherman can give an IOU to the farmer during the summer, and then fulfil the promise in the autumn, by giving the farmer fish. (By the way, just as an historical aside, this kind of system of IOUs was working, not in the mists of time, but more in the trading halls and merchant houses of medieval Europe.)
But there’s a difficulty with this IOU system, as Amar Radia, one of the articles’ authors, explains:
You can imagine where there’s lots of people interacting, trading lots of different goods and services: if everyone was just issuing their own IOUs, things would get very complicated, very quickly. And crucially, for that system to work, everybody would have to trust one another. So even though I may trust you, if you give me an IOU and your ability to fulfil that IOU depends on an IOU that you have from somebody else, I would then have to trust that person in order for me to think that your IOU was worth anything.”
So money is a special form of IOU, because unlike the one-to-one trade between farmer and fisherman, everyone expects that this IOU will be redeemable against all varieties of goods, and this IOU will be received by anyone; so if one trader fails or is untrustworthy, you can go to another trader. The fact that money can be used anywhere, without having to rely on others’ trustworthiness has given rise to the witticism: “Evil is the root of all money.”
So money is a claim on goods, which is easier to redeem than a one-to-one IOU: to have it to have an asset, like the farmer has an asset in holding the IOU against the fisherman during the summer, and the fisherman has a liability, a debt, in that he owes the fish in the autumn.
Equally, that means that one person’s financial asset, their money, is another person’s financial liability, their debt. In an imaginary closed economy, where there is no exchange with other, outside economies, financial liabilities are equal to financial assets. The introductory Bank of England article states: “If a person takes out a mortgage, they acquire the obligation to pay their bank a sum of money over time – a liability – and the bank acquires the right to receive those payments – an asset of the same size. Or if they own a company bond, they have an asset, but the company has an equally sized liability.” I hope you get the idea.
To understand the different senses in which money is an IOU, you have to look at the different types of money in the economy, which are each a different type of IOU. These are currency, bank deposits and central bank reserves, which we’ll take in order.
So, type of money number one is currency, which is notes and coins, is an IOU from the central bank to, mostly, consumers. Under the gold standard, you could of course exchange a bank note for its worth in gold, so it was more obviously than now a kind of IOU. But the fact that it’s universally accepted makes it useful. It is a claim on the goods you can buy with it, and to that extent a universally functioning IOU. One of the means by which it becomes universally accepted is by being accepted by the state in payment of tax. On the other hand, if the state wants people to use currency, it has to make sure it maintains its value, is not subject to wild inflation, so that even if it doesn’t command a certain amount of gold, it will buy a stable amount of real products. The delinking with gold, by the way, mostly served to counter the deflationary pressure of there not being enough money to facilitate economic activity.
How does currency happen? The European Central Bank, the ECB – by the way I’ll be using eurozone examples, despite my source in the Bank of England articles – the ECB prints enough banknotes to meet the public demand. Commercial banks buy banknotes, paper IOUs from the ECB, by swapping it for central bank reserves, which as we’ll see later are electronic IOUs from the ECB. It’s a straight swap, and the central bank pays for the cost of issuing notes through other assets on which it gains interest, like government bonds.
Type of money number two is bank deposits, which are an IOU from commercial banks to consumers and businesses. By far the majority of money in the economy is in bank deposits, for a number of reasons: there is the fact that it keeps money safe and the fact that many deposits pay interest. And also these days, because of the ease of electronic circulation of money, deposits are the default money because there is no need to convert them into currency.
How do bank deposits happen? The small-scale depositing of banknotes into accounts aside, bank deposits are mostly created by commercial banks themselves. Bank deposits are created through banks’ making loans: the bank credits the customer with a higher balance. The new money is an IOU from the bank to the borrower, and the borrower also creates an IOU to the bank: through his agreement to repay the loan in the first place, and in collateral if the loan can’t be repaid. But the bank’s IOU, unlike the borrower’s, is accepted as payment everywhere: that’s what makes it money.
The third and final type of money in the economy, after currency and bank deposits, is central bank reserves. In the same way as bank deposits are owned by customers and held by commercial banks, central bank reserves are owned by commercial banks and held by the central bank. They are the banks’ bank account at the central bank. And in the same way as bank deposits are IOUs from the commercial banks to customers, central bank reserves are IOUs from the central bank to commercial banks.
Money today… is a form of debt.
Simply put, the central bank reserves are how commercial banks make payments to each other. If, let’s call it, Bank of Mireland owes more to Allied Mirish than vice versa at the end of the day, the central bank adjusts their reserves balances to the correct sum. The reserves are essentially commercial banks’ current accounts. And, as I mentioned, they are also used by commercial banks to purchase currency from the central bank.
It’s worth saying that, together, currency and bank deposits are called “broad money”, because they are the types of money used in everyday spending in the economy. And then, in contrast to broad money, there is also “base money”, which is also made up in part of currency – again, an IOU from the central bank to consumers – and also central bank reserves, those reserves being an IOU from the central bank to commercial banks.
The names broad money and base money could be a bit misleading if they’re thought of as reflecting the academic understanding that broad money used for spending in the economy is based on a multiple of the base money that comes from the central bank. But there we are. Still, the fact that an economy’s central bank, the European Central Bank in the Irish case, the fact that it is the sole issuer of currency does give it the means to implement the ECB’s monetary policy, through the central bank interest rate, which we’ll get back to later.
What we really need to take from all this is that money today, for example the euro, is a form of debt, an IOU, that is accepted throughout the economy; and is thereby an asset for the person who possesses it. And most of it is bank deposits, created by commercial banks themselves. Now we need to look at how that money creation by commercial banks happens.
IN THE REAL WORLD
The second of the Bank of England articles, titled “Money creation in the modern economy”, does describe how money creation and lending by commercial banks happens. And along the way it corrects two common misconceptions about how the process works. They’re exactly the ones that I mentioned at the start of this podcast that people had recited to me.
Here’s how it happens. New money is created when banks make loans. When the bank puts money in your account to buy a house with or to invest in a business with, that is the creation of new money. It may or may not be right to say that this is an easy process, but the fact that there are no physical impediments to it is why it really is money created using a computer and a keyboard, why it used to be called fountain pen money, and in that sense, easy or not, it is simple.
Just as we saw that when the farmer had the asset of the IOU for fish, and the fisherman had a corresponding liability, so that every asset created also creates a corresponding liability, it’s worth looking at how the situation of the players involved is changed, when new money is created in the form of a loan granted by a bank.
The consumer has the asset of the new deposit and the corresponding liability of the new loan, which eventually has to be repaid. The commercial bank has the asset of the new loan, and the corresponding liability of the new deposit in the consumer’s account. The central bank’s position, unlike the other two players has no change – at least for now. Just as before it has the same level of assets from its dealings with the commercial banks, and corresponding liabilities in the forms of currency and central bank reserves, IOUs from the central bank to consumers and commercial banks respectively. So for each of these three players, there are differences here from how many people think about the process of banking and money. The consumer is not being lent pre-existent saved money, but new money. For the bank, the deposits it holds are not assets, but a liability that it owes, whether to a thrifty old lady or a spending young homebuyer. And the central bank does not constrain the loan from the commercial bank to the consumer on the basis of the quantity of central bank reserves. After the consumer loan has happened, commercial banks may need to hold more central bank money, either as currency to give out to consumers, or as central bank reserves to make payments to other banks. But that change is at the far end of the lending process, rather than determining it from the outset. As I say, at the level of consumer, bank, and central bank these are all big differences in how money creation is traditionally conceived.
It’s exactly the other way around.
The misconception that this accurate picture of money creation through bank lending corrects was that a bank is an intermediary, taking money from savers and then lending it out to borrowers. But if that thrifty woman keeps deposits in her bank account, all that means is those deposits are in her account, rather than in the accounts of companies which she might otherwise have bought things from. So her saving doesn’t increase the amount of funds available to the bank for lending.
Despite the fact that new money is typed in on a keyboard, despite its simplicity, there are factors that limit money creation, so money creation is not easy. Before going into all the details, I will mention above all, in flashing lights, the interest rates charged by commercial banks to consumers, what is effectively the price of money, the price of loans, is a critical potential limit on money creation. Obviously, the higher the price of money, the less consumers will want to borrow.
But we should also look at the factors limiting money creation from the points of view of the same players I mentioned before – the central bank, commercial banks, and consumers – which also helps them determine that “above all” factor of the interest rate.
So starting with the central bank – in the case of the eurozone, the ECB – the various incentives and limits it places on money creation effectively go to make up the ECB’s monetary policy. By its own account, the monetary policy of the ECB has the stability of prices of consumer goods and services as its primary goal. The historical hinterland here is obviously the memory of hyperinflation in Weimar Germany, since the ECB is so heavily influenced by Germany. Anyway, the cost of goods on the index of consumer prices, anyway, is supposed to increase by no more than 2% in a year, and in fact that 2% goal is the same as the Bank of England’s. The ECB implements its monetary policy by influencing short-term interest rates throughout the economy. And it does that by setting the rate paid to commercial banks for the reserves they hold at the national central banks. Yes, that’s right, commercial banks do earn money for keeping their money at the central bank. Part of the reason for that is that it means the central bank interest rate has an influence on the rates that banks lend to each other at on the open market. Obviously, if the central bank rate is low, the Bank of Mireland will be happy to accept a low, but slightly higher, rate of interest when it lends to Allied Mirish; whereas if the central bank rate is high, the Bank of Mireland might only be willing to lend to Allied Mirish at an interest rate higher again. So there is an influence from the central bank rate onto the open money market.
By the way, the reason why the central bank rate has such an influence over the economy is that every bank has to have a relationship with the central bank. The central bank is, after all, the monopoly provider of central bank money. That central bank money is the ultimate means of settlement with each other, the ultimate way of paying each other, that commercial banks have. And it’s also what they use to pay for banknotes. So there is always a demand for central bank money, and that allows the rate paid on it to have, quoting the Bank of England now, “a meaningful impact on other interest rates in the economy”.
In addition to the central bank rate, in pursuing its monetary policy, the ECB does also get involved in various ways in the money markets where banks are lending to each other as well. Guess what I’m about to mention. Yes, quantitative easing is the most famous way central banks have got involved in the money markets. But we’ll get to that later. The point is that both the central bank rate and the money market operations of the central bank feed through to interbank interest rates, and from there on to many different interest rates set by commercial banks across the economy, for different markets and at different levels of risk and maturity, and these commercial rates are the ones that a borrower faces when seeking a loan or that a depositor gets when saving.
And this is the second big misconception about money creation, and about how central banks like itself operate, that the Bank of England article corrects. Because one thing it is very keen to point out is that what they say they do, which is the way I’ve just described it to you, is very different from textbook descriptions of what they do. Apparently, the textbooks say that “central banks determine the quantity of broad money in the economy via a ‘money multiplier’ by actively varying the quantity of reserves. In that view, central banks implement monetary policy by choosing the quantity of reserves. And, because there is assumed to be a stable ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank deposits as banks increase lending and deposits.”
The reason all that is wrong, according to the Bank of England, is that it gets things in the wrong order. It’s exactly the other way round. The central bank isn’t choosing the quantity of reserves that commercial banks need to have, which then brings about the desired central bank rate and other interest rates; instead the central bank concentrates, by setting the central bank rate, on influencing interest rates throughout the economy. And then commercial banks react to the level of money creation going on at those interest rates by demanding an appropriate amount of central bank reserves and currency to settle debts with other banks and meet demand for currency from customers, which the central bank then, at the end of the process, accommodates on demand. So the quantity of reserves already in the system does not constrain the amount of new lending that may happen, which happens in reaction to interest rates.
The Bank of England sums all this up by saying, “demand for base money is therefore more likely to be a consequence rather than a cause of bank making loans and creating broad money. This is because banks’ decisions to extend credit are based on the availability of profitable lending opportunities at any given point in time. The profitability of making a loan will depend on a number of factors. One of these is the cost of funds that banks face, which is closely related to the interest rate paid on reserves.”
WHAT LIMITS MONEY SUPPLY?
So now, having looked at matters from the point of view of the central bank, let’s take up that hint: what are the factors that operate to constrain lending by commercial banks?
The first thing to say is that banks are seeking to make a profit. Their business model is to receive a higher interest rate on its assets, such as loans it makes, than the rate it pays out on its liabilities, like customers’ deposits. So one prime constraint on a bank’s lending, on its money creation, is that of lending profitably; and it is also seeking to lend profitably while in competition with other banks, which means that to make extra loans, a given bank will in theory have to lower its loan interest rate relative to its competitors, in order to draw more borrowers to itself.
Now, when such a loan made at a rate profitable to the bank happens, when that hurdle is passed, an interesting thing happens: another constraint on the bank’s lending heaves into view. To give an example: a household takes out a mortgage for a house from the Bank of Mireland, and as we’ve seen, the Bank credits the household’s account with new deposits. When the household buys the house, it passes on those deposits to the seller. That seller is more likely than not going to place those deposits in a different bank, Allied Mirish, and in our example he does. So now the Bank of Mireland pays Allied Mirish by transferring central bank reserves. The point is, if the Bank of Mireland keeps lending this way, and losing the deposits it creates to Allied Mirish, it will soon run out of reserves. So a bank has to attract or keep new liabilities to match the new asset it has in the mortgage loan. That can sound odd, but remember that in attracting new liabilities in the form of bank deposits, it is also bolstering the reserves it needs to operate. And it can obtain those liabilities by receiving deposits from other banks, so again if Allied Mirish created a mortgage, and the house seller had an account with the Bank of Mireland, it would attract a liability, and matching reserves, that way; or simply by borrowing from other banks.
But of course to attract these liabilities, it needs to pay out on them, to pay interest on them. So now you can see the full picture of what it means for banks to lend profitably in a competitive market, and how that constrains money creation. As the Bank of England sums up, “if a bank continued to attract new borrowers and increase lending by reducing mortgage rates, and sought to attract new deposits by increasing the rates it was paying on its customers’ deposits, it might soon find it unprofitable to keep expanding on its lending.”
As you might be able to guess from the fact the problem only definitely arises if one bank is doing all the lending, and not attracting matching liabilities, if all the banks in an economy simultaneously decide to lend more, there is no need for money creation to be limited by these constraints, because each bank will be gaining deposits when others make loans. That general lending increase would happen because of an improvement in the overall economy. Or it could happen because banks believe loans are not all that risky, and this was certainly the perception before the 2008 recession.
A second factor constraining bank lending, apart from profitability of loans, is the risk that comes with loans. One big danger we’re talking about here is liquidity risk, that deposits will be withdrawn in big sums in a short time, which runs into the bank’s reserves. That’s why banks offer fixed deposit accounts, that can’t be withdrawn on demand, to counter that risk, which of course has to be rewarded with a higher interest rate. And another big danger is credit risk: lending to borrowers who end up unable to repay. So the bank keeps capital to absorb any unexpected losses, and it’s taken into account in the pricing of loans. Higher risk loans means higher loan interest rates, which will tend to curb lending.
And a third and final factor constraining bank lending is financial regulation, simply because those liquidity and credit risks don’t always work in constraining the banks’ risk taking. As we learned to our cost. It doesn’t bear much thinking about.
So let’s move on to constraints on money creation arising in the last sector we need to mention, households and companies. Before we get into the details of that we need to understand a concept that I anyway had a little difficulty with to begin with. I just thought I’d mention that in case anyone starts to scratch their head. Very simply, just as money can be created, it can be also destroyed. The same way that a loan creates money, its repayment is the destruction of money. I have to admit that even when I was thinking something like, “those dumb schmucks think money comes from the government,” insofar as I thought of it at all I was also thinking that loans that are repaid to the bank are now its money, its capital. I guess? But I was wrong: as I said just now, banks make their profit on the difference between the interest rates, the prices of money that they pay and charge, and through fees too. The destruction of money by the repayment of loans can actually be exemplified very simply with the credit card. When a consumer does the Christmas shopping with a credit card, each purchase adds to the loans made to the consumer’s balance sheet and straightaway creates deposits in the shops’ balance sheets. And, as we all know, when the consumer pays the credit card bill, the bank for the first time reduces the amount of deposits in the consumer’s account by the bill total: voila the destruction of the money that had been created when the Christmas shopping was done. And the bank is making its money on the interest charged.
That concept of money being destroyed plays a critical role in how households and companies can constrain money creation. Because once the money is created in a loan, and then, for example, the house is paid for, how the person who sold the house and receives the money acts upon receiving the money determines whether that money continues to exist. If the house seller repays their mortgage, the money they use to do so with is destroyed. Whereas, if their mortgage is already paid, then they’ve got a lot of money to play with. And of course how these things play out in real life has a huge effect in the economy. In recessions, households and businesses tend to repay their existing debts, so there is lots of money destruction; whereas if people spend the money they have, there is usually a boom and inflationary pressure in the economy.
So, all of that is a fair picture of what money is, the different types of money, how money is created, and the forces that constrain money being created: being created through lending, and with interest rates, risk, and spending decisions operating to constrain it. But it’s not the whole picture. Most money is created when lent by banks, but it can come into being in other ways and one of the famous has been the quantitative easing, where central banks brought different types of financial assets in order to increase the money supply, to stave off money destruction, in the wake of the Great Recession which began in 2008. While there’s no doubt that the Bank of England articles are an empirically accurate account of how money creation works, I do think that part of the purpose was to justify quantitative easing in part to those sceptical about it, above all in regard to various easily disproved misconceptions about how it works.
How does QE work? Before getting to that head-on, we’ll look broadly at an important other way, apart from lending, that money is created. Fundamentally, deposits are created whenever the banking sector, including the central bank, buys an existing asset, like a bond, from companies or the government. For example, if a bank buys company bonds, they credit the company they are buying it from with money in their account, with the same simplicity we saw there was in lending and creating new money that way.
QE has arisen in a time when not enough money is being created. Normally, in these circumstances, central banks would cut their interest rate; that is, as we saw, cut the amount of money they’ll pay on money commercial banks hold at the central bank, so that the commercial banks would have an incentive to do something more profitable with it. But after the financial crisis, the Bank of England rate was at what it calls the effective lower bound 0.5%, and the ECB has managed to go below that so-called effective lower bound. In July 2008, the ECB rate was 4.25%. In October, a month after the Lehman’s crash, every central bank in the Western world cut their rate by half a percent, and the ECB and the Bank of England did it again in November, so the ECB rate was 3.25%. Between 2009 and 2011, the interest rate cruised between one and one and a half per cent. Since 2012 it’s been less than one percent. And since March 2016, the ECB rate has been zero per cent: no reward for holding money at the ECB. Incidentally, in a footnote, the Bank of England notes that “If the central bank were to lower interest rates significantly below zero [I’ll interrupt here to say that this negative interest rate would mean the central bank was charging banks to hold money at the central bank], banks could swap their bank reserves into currency, which would pay a higher interest rate (of zero) […] Or, put another way, the demand for central bank reserves would disappear, so the central bank could no longer influence the economy by changing the price of those reserves.” Couldn’t have that. But still, economically, in Europe as a whole, things have remained for most purposes relatively stagnant, so further action was necessary.
QE has been a policy to stave off the worst of these tendencies to stagnation, theoretically at least to provide some level of stimulus to the broad economy, though in polemic it has often been said, for example by Guido Preparata in the interview I did with him, which again is worth listening to for a different take on matters, QE is said merely to have refinanced the financial system, leaving the wider economy not influenced to the degree it should have been. Another matter is that as a programme it is now being drawn down. In August of this year the Bank of England set down a new monetary course and QE is to be phased out. So, now nearing at its end, maybe for some listeners, this will be a first opportunity to learn something of what it was about. The opposite of quantitative easing is naturally quantitative tightening, which as a barber said to me sounds like the opposite of something you’d want to have done to you. Some version and extent of that seems to be where we’re now headed.
Here anyway is the bare mechanism of how QE was supposed to work. In the same way that I mentioned that banks can purchase assets by creating deposits for those from whom they are buying, under quantitative easing central banks bought assets such as government bonds from non-bank financial companies like pension funds and insurance companies. But pension funds and insurance companies don’t have accounts at the central bank. So if the ECB bought a €1 billion worth of government bonds from a pension fund, the pension fund’s bank would credit the pension fund’s account with €1 billion, and the central bank would credit the commercial bank with €1 billion in reserves. The financial companies had new deposits in a commercial bank, while the commercial bank, which was being used as an intermediary, had new reserves in the central bank; there was a direct increase in both broad and base money.
The idea after that is that the non-bank financial companies will be holding too much money, compared to other, higher-yielding assets they might want, like company bonds and shares. So the pension fund in our example buys various companies’ bonds, and the companies whose bonds and shares they buy receive those funds. That then leads to higher spending and growth in the economy. Voila.
The Bank of England was keen to counter two ideas, misconceptions as they characterise them, about what QE involved. Indeed I think it’s possible these articles, which carry on over 23 pages, have as their real goal, a defence of QE and especially a self-defence by the Bank of England on various expressions of scepticism about QE, as reflected in the fact that it is these defences that appear in the YouTube videos that accompanied the article. Rather than attempting to evaluate the importance of the Bank’s objections, I will let Ryland Thomas, one of the article’s authors, explain the Bank’s defences, which are doubtless firmly based on the technical points. The first misconception is that the extra reserves are free money for banks:
It’s true that QE will lead to an increase in the reserves that banks hold with the Bank of England [or other central bank]. But if you consider what’s going on, on the balance sheets of the parties involved, you can see that it’s not really free money. The main point is that QE mainly involves buying government bonds, from pension funds and other asset managers, not from banks. The pension fund in this example will receive money in their bank account in exchange for those government bonds. The banks simply act as an intermediary to facilitate this transaction between the central bank and the pension fund. The additional reserves are simply a by-product of this transaction. Now while banks do earn interest on the newly created reserves, the key point is that QE also creates an accompanying liability for the bank, in the form of the pension fund’s deposit, which the bank will itself pay interest on. In other words, QE leaves banks with both a new IOU from the Bank of England [or other central bank], but also a matching IOU to consumers, in this case the pension fund, so in that sense it’s not really free money.”
The second misconception is that the new reserves created through QE are “multiplied up” into new loans and broad money:
It’s true that QE will lead to additional reserves held by the banking system. But banks cannot lend those reserves directly to households and companies. They have to make additional loans, and matching deposits. The simple fact of banks having more reserves will not materially affect their incentives lots of additional loans to households and companies in the way the money multiplier mechanism would suggest.
QE affects the economy mainly through the extra bank deposits that pension funds and other asset managers end up holding. Those asset managers will use those deposits to buy higher yielding assets, such as the bonds and equities that companies issue. That will raise the value of those assets, and lower the cost to companies of borrowing by using those instruments. That’s the key way in which spending in the economy is affected. But that could also mean that QE might reduce bank borrowing, if companies use some of the funds raised by issuing bonds and equities to repay some of their bank loans.
I first read about these two articles in a book called The Production of Money, by the economist Ann Pettifor. Her expressions of gratitude should communicate the tenor of why some people were so glad to read them: She said they were “met with delight by monetary reformers, and indifference by many mainstream economists.” She said their content “invites Keynes famous question, ‘Why then… if banks can create credit, should they refuse any reasonable request for it? And why should they charge a fee for what costs them little or nothing?’”
And the anthropologist David Graeber, who’s associated with Occupy Wall Street, and whose most famous book is Debt: The First 5,000 Years, wrote an article in the Guardian saying, “The Bank of England has let the cat out of the bag”, and “effectively thrown the entire theoretical basis for austerity out of the window”. The Bank of England articles absolutely didn’t get involved in government policy. But what Pettifor and Graeber were getting at, speaking loosely, is that if there is no limit on the basis of banks only being able to lend a certain amount to government, then there is no reason the government cannot boost the economy, through its spending.
An interesting part of Graeber’s article came when he speculated about the Bank’s motive in publishing the articles. “Why did the Bank of England suddenly admit all this?” he asked. And his answer was that, “one reason is that it’s obviously true. The Bank’s job is to actually run the system, and of late, the system has not been running especially well. It’s possible that it decided that maintaining the fantasy-land version of economics that has proved so convenient to the rich is simply a luxury it can no longer afford.”
Because I haven’t been reading central bank articles all my life, I can’t definitively say whether the Bank was saying something new, coming clean, and “admitting” something about money creation, as Pettifor and Graeber are saying. But I do get the impression the Bank of England and other central banks must previously have said nothing, and just maintained a tactful silence about money creation, because the sense in the media reaction that the Bank was making a semi-official statement, and thus confirming what many economists have long said, is very striking.
At the very least, the least I can say for Pettifor and Graeber after researching this podcast, is that I will never be able to hear the phrase “there’s no magic money tree” again without a certain amount of annoyance. Of course there isn’t. But that’s not the issue. And just as a last thought, I’m going to mention a phrase, coined as far as I know by Ann Pettifor, that has struck me the same way as “no magic money tree” or “where’s the money coming from?” has struck others; I mean, that it strikes me both as blinding common sense and also as resonant. The phrase is: “We can afford what we can do.” Think again, one last time, about most money being created by banks, very simply, through loans. And then think that while we may not be able to do everything, we should at least be able to afford the things we can do, pretty simply. That money should be no bar on action. It’s an idea anyway.