Money doesn’t grow on trees – so we are told. Yet central banks like the Bank of England can create it out of nothing. Do they really know what they are doing? And who has gained most from their monetary alchemy?
The age of alchemy
The Credit Crunch – aka the Financial Crisis – of 2008-09, which followed the collapse of Lehman Brothers on 15 September 2008, transformed the entire political and economic framework in which we live. For both apologists of capitalism (such as this writer) and its most vitriolic anarchist opponents, the game fundamentally changed. Indeed, sometimes it seems almost as if the laws of the dismal science of economics itself have changed.
Here in the UK the central bank, the Bank of England, printed – sorry, created – about a half a trillion pounds of fresh money from 2009-15 in a programme that went by the unlovely neologism of Quantitative Easing or QE. In the USA about $1.3 trillion was pumped into the economy by the Federal Reserve over 2008-10 alone.
Now, technically, the ability of central banks to control the money supply by manipulating interest rates and by buying and selling financial instruments – which back in the day was called open market operations – was nothing new. What was new was that the central banks of the USA, the UK, Japan and others all, post-Credit Crunch, set up deliberate and coordinated programmes to boost their money supplies over a sustained period. In fact, that was historically unprecedented (though the Japanese had been at it since the early 1990s).
If you go back to the late 1970s and early 1980s (and I fear I can remember that far back) the main problem with the money supply was that it was rising too fast and therefore driving inflation. A simplistic version of the monetarist theories of the hugely influential economist Milton Friedman (1912-2006) held that there was a direct relationship between the stock of money and the rate of inflation. (Actually, this was itself derived from the Quantity Theory of Money developed by that other great American economist, Irving Fisher (1867-1947).)
Because rampant inflation was an economic scourge in Europe and North America after the Oil Shock of 1973, it became mainstream to argue that the stock of money (the money supply) should be controlled by governments. That is why under Mrs Thatcher’s first administration interest rates in the UK reached 17 percent and the Fed at the same time raised rates in the US to 20 percent!
Gordon Brown, the new Chancellor of Tony Blair’s first government, gave “independence” to the Bank of England in 1997. Independence for a central bank means that it can pursue monetary policy – setting interest rates and open market operations/QE – without the say-so of the Ministry of Finance. So, since 1997 in the UK, monetary policy has been prosecuted by a bunch of mandarins-cum-academics who populate the Monetary Policy Committee of the Bank of England. They are unelected and entirely unaccountable. Though, occasionally, some of these alpha intellects are summoned to the House of Commons Treasury Select Committee hearings where they are grilled by MPs who think that M3 (the main measure of the aggregate money supply) is a motorway in Hampshire. It is not a pretty sight.
The primacy of macroeconomics
Macroeconomics, which since the classical economists is presumed to be the task of governments, consists of fiscal policy and monetary policy. Fiscal policy is one of setting taxes and collecting them. (Hopefully in a benevolent, efficacious and equitable manner. The Window Tax of 1696 and the Poll Tax of 1988 were both injudicious and unpopular.) Monetary policy consists of regulating the amount of currency (“coinage”) in circulation and ensuring the viability of the banking system.
But fiscal policy is value-driven. Before I go any further, I must admit a cultural bias. Northern European Protestants are inclined to think that people (and governments) should live within their means: they should manage their money within the constraints of their incomes. This has been exemplified in recent years by the attitude of the German government towards the plight of the Greeks. But Southern European Catholics (I generalise, though hopefully I do not stereotype) believe that needs must: so long as people are buying your bonds, why worry?
Again, I generalise: the British, from the Protestant Reformation to WWII were disciples of Mr Micawber[i]. Then we became good Keynesians who thought you could spend your way out of an economic crisis for the common good. We subsequently briefly became Thatcherites in the 1980s who famously believed that there was no such thing as a free lunch… Now, we are just confused…
Why QE?
There are basically three reasons why the major central banks embarked on a programme of QE and set about pumping money into the financial system.
Firstly, at the height of the Financial Crisis in October 2008 there was the real and present danger of a systemic banking collapse which would not have been confined to one country. QE was supposed in the first instance to create liquidity within the banking system in order to forestall catastrophe.
Secondly, the Financial Crisis was followed by dramatic falls in the overall level of global economic activity and world trade. QE was intended to stimulate demand. To this extent, the central bankers were mindful of the mistakes their antecedents had made during the Great Depression of the 1930s, when policies of tight money and tariffs on foreign imports cut demand further and thus exacerbated the depression. In particular, Ben Bernanke (Chairman of the Federal Reserve 2006-14) was an academic economic historian who had written extensively about the lessons to be learned from the policy failures of the 1930s.
In normal conditions a central bank could stimulate demand just by cutting interest rates – the price of money. In these extraordinary conditions, even though most central banks across Europe, North America and Japan had cut interest rates to near-zero, the global economy continued to contract. There was a period when it seemed likely that, as a result, rates might have to be cut to below zero levels. That would have entailed a world of Alice in Wonderland economics where corporations and individuals would have to pay for the privilege of placing money on deposit while borrowers would be paid to borrow money…The alternative policy of just printing money like crazy was considered saner.
Asset-owners all got richer while those without assets flat-lined.
The third reason was that there is one thing that central bankers fear more than inflation – and that is deflation. Inflation is corrosive and inequitable in so far as it erodes the purchasing power of the savings of provident people who have done the right thing and built up a nest-egg. Deflation, however, is potentially catastrophic as it erodes the ability of debtors to repay loans taken out against assets which are falling in value. That, in turn, increases the risk of bank failures. So the central bankers deliberately set out to create inflation – though hopefully not too much – to counter the deflation which began to manifest itself in 2009. Interestingly, one of the first speeches that Ben Bernanke had made as Chairman of the Fed was entitled Deflation: Making Sure It Doesn’t Happen Here. In this speech he outlined what was later referred to as the Bernanke Doctrine.
It should be said that the European Central Bank (ECB) embarked on a programme of QE under its new Chairman, Mario Draghi, in December 2011, for an additional reason. Signor Draghi took over the helm at the most acute moment in the European Sovereign Debt Crisis. The danger was that certain European governments (the PIIGS – remember them?) would become insolvent and thus bring down major banks which had massive exposures of euro-denominated government bonds. That again could have precipitated a systemic banking collapse within the eurozone – the Germans’ worst nightmare.
As I have written previously, the main purpose of the ECB’s programme of loans to banks, bond buy-backs and the concomitant round of “bail-outs” was not to save the Greek or Portuguese people from torment, but rather to save the French and German banks. Over 2010-11 the likes of BNP Paribas (EPA:BNP) and Commerzbank (ETR:CBK) were able to offload virtually all of their Greek and Italian government bond positions to the ECB.
How did they do it?
This week, I downloaded an excellent podcast from the BBC in which financial journalist Michael Robinson asked who was telling the truth[ii]. Is there, or is there not a magic money tree? This is a question that I have written around for some time. It turns out that the magic money tree really does exist. It is a dealing room in the bowels of the Bank of England on Threadneedle Street.
It works like this. Pension funds and other financial institutions buy government bonds (gilts) from the UK Treasury, though, to be correct, they are issued by (you’ve guessed it) the Bank of England. The proceeds of such gilt issues are of course paid over to the Treasury and used by the government to fund the NHS, schools, the armed forces and to make welfare payments and so forth.
Thereafter, the BOE can buy back those government securities from the pension funds et al in a gilt auction with cash that they have created on a computer screen. Essentially, the money that the BOE uses to purchase those gilts from the pension fund is a new liability on the BOE’s balance sheet which is perfectly balanced by the value of those gilts on the assets side. The impact on the central bank’s notional capital is neutral. (But – does a central bank really have capital? That is a question I shall attempt to answer another time.)
If this sounds weird then consider that, as a result of QE, a portion of the UK government’s outstanding debt (which amounted to about 89 percent of UK GDP at the last count) is actually owed to itself… I know this all sounds more like quantum mechanics than economics – though much, much dodgier.
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And it gets worse. What happened after 2009 was that, as pension funds sold back their stocks of gilts to the BOE, they used the cash so raised to buy more risky corporate bonds which of course have higher yields. As a result, corporates responded to the new demand for bonds by issuing more of them. Between 2010 and 2015 there were thousands of new sterling bond issues by British corporates. But as Michael Robinson revealed, the vast majority of these new issues were undertaken by banks. The number of companies issuing new bond debt to finance capacity expansion was vanishingly small. In fact, according to Colin Ellis of Moody’s, only 0.8 percent of the total funds raised by such bond issues was specifically invested in new productive capacity. Most bonds were issued for “general purposes” which means either working capital finance or refinancing.
Under the so-called Funding for Lending Scheme (FLS) launched by Mr Osborne in August 2012, the Bank of England was tasked to lend invented money to the high street banks at preferential rates so as to boost bank lending to households and companies. The BOE would use the banks’ portfolio of loans as collateral. The scheme’s target was to increase bank lending by up to £70 billion but the actual figure to date is around £100 billion.
Michael Johnson reckons that much of that money ended up in bricks and mortar – specifically financing well-off individuals to fuel the buy-to-let craze which pushed residential property prices higher. In fact, the government changed the rules of the scheme in January 2014 so that funding available under FLS could no longer be used to finance mortgages. Yet, somehow, very little of that £100 billion seems to have found its way to small businesses.
Evaluating QE
Did QE work? This is a question which everybody, whether they swing to the left or to the right, should ask. And where exactly did all that money go?
The purpose of QE was to stimulate the economy. And defenders of QE like the Bank of England’s Chief Economist Andy Haldane, argue that that objective was achieved. Certainly, the prospective systemic banking collapse was avoided – though QE was sustained for several years after the Crisis. Thankfully, we were saved from a repetition of the Great Depression of the 1930s.
But the evidence is now mounting that much of the nearly half a trillion pounds the BOE created was absorbed in asset prices – property, bonds and equities. The same goes for the USA and Europe though it should be said that Japanese asset prices remained depressed until relatively recently. I also note that the real take-off in the US equity markets – the Trump Bump – has occurred well after QE was halted in America.
So, while ordinary folk should be glad there was no new depression which would have put many of them out of work, it was the asset-owners – the better-off and indeed the rich – who benefited the most. Asset-owners all got richer while those without assets flat-lined. Therefore, inequality of wealth has accelerated. Moreover, with high property prices and flat to declining real disposable incomes, huge numbers of young people in this country have given up hope of ever being able to buy their own home. This removes a lot of aspirational energy and ambition from the labour market.
The political fallout
Some economists have suggested that, rather than the programme of QE as it was rolled out, it would have been better to have pursued a helicopter money strategy. This is where money is just doled out as if scattered from a helicopter. Specifically, the BOE could have sent everybody in the land a cheque for £7,500[iii] with a nice note asking them to go out and spend it on whatever they wanted. That would certainly have stimulated demand and would not have so blatantly benefited the rich.
All this has prompted left-leaning economists to ask why the magic money was not spent on tangible investment in infrastructure and productive capacity. QE, they say, was a missed opportunity. Could not HS2 have been financed and built already courtesy of the magic money tree? Surely that would have created more jobs than boosting asset prices? There are also voices in Mr Corbyn’s Labour Party asking, if there really is a magic money tree why could we not use it to finance the National Health Service?
Mr McDonnell and his team have proposed the establishment of a National Investment Bank funded by magic money which would finance, inter alia, the construction of new schools and hospitals. They argue that Britain needs new institutions to target investment into new productive capacity. The conventional wisdom of the right that the market knows best, that it is not the business of government to pick winners and drop losers; that the profit motive should always be the guiding hand of economic activity – all this is anathema to the left.
It matters little what people like me think. The point is that, once QE has been embarked upon and the existence of the magic money tree has been made known to the masses, the genie is out of the bottle. Combine that with a profound distrust, nay distaste, for capitalism amongst the young – plus their preference for “fairness” above freedom – and you have a recipe for an unprecedented – and highly risky – economic experiment.
When the history of our era is written, it may well be concluded that it was the brilliant central bankers who, unfettered by elected politicians, ultimately sabotaged capitalism from the inside – and allowed the Corbynistas to seize control of the magic money tree.
[i] Charles Dickens: David Copperfield (1850). Mr Micawber famously tells David: “Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”
[ii] Available at: http://www.bbc.co.uk/programmes/b09pl66b#play
[iii] £450 billion divided by 60 million inhabitants.