The Bank of England - The Printing Presses Start Turning

The inevitable has now happened....the Bank of England (BoE) is now starting a policy of 'Quantitative Easing' (QE) - or printing money to you or I. I first suggested that this was inevitably going to happen in July of last year, and predicted the circumstances of ever greater government borrowing as being the driver behind the policy. That is the current situation.

Since then, I have detailed two changes in policy that strongly suggest that the government/BoE were seeking to hide exactly what they were doing (see post here and here). However, it now appears that they are accepting that they must at least say something about what they are doing, and I will later analyse exactly what they are proposing. In the meantime, I will briefly explain the reasons that might provoke some concern over the policy, over and above the potential for hyper-inflation and potential collapse of the £GB (I will leave these out as many news sources outline these risks).

Regular readers may want to skip this section, as I have previously discussed what printing money actually means for an economy. However, for any new readers, I will give a very brief summary from a previous post:

I will try to explain what printing money actually means, through simplifying the process (for regular readers of the blog, you may want to skip the explanation, as I have explained this before). As we are all aware, the UK has an output of goods and services in many sectors. However, for the sake of simplification, I will just use the example of milk, and will describe the UK's output as if it were only milk, and will use small numbers to make it as clear and as easy to understand as possible.

In this illustration, we will say that the UK has a total output of milk of 100 litres, and that there is a total amount of £100 in the UK economy. In this example, therefore, the price of milk will be £1 per litre. If we then imagine that the government prints another £10, so that there is a total of £110 in the economy, we have a problem. The amount of milk has not increased at all, but the amount of money available to buy milk has increased. Instead of having £100 chasing the 100 litres of milk, we now have £110. In this simplification, remember, there is only the 100 litres of milk to buy with the money.

The only thing that can then happen is that the milk will increase in price from £1 per litre to £1.10 per litre. In other words, if you increase the money supply without increasing output, then you have a situation of inflation.

In addition to this, printing money has lots of other nasty effects. The first of these is that printing money is a form of taxation, and I will explain how this works.

As we have noted from the milk example, if you print money without increasing output, you are effectively devaluing money. Yesterday, your £1 could buy you a litre of milk, today that is not possible. If you are devaluing money, where has the value gone? The answer is that part of the value of your £1 has been transferred onto the newly printed money. If you then ask who has this newly printed money, you see that it is the government that holds it. As such, what you have is a situation in which the government is placing a tax on every unit of currency, and transferring that tax into the newly printed money. This means that there is a tax on every coin and banknote in your pocket, a tax on every £1 that you have in your bank account, and a tax on every asset that you hold that is denominated in the £. In other words, it is a tax on everything.

Another effect of printing money is that it a method for governments to default on debt. If you imagine that you are an overseas investor, and you have lent the UK government £1, then the value of that money was equivalent to being able to buy one litre of milk (using the milk example again). If you imagine that the government is running out of money, so that it has only £0.90 left to pay the lender, they will have a choice. Either they can pay back part of what they owe the investor, which means partially defaulting on the debt, or they can print money and give £1 to the investor. In the case of giving the lender £0.90, this is not enough to by a litre of milk, which means that the lender has lost money. However, if the government prints money, as in the example I gave earlier, then the investor will have his £1 returned, but it still will not buy the litre of milk, as milk has increased to £1.10. In both cases the effect is exactly the same, and in both cases the government has defaulted on debt.

Essentially, however it is spun, government money printing is fundamentally dishonest.

Regular readers will know that I have been pressing for greater transparency on the policy, including writing to and speaking with the BoE press department, with a view to gaining some clarity on the policy. Their answer was that an exchange of letters between the Chancellor, and the Governor of the Bank of England (BoE) would detail the policy. I have now read the letters (the Chancellor here and BoE Governor here), along with the following:

• All of the the Asset Purchase Facility (APF) documents on the BoE website
  
• The recent Banking Bill
• The Bank of England Act 1998

My aim was to try to understand what the obligations were for transparency, and try to understand the operations of the policy. My reading has left me with some significant concerns.

However, before discussion of these documents, I will look at the way this policy is being reported in the press, starting with the Guardian who explain QE as follows:

With interest rates now so low, central banks can no longer hope to revive the ailing economy by cutting the price of money and making it cheaper for people to borrow – they've run out of ammunition. Instead, they can choose to inject more money directly into the economy.

They do so by buying assets, usually government bonds, known as gilts, from banks or other financial institutions. The sellers of these assets can then use the extra funds the Bank gives them to spend on other assets, or to lend to households or businesses.

Also, many other interest rates are priced according to government bond yields (the income they pay relative to their price). So by buying up bonds and driving up their price – and reducing yields, which automatically move in the opposite direction – the MPC should also help to cut interest rates right across the economy.

The first thing you will note is that their is no discussion of the implicit taxation in the policy, or the fact that it is effectively a partial default on government and other debt.

Also of note, within this description of QE, is that they say that the purchase is 'usually government bonds, known as gilts' (italics added). The first point to be made here is that it is difficult to say how this might be usual, as this is the first time QE has been undertaken. The second point is that there is absolutely no necessity for the BoE to buy government debt if the BoE wants to inject more money into the economy. Buying corporate bonds (financing company debt) would be a more direct way of ensuring that credit reached companies in need of finance.

I have highlighted this, as this is quite typical of the kind of reporting of the policy, much of which suggests that the authors are struggling themselves to understand what they are looking at. With regards to the purchase of gilts 'usually' being used the Telegraph offers this on the US policy of QE (the Telegraph appears to be the best of the papers on economics reporting):

That the BoE has come slowly to QE is understandable. Money printing can be used well or irresponsibly. If a central bank monetizes an irresponsible government's deficit it will provoke high inflation or even hyperinflation - as is the case today in Zimbabwe.

The Fed cannot be accused of directly funding the spiraling US fiscal deficit as it is not (yet) buying government debt. The UK public, however, may well become nervous when it understands that the BoE plans to buy substantial amounts of UK government debt.

But the BoE will limit the amount of debt it buys and will aim eventually to sell it back to the market. The boost to the money supply will be limited in size and duration. There will be no intention to begin a hyperinflationary monetization of the government deficit, and every intention to avoid it. Yet with both the BoE's and Bernanke's approach to QE there are inflationary risks if, as the economy recovers, the money supply is allowed to grow too fast.

In another article the Telegraph has this to say on the details of the policy:

The Bank's action, which comes after it was granted official permission from Chancellor Alistair Darling, is a more aggressive stance than the one adopted by the US Federal Reserve. The initial £75bn sum represents about 5.4pc of gross domestic product in Britain, whereas the Fed has pumped around $670bn into the system, or 4.7pc of GDP.

In his letter to the Bank's governor Mervyn King, published today, Mr Darling authorised the request from the Bank's Monetary Policy Committee to spend a total of £150bn on government debt and private sector assets. By lifting the actual supply of money in the economy, the Bank hopes to ease the credit drought suffered by consumers and businesses alike.

The MPC's move left sterling almost a cent lower against the dollar at $1.4125, sent the price for government bonds soaring and did little to ease a slump in the FTSE 100, which was hit by fears over the capital position of insurers.

The point to note in this is that this is an injection of money amounting to 5.4% of GDP and note the figures that they are presenting with so much certainty. You may also want to look at the Times articles on the subject (here and here), or the BBC (here) or their interesting explanation of what QE is, in which they say the following:

Why is it different from Weimar and Zimbabwe?

Printing money can be defined as the central bank financing of government debts. This is what happened in both Weimar and Zimbabwe and what the British government will insist it is not doing, although the short-term effect is similar.

According to the Maastricht Treaty, EU member states are not allowed to finance their public deficits by printing money. That is one reason why the Bank of England will buy government bonds from financial institutions, not directly from the government.

The Bank believes this form of QE is different because they are "printing money" as part of monetary policy - to prevent deflation. They are not printing money to help the government finance its deficit. Also, unlike Zimbabwe, this is a temporary policy: the Bank expects to sell the government bonds back into the market when the economy recovers.

They appear very certain that there will be no direct purchases of gilts, but more of that later. For the moment, let's assume that they are correct that there will be no direct purchases. In this event, they will be purchasing gilts (government debt) from institutions. Those institutions are incentivised by capital adequacy ratio requirements to hold government debt, in accordance with the regulatory framework called Basel II. Don't worry too much about the jargon here, but the key point is that banks broadly want to have a certain amount of government debt in their holdings. As such, if a bank was to sell government debt, then they will be incentivised to buy new government debt to replace that which they have sold.

With the government as a shareholder in many banks, they might reasonably press the banks to recycle the government debts (i.e. sell the debt then just buy more of the same). In this way, it is possible that the BoE might use the banks as proxies for direct purchase of government debt. However, this would require more complexity, and would also be subject to more people being aware of the activity, with potential for whistle blowing. As such, direct purchase by the BoE might be a better method, but with greater risks if it is disclosed.

I have digressed slightly from a broader commentary on the way that the media are reporting the policy. As I have looked through various reports I have identified some general themes as follows:

• Attempts to delineate the policy from that of Zimbabwe etc.
  
• Emphasis on the idea that interest rates are not working and that this is the last option remaining
• Emphasis on the BoEs option of later selling the assets that they buy, thereby reversing the expansion
• The risks of inflation, but always alongside how the risks might be minimised (see point above)
• The potential benefits of getting banks lending again

I have not seen, in any single article, any discussion of the fact that this is a taxation on money, or that it might be seen as an indirect default on debt. I do not think that this is conspiracy, but rather that a result of lack of curiosity, and a narrow Keynesian economic outlook that are to blame. The result appears to be that the press have, as one Telegraph commentator put it, 'signed up' to the policy. As such, I am not sure that they are looking at the policy with critical eyes, and this might be a matter of some concern.

As a result, having given a brief overview of what the press are saying, I will now offer an analysis of the policy on my own account. The first point I would like to make is that the method of reporting the activity of QE is, to say the least, very dubious, and the letters explaining the policy of QE are filled with language that is either vague or offering no clear commitments.

I will quote directly from the Governor of the BoE's letter as follows with regards to the method of reporting:

Those minutes and the minutes relating to them would be published in accordance with the stipulations of the Bank of England Act of 1998. The Committee [the MPC] would be accountable for its use of the Asset Purchase Facility in the same way that it is for its decisions on the level of the Bank Rate. It would continue to explain its monetary policy through the Inflation Report and its evidence to the Treasury Select Committee.

Having read this, I decided that it was time to read the Bank of England Act of 1998, and my first point of interest was the Monetary Policy Committee (MPC) reporting requirements. The MPC is required to report on 'a decision to intervene in financial markets' or 'a decision about the publication' for such decision (Section 15.2 a and b), but I also found the following:

Unless the committee has decided that publication of the decision to intervene would not be likely, or would no longer be likely, to impede or frustrate the achievement of the intervention's purpose.

Section 14.2 makes a similar point. In plain English, this means that, as long as they can provide a justification, they might not report their actions. There is no boundary for what that justification might be. Furthermore, the bank might publish the minutes 'in such a manner as the bank sees fit'. Finally, in the section titled 'Disclosure by the Bank to Other Authorities', there are many caveats that would allow the withholding of information, and the 'Treasury may by order' restrict disclosure of information (including to the ONS), as well as there being limitations of disclosure to protect commercially sensitive information.

What we actually have is a system in which disclosure of activity might be restricted under any number of reasons, and therefore it is quite possible that the BoE can act without reporting its actions.

An interesting point in the discussion of reporting of the MPC is the following statement, which offers no commitment even to reporting under the limited remit already described for the MPC. This is how the reporting was prefaced:

I envisage [italics added] that the Committee would vote each month on a resolution concerning the asset purchases it deemed necessary to meet the inflation target.

This envisaging appears elsewhere in the letter. We can all envisage things, but to envisage something says nothing about intention to act, and makes absolutely no commitment whatsoever.

My reading extended to the whole 1988 Bank of England Act, and it was here that I started to notice points which suggest that the BoE is not as independent as we would imagine. For example, the MPC consists of The Governor and Deputy Governors (appointed by H.M. Queen?), two members appointed by the Governor 'after consultation with the Chancellor', 'four members appointed by the Chancellor'. (section 13) In addition, in a later section (proceedings) the Act says that 'A Representative of the Treasury may attend, and speak at, any meeting of the committee'. I am really not sure how such a committee might be seen as independent.

As a slight digression, one particular part of the Act grabbed my attention, which is under the heading of 'Treasury's reserve powers'. I will quote section 19.1:

The Treasury, after consultation with the Governor of the Bank, may by order give the Bank directions with respect to monetary policy if they are satisfied that the directions are required in the public interest and by extreme economic circumstances. [italics added]

The point to be made here is that, under extreme economic circumstances (now), the Chancellor can take direct control of monetary policy. According to this section, the Chancellor (if I have understood correctly) must let parliament know within 28 days of the action. As such, it appears that it must be reported, but it gives the flexibility for the Chancellor to regain power over monetary policy.

Returning to the letter it suggests the following at the end of the paragraph:

It would continue to explain its monetary policy through the Inflation Report and its evidence to the Treasury Select Committee.

It should be noted that this does not say that it will report on the QE policy. It is a sentence tacked on to the end that does not relate this to the Asset Purchase Facility (APF) or the QE policy. This may appear to be hair splitting, but hair splitting is the 'meat' of politics. Furthermore, if you look at an inflation report, the content is very generalised, and again are published in a manner as the 'banks sees fit'. The most recent inflation report can be found here, and the reason why this is not a useful method of reporting on QE will be evident once you see a copy.

It is worth noting here that the APF and policy of QE are being mixed up and blended into a single policy. The original APF was a facility to use treasury bills to purchase things such as asset backed securities and bonds, and did not include printing money or a facility to purchase gilts (government bonds). The APF was limited to (if that is the right expression) £50 billion worth of purchases.

Many readers will have seen many news reports that confidently tell you how much of what will be purchased with the printed money, and may notice that the numbers vary with different reports. However, to my knowledge the only official description of how much will be spent on what is to be found in the letter between the BoE Governor and the Chancellor. The problem is that, the letters do not ever actually explain what is to be purchased with how much money, and the letter confuses and muddles the old APF and the new QE policy. Furthermore, it does not expressly state that it will only purchase the gilts on the secondary market, and thereby allows for direct purchases from the DMO (Debt Management Office):

To the extent that the facility could be used to buy gilts on the secondary market financed by central bank money, this would be similar to the current implementation of monetary policy [... italics added]

It is only later that we come to the amount of money that might be created, and then the lack of clarity arises as to how much of the money is new printed money, and how much money is actually the original APF financed by Treaury bills. I suggest that you read the paragraph two or even three times and see if you can tell whether it is £150 billion of new money, or £100 billion of newly printed money and the original £50 billion of money from treasury bills in the original APF:

In order to facillitate an expansion of the monetary base the the Asset Purchase Facility, the MPC proposes that gilt-edged securities be added to the list of eligible assets set out in your letter of 29 January. I suggest the MPC be authorised to use the the facility to purchase eligible assets financed by central bank money up to a maximum of £150 billion but that, in line with the current arrangements and in recognition of supporting the flow of corporate credit, up to £50 billion of that should be used to purchase private sector assets. Within those limits, the speed and scale of the purchases would be for the committee to decide. [italics added]

At this point you may wish to return to the news reports of the policy and ask yourself how on earth they might make such confident assertions on the numbers that they are providing. The only source of such assertions must be off the record briefings, as there is certainly no substance to them in the only policy document on the subject. If you want further examples of the obfustication in the BoE letter, this is a good example (again, italics added and my comments are in [my comments]):

Therefore I envisage that purchase of private sector assets will continue as planned [with printed money or borrowed money?] and the scale of the purchases will not be effected by the extension of the Asset Purchase Facility [this might suggest that none of the newly printed money is going to be used for this purpose, in which case it will be used exclusively for gilts]. The option of issuing Treasury Bills to finance such asset purchases will remain open [this suggests that the £150 bn really is new money]. If and when the MPC decides that private sector purchases should be financed by the creation of central bank money, the Bank executive will apply the same criteria in selecting those assets as if the purchases were financed by the issuance of treasury bills. And in that case, I would expect that the need to finance using Treasury bills would cease, at least initially [so will the old 50bn APF facility will no longer be used? Is £150 bn of printed money taking its place?].

This is all very unclear, and might even be described as obfustication. I have read the original letters for the APF, and have read these letters, and the reality is that we have absolutely no idea how much the BoE is printing, and what it will be using the money to purchase. My own view is that the BoE will be creating £150 billion of new money, and may in addition continue to utilise what remains of the original APF, but this money may now be used to purchase gilts.....

Finally, we have the question of what will be done to prevent inflation as a result of the policy. Once again, we enter very vague territory:

At some future date, I would expect that the MPC would wish to exit from the strategy of buying assets [...] if sales are required, the Commitee will [...]

As you may gather, I am not very convinced that the exchange of letters offers any great clarity, and this is worrying in light of some of my earlier concerns. In summary this is the position:

1. The BoE has no obligation to report all of its activity
2. It would be difficult to describe the BoE as being independent of the Treasury
   
3. The Banking Bill has removed the necessity to publish how much money the BoE creates
4. The method for gilt auctions has just been reviewed, and included discussion of direct purchases of gilts, which would suddenly allow direct purchases by the BoE (altering a 300 year old system)
5. The only published policy on QE does not make clear the method of purchase of gilts, thereby allowing for direct purchases of gilts
   
6. The total maximum amount of money to be printed is completely unclear, but it appears that journalists are getting off the record briefings and reporting them as hard fact. A reading of the letter from the BoE suggests that the total amount of money to be created is £150 bn.
   
7. No timescale is given for when the purchases will take place
8. There is no end strategy or time whatsoever
   

The letters, and other information on the BoE QE policy, therefore do not preclude the direct financing of government operations and are very opaque in their description of the policy, and offer no formal or clear method of reporting. As such, it is quite possible that the government is doing a 'Zimbabwe'.

Whilst we are now in a position where we can speculate on the numbers, and speculate on what methods they might use, and what assets they might purchase, this is a long way from offering any clarity. As such, I will be sending another letter to the BoE requesting further information, which can be found in note 1.

Before getting too carried away with any ideas that the government and BoE are seeking to hide what they are doing, it is quite possible that the letters that outline the policy are simply a case of poor expression. It might be that the authors are so close the subject, that the lack of clarity is resultant of their forgetting that those who might read the letters were not privy to their previous discussions.

However, another interpretation, and the one that I hold, is that they are obfusticating. If they are obfusticating, it is necessary to ask why they would wish to do so? As such, as before, I am offering them the opportunity of offering some clarity on the policy. If they are comfortable with the nature of the policy, then I would see no reason for them not to give direct and clear replies. If they believe that the policy is sound, then they would presumably want as much understanding amongst the public of the policy as possible.

As such, I hope for a positive reply to my latest letter, and will keep you informed of progress.

Note 1:

[formalities]

I have now read the exchange of letters regarding the revision of the APF to allow/include central bank money creation. Having read the letters, there are still some points that are unclear. I would be most grateful if you could clarify these points, some of which are carried over from my original request.

1. In the letter written by the Governor, he mentions a figure of £150 billion being available for the purchase of assets. Can you clarify whether this figure is an additional facility over and above the £50 billion that was previously available in the APF? In other words, can you confirm that this £150 billion is all central bank created money?
2. Can you give a projected split / proportion of which type of assets will be purchased in the period March-May, and the period June-August 2009? Please give totals or ranges under consideration, and any projected figures that you are using as the most likely scenario?
3. Can you give a clear description of how the split/proportion of assets to be purchased under QE has been determined?
4. Can you confirm that, under no circumstances, will the BoE be making direct purchases from the DMO of gilts? This question includes a request for confirmation that you will not be using a proxy to act on your behalf in DMO auctions, or a proxy used for direct purchases.
5. Can you confirm that there will be no use of the provision of the Bank of England Act of 1998 15.2 (a) and (b) as a reason for non-disclosure of any purchases made through the APF, or any other provisions of the act? In other words, will there be full disclosure of what has been purchased, how it was purchased, and in what amount? I note that the MPC has no obligations to report this information, and the readers of Cynicus Economicus would therefore be reassured by a formal statement committing to such a policy.
   

I am sure that you would agree that clarifying such questions would go a considerable way to help readers of Cynicus Economicus to understand the nature of the policy, so that they can then take an informed view on the policy. I am sure that you would agree that it woudl be good for the voters of the UK to be informed on the nature of economic policy, as well as others interested in UK economic policy.

As I mentioned in my previous letter, all of this information should be very readily available so I would welcome an early reply. In light of the possibly controversial nature of this policy, I would ideally like to have the answers in writing so that there is no potential misunderstanding of the information provided. I would not want to cause alarm through misinterpretation of your answers.

etc...

Note 2: I am sorry that the post is rather clunky. This is a combination of the subject matter, and my wanting to get the post out whilst there is still wide interest in the subject. I hope that such a rushed approach is not self-defeating.

Note 3 (added about 30 minutes after original post):

It seems that the press have started to sort out the numbers on the QE policy, and it is being recognised at £150 bn of newly printed money.