Tuesday, September 29, 2009

Bank of England Bills and Printing Money

Regular readers may remember that, some time ago, I sent some questions to the Bank of England regarding quantitative easing (QE - printing money), following an offer by the deputy governor to answer QE questions. I sent an email on July 16th, and now have a response. Before looking at the reply, these were my questions:
1. Reuters has reported on the 9th July that, following no announcement of an extension of the policy of QE by the Bank of England, bond yields rose sharply. Bearing in mind that just the possibility of an end to the policy caused this reaction, does this not suggest to you that QE is propping up the Bond Market?

2. The CPI has finally dipped below the 2% target that the Bank of England uses in setting monetary policy, but is still not far enough off target to require a letter of explanation. I believe that the Governor of the Bank of England has identified QE as an untried unconventional policy with uncertain outcomes. Bearing in mind that during all but the last week, CPI has not fallen below target, how can such an untested policy be justified? In particular, with monetary stability as a key aim, how can such an unconventional policy be justified?

3. With regards to exit strategies for QE, the Bank of England Quarterly Bulletin for 2009 Q2 states that 'Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills.' Is this policy? If so, can you confirm exactly when and under what circumstances you will finally sell the gilts that have been purchased?

4. A secondary question as a follow on to question 3. If the purpose of QE is not to monetize government debt, then why would you not sell gilts at the end of QE policy? Do you have concerns that the existing expansion of gilt issuance would preclude the sale as the sale might destabilise the gilt market? Is this not a recognition that the gilt market can not support the level of issuance?
The BoE took the trouble to write to me with some answers in an email but, they also referred me to other general answer to questions on their website, pointing me to answers 1, 6, 11 and 13 in particular. I will use the answers from the email and some of the general answers in this post, but you may wish to see the originals general answers in full.

The first point to note is that there was no direct answer to my question (1) in any of the answers that were provided. It appears that the Bank of England does not want to comment on whether they might be propping up the bond market. It might be argued that, in purchasing bonds, the intention is to hold down yields, but I think the implication of a spike in yields on a mere sniff of an end to QE goes beyond this. The question is, of course, an indirect way of asking whether the BoE is monetising government debt. This they have answered, and this is from the email they sent:
Quantitative easing has not been carried out to help the government meet its financing needs, and asset purchases by the Bank have not been made to keep gilt yields at a particular level. Other things being equal, yields can be expected to fall in response to the Bank’s gilt purchases.
In the general answers, they add that monetization of government debt would infringe upon article 101 of the Maastricht treaty, and that they are not being forced to make up a shortfall between government debt and expenditure:
The key point is that the Bank is not being forced to create money in order to cover the gap between the government’s tax income and its spending commitments. If it were carried out to finance the budget deficit, it would be a violation of Article 101 of the Maastricht Treaty (which the United Kingdom must abide by, even though it is not a member of the euro zone). [...]

Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets and such operations are not deemed to amount to monetary financing under the Maastricht Treaty.
The interesting word in this answer is forced, as it is not apparent where this word has come from. This is the original article 101:
1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions.
The interesting point in this article is that the direct purchase of government debt is actually prohibited, but there is nothing to prevent indirect purchases (as they point out). At the same time, it is not apparent where this idea of 'forced' has appeared from. The implication of this is that, if the BoE were to monetize debt without being forced, this would all be right and proper. It is a most puzzling answer...

With regards to the question about why the policy is being enacted whilst CPI has barely moved below target, this is the answer in the email:
The objective of the MPC remains to hit the Chancellor’s 2% CPI inflation target. Therefore the MPC continues to focus on the medium term prospects for inflation when setting monetary policy. The MPC judged in March that in the absence of a further monetary policy stimulus, the growing margin of spare capacity created by the recession would push inflation significantly below the target in the medium term. With Bank Rate already almost as low as it could go, the MPC decided that a substantial stimulus through quantitative easing was warranted. That was the reason for embarking on unconventional monetary policy. Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets. What distinguishes quantitative easing from normal operations is their scale and the length of time for which the assets are likely to be held.
There is nothing new in this answer. The BoE been wrong in their inflation forecasts up to now, such that the expected fall in the CPI has not taken place ....it is not clear therefore why QE is still being enacted, as it is freely admitted that it is 'unconventional' and therefore carries with it risks that are unknown? Under their own considerations, it will take at least 6 months for the impact of the policy to be felt, so it is not the policy that has prevented deflation. Deflation has simply not happened.

Questions (3) and (4) generated some interesting answers, with this from the general answers:
When it comes to tightening policy, the MPC will have two instruments available: raising Bank Rate; and selling back assets. Removing money from circulation can be achieved by selling the assets back to the private sector. The MPC will be likely to use a combination of raising Bank Rate and selling back assets, although the precise sequencing and the relative importance of the two instruments will be considered month by month at each MPC meeting. The Bank will seek to sell the assets it owns in an orderly fashion in order not to disrupt the market for government debt.
And this is the answer sent in the email:
The market for UK government debt is one of the deepest and most liquid financial markets in the world. Nevertheless, buying and selling large quantities of assets quickly is likely to influence prices.If the MPC decides that it wants to reduce the quantity of reserve balances held by the banks, it could issue Bank of England bills in exchange for the reserves, rather than selling the Bank’s holdings of government debt back to the non-bank private sector. The assets could then be sold back in an orderly fashion over a longer time period. Whether the Bank issues extra bills in exchange for the reserves or not will ultimately be a technical decision that will be taken with a view to market conditions at the time [emphasis added].
It is notable that they do not mention the sale of Bank of England bills in the general answers, but instead simply say they will sell 'assets'. It is apparent that I was correct in thinking that the BoE is not planning to sell the government debt back into the market for a long time, but is rather planning on tightening monetary policy through issuance of Bank of England bills. This is still not public knowledge, and I am uncertain that the distinction would be understood.

The BoE are right to assert that any quick sale of the bonds would influence prices, but this bumps up against a fundamental concern. How might the BoE sell the bonds into the market at any time during which there is already such massive issuance of new debt? How long will the BoE have to hang onto the government debt, and what market conditions might be considered opportune for selling the bonds?

The bottom line is that the BoE will not be reversing the QE policy in what might be seen as a conventional way (e.g. selling the original assets back). It might be argued that there is no conventional way in an unconventional policy, but I do not believe that open market operations, the nearest equivalent, would allow for assets to be purchased and held in this way. With such a radical policy, it would be expected that the BoE would have clear criteria for a return of the bonds to the market in an orderly way, and under what circumstances they might sell them.

The logic of QE is that, should an upturn in the money supply or inflation become apparent, they will need to reverse the policy. However, this would not mean an immediate tightening of the money supply, but would likely be a progressive tightening. Just as interest rates are not normally altered by large increments, or the policy of QE undertaken in one large 'dollop', there is no reason why the end of QE should be undertaken as a 'dollop'.

There is no discussion of any detail, because the Bank of England will certainly know that, with government issuance of debt flooding the market, there is absolutely no time in the foreseeable future at which they might offload the bonds without causing a crisis. The BoE's holding of government debt is simply too large...The only reason that any other method might be used for monetary tightening is that the amount of debt being issued by the government can simply not be digested by the markets. There is more debt being issued than demand. The BoE is simply filling the hole in demand.

As another concern, this is a quote from the general answers, on reselling of BoE holdings of bonds:
It is possible that gilt prices will fall, thus raising the corresponding interest rates, when the Bank starts to sell its holdings. Subject to achieving the 2% inflation target in the medium term, any sales will be co-ordinated with the Debt Management Office so as to limit any adverse impact on the functioning of the gilt market.
This should be a matter of some concern. The BoE will be co-ordinating the sale with the DMO, which is the arm of government that raises finance. There should be no direct linkage between the activity of monetary policy and the issuance of government debt. The BoE has no business in ensuring that the government might be able to finance their debts or at what rate, and is now admitting that their operations are now (at least partly) being controlled by the central government through the DMO.

This is the basic problem; if the government were not issuing too much debt, then there would be no need for the co-ordination, as a steady offloading of the debt would not unduly interfere with the market. Also, if a private institutions were to co-ordinate with the DMO there would be outrage. The BoE and the DMO acting together is, quite literally, rigging the market.

What we have is a situation where the BoE is preparing to find reasons to hang on to government debt, and to not return the debt to the market (where it belongs) without the permission of (sorry, co-ordination with) the DMO. All the while, they continue to purchase more debt, despite the fact that CPI is still at a level at which there is no need even for a letter of explanation.

Over and above the answers to my questions, there were some interesting points in the general answers. For example, they go to some lengths to distance themselves from the idea that what they are doing is a variant of the Zimbabwe problem. This is the disingenuous explanation:
In the Weimar Republic and Zimbabwe, the central bank printed money to finance government expenditure. This vastly increased the money supply, and hence prices rose rapidly. This is not happening in the United Kingdom. Here, the Bank is buying assets from the private sector to stimulate the wider economy, because otherwise we risk undershooting, rather than overshooting, the inflation target. Quantitative easing is not carried out to help the government meet its financing needs. When the economy recovers, most of the purchased assets will be sold back to investors, reducing the money supply.
Note the misdirection in suggesting that they are buying 'assets' from the public sector. Whether directly or indirectly, they are buying government debt, and therefore they are supporting the purchase of government debt. Note also, that they are talking of when the economy recovers, and also implying that they will sell the government debt back. However, the prospect of sales of Bank of England bills in place of reselling the bonds directly contradicts this.

The last quote is one which is not of great importance in the big picture, but is indicative of the way in which the BoE is trying to bury the simple fact that they are printing money.
What is the difference between reserve balances and printing money?
Reserve balances are, in effect, electronic money held only by commercial banks and can only be used to settle transactions between them and with the Bank of England. The Bank issues paper currency in response to the demand for banknotes from the public. But reserves and notes both represent claims on the Bank of England (‘central bank money’) and the banks can exchange the reserves for notes, although as they receive Bank Rate on their reserves they will only do this if the notes are needed to meet, for instance, withdrawals of deposits. When the Bank buys assets under its quantitative easing programme, the bank account of the seller goes up by the value of the sale and their bank simultaneously acquires an equal quantity of reserves.
How this might differ from running money off a physical printing press and depositing the money in the vault of the recipient bank completely eludes me. In both cases, the recipient bank has the money available to them to do with as they wish, including converting reserve balances into bank notes. The implication here is that a reserve balance is not printing money, and whilst technically correct (there is no physical printing press) the outcome is identical.

In amongst such obfuscation, I would just like to highlight the one useful new piece of information that has emerged. It is apparent that the BoE holding of government debt is not going to be returned to the market for a long, long time. Whilst they have not said this directly, I believe that their direction is pretty clear. Their explanation for why they might not sell back the bonds in a rush is plausible, but there is nothing that would stop them from steadily selling - if the market were not already flooded.

This is the key point. The BoE have been stepping in to support issuance of government debt which would otherwise almost certainly not find sufficient buyers. The issuance of debt from the government is ongoing, and there is therefore no opportunity to sell the bonds in the foreseeable future. The Bank of England is therefore engaging on a policy of purchasing government debt which it will hold over a long period, and it is doing it with printed money.

It is, quite literally, monetization of government debt and, even if it was started as inflation policy (unlikely), it is now the only thing that is preventing government bankruptcy. That the BoE must hold on to the debt is an indictment of the government, and their fiscal incontinence. I have long argued that this is a policy of debt monetization, and the use of BoE bills to reverse QE is just further confirmation.

Note 1: Despite my cynical view of the BoE policy, I am always impressed with their polite approach in their answers. As a strong critic of the BoE, this is to their credit.

Note 2: Please accept my apologies for the lack of replies to many comments. My 'real life' is very busy at the moment, such that I am very pressed for time. I have even been forced to rush this post, even though it is one of the subjects of particular interest to me, and would have preferred a better researched post (finding article 101 in EU documentation exacerbated the problem, as it was not very easy to find). I hope that the rush does not show.


  1. The widely touted theory (seen from the BoE's comments) of how Weimar and Zimbabwe underwent a period of rising prices and subsequent hyperinflation is due to a large increase in the money supply, the implication being that if QE is undertaken in a controlled manner things won't go the same way.

    However I have read that hyperinflation occurred due to a collapse in the currency as a result of a loss of confidence in the currency.

    As confidence fades and the currency devalues the prices of imported goods will rise, not because there is more money to buy them with. The government issues more and more money to meet its outgoings thereby further undermining the currency and it gets caught in a downward spiral.

    I seem to recall the author asking for someone to point to a period of hyperinflation that actually resulted from an increase in the money supply and not a loss of faith in a currency.

    If this latter theory correct then conditions are ripe for a similar thing to happen to countries who are starting to monetize government debt.

  2. I have long been suggesting that we are bust to all intents and purposes, and it appears that you have arrived there after more study and thought than I could give. So just what happens next? And what is worse is that we have many months with the situation on hold and for something nasty to surface.

  3. If I could ask a couple of very stupid questions:

    (1) What are the "assets" that the BoE buys? A difference between QE and printing money appears to be that some 'assets' are 'bought'. What happens to those assets while the BoE owns them? Are they removed from 'circulation' and placed in a secure compound (figuratively speaking), or does the BoE use them, or rent them out?

    (2) From whom is the BoE buying the assets?

    (3) Are the 'assets' junk? Presumably not because the idea is to sell them for a similar price later. But the BoE could win in any auction for anything. So who sets the price?

    I would really love to understand the nuts and bolts of this!

  4. The UK Pound Stabilizes?

    I can't help but notice that you predicted a massive collapse in the value of the UK pound last December (2008):

    My prediction was that UK economy would one of the worst hit in the world, if not the worst. One of the key transmission mechanisms of the collapse of the UK economy that I identified would be a collapse in the value of the £GB. …. The simple reality is that, as each day goes by, as the £GB slides further, every single individual holding and earning in £GB becomes a little poorer. The £GB has a long way to fall yet....


    If the UK pound went into free fall, this would indeed be a sign that hyperinflation was on the way.

    There has been a very sharp drop in the value of the pound:

    The pound stands 25 per cent down on where it was two years ago, a scale of depreciation at least comparable to other historic episodes, such as the 1967 devaluation, the crises of 1976 and 1985, and Britain's forced exit from the European Exchange Rate Mechanism (ERM) in 1992


    But, in relation to the US dollar, it looks as though the pound has stabilized:


    You can see here that the pound reached a low of 0.58 GBP to $1.00 US on the August 5 this year. The downward trend evident in the pound’s value against the US dollar stopped in early August and there has been an upward trend since then.

    But of more interest is the trade-weighted value of the pound:

    The best way of measuring the pound's value is by reference to its trade-weighted index … For the decade prior to the onset of sterling's sharp slide towards the end of 2007, the pound had been relatively stable. Its trade-weighted index rarely strayed lower than 95 or higher than 105. But from around the start of the turmoil in financial markets two years ago, the pound fell precipitously, eventually reaching a trade-weighted low of 73.4, €1.02 against the euro and $1.38 against the dollar. What's more, some people expected it to drop much further. Jim Rogers, chairman of the Quantum fund and veteran investor, famously proclaimed in January 2009 that the pound was "finished" and that he expected it "to make new lows … In fact, in the months after Rogers' comments, the pound rose by over 20pc against the dollar to a peak of $1.70, and €1.18 against the euro. On a trade-weighted basis, it reached 84.9, an increase of over 12pc …. [and] even after last week's drops, the pound/dollar rate is still about 16pc above the low reached at the Jim Rogers moment. On a trade-weighted basis, at the end of last week it stood just below 79.

    Roger Bootle, "Thank heaven we didn't join the euro when Blair wanted us to," 27 Sep 2009, Telegraph.co.uk

    We can look at a more historical graph here of the dollar/Sterling exchange rate:


    In historical terms, the value of the UK pound was at its lowest point in late 1984/1985, when it was at par with the US dollar.

    As you can see in the graph we have a long way to go before its gets to that level.

    And, as has been pointed out, the depreciated pound will be good news for British exporters if and when the world economy recovers, as they will find their exports more competitive.

  5. See this interesting blog on QE:

    There are also those that claim that quantitative easing will expose the economy to uncontrollable inflation. This is just harking back to the old and flawed Monetarist doctrine based on the so-called Quantity Theory of Money. This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase. Should quantititative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.


  6. The BoE has to stop printing money now, really. Even if there's a little more, it cant go on much longer.

    When they do, then we'll see what's what.

  7. Cynicus: a fascinating explanation as to the role of SDR's in the Fed's strategy to inflate the dollar.


    (Don Keyes)

  8. Lord Keynes,

    If QE money printing is so good for our economy, then why not QE 100's more than the B of E is currently printing, and we can all become rich. If however you believe that excessive QE money printing is bad for the economy, you have to ask yourself why, and how doing it slowly is different in the final outcome that cannot be reversed without terminal consequences.

  9. See Steve Keen's new post on Debt Watch:

    [the] proposition that excessive Chinese savings caused the financial crisis is straight out of the neoclassical macroeconomics textbook, which portrays the financial sector as the means by which those with excess funds from savings lend to those with insufficient funds, thus financing the investment the debtors wish to undertake ....

    In fact, the action in a credit-driven economy begins with the lender: lending creates the money which—once spent by the borrower—turns up in other people’s bank accounts. The actual causal sequence that gave us the [Great Recession of 2008-2009] was therefore:

    (1) American lenders lent to Americans to finance the housing and stock market bubbles, and copious purchases of consumer goods as well as Americans falsely believed their wealth was growing as house and share prices skyrocketed;

    (2) These American borrowers spent large slabs of this borrowed money on imported Chinese goods;

    (3) The Chinese recipients of this American spending racked up a large surplus of US dollars, which added to Chinese foreign currency reserves;

    (4) Some of these reserves were used to purchase US assets, including Subprime bonds but also government bonds, equities, and other financial assets around the world.

    So the problem began, not with Chinese saving, but with American lending


  10. Death of the dollar?


  11. Lord Keynes

    Isn't it chicken and egg?

    Without the Chinese people saving i.e. foregoing consumption, the American credit boom could never have got as far as it did.

    (But I realise I am probably dabbling in things I do not understand!)


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