Quantitative Easing - Monetizing UK Government Debt

It is a long time since I have taken a look at quantitative easing (QE -printing money). Long term readers of the blog will know that I have have offered objections to the policy from the outset, and I have seen it as a barely hidden method of 'monetizing' government debt (printing money to pay the government bills). I have also warned of the potential risk for hyper-inflation that is inherent in the policy.

I have written this many times, but it is worth repeating what inflation actually is. If you have an output of 100 units, and 100 units of currency and increase the units of currency to 110 units, the only outcome is that there are more units of currency chasing the 100 units of output. That is inflation. In the case of the UK at present, there is a fall in output at the same time as an increase in currency issuance, thereby making the currency issuance more potent. This is a simplistic explanation, and there are complications that I discuss here. However, those complications do not directly impact on what is being discussed in this post, which is related to the mechanism of QE.

Before moving forwards, is QE the same as printing money? One of the most amusing things I have seen regarding the policy of QE is the attempt by Charles Bean, Deputy Governor for monetary policy of the Bank of England, to try to suggest that QE is not the same as printing money:

Quantitative easing has been described in some quarters as “printing money”, though it is not literally that. It is more akin to us buying the asset with a cheque drawn on the Bank of England, which the seller then deposits with his own bank. As a consequence, the quantity of bank deposits in the economy goes up, while the claims that the banks hold on the Bank of England also increase.

This is simply disingenuous. The method of QE is as follows, and this is from a Bank of England paper:

The aim of quantitative easing is to inject money into the economy in order to revive nominal spending. The Bank is doing that by purchasing financial assets from the private sector. When it pays for those assets with new central bank money, in addition to boosting the amount of central bank money held by banks, it is also likely to boost the amount of deposits held by firms and households. This additional money then works through a number of channels, discussed later, to increase spending.

You will note the term 'new central bank money'. Whilst there is no physical printing press, the Bank of England literally creates the money. Any suggestion that this is not 'printing money' is disingenuous nonsense. It is exactly the same effect as running a printing press to create new £50 notes.

For those unfamiliar with the mechanism of QE, the Bank of England buys an asset such as a government bond and credits the institution from whom they buy the asset with the value of the asset, by 'creating' the credit in the account of the seller. They have literally just created the money, and that money now sits in the account of the seller, ready to be used in the market.

As an illustration of the underlying principle, if you were to imagine that the Bank of England decided to buy your house for £250,000, it is doing the equivalent of printing enough notes for the £250,000 and giving you the notes fresh off the printing press. You could then go and spend that money as legal tender, and the amount of money in the economy has increased by £250,000. To reverse the increase in money, the Bank of England could then sell your house. Once they received the £250,000 they would then put the notes in a furnace and burn them. As such the £250,000 of additional money would disappear. This is the way in which the Bank of England can try to control the money supply, but they simply 'credit' the account of a bank rather than actually physically printing the money.

If we use the house example, in the modern sense of printing money, rather than getting cash, you would find that £250,000 appeared in your bank account from the issuance of a credit from the Bank of England.

The most interesting point is that the QE policy was justified as a fight against deflation, and that this justification is still being trotted out. I will quote from Mervyn King at the February select committee just to confirm that the excuse for QE is fight deflation and maintain inflation:

The reason we are doing that is because our judgment is that since last autumn, with the remarkable change in conditions last autumn, the amount of money in the economy is simply not growingfast enough to enable us to reach a sustainable growth rate with inflation close to the target. [question 11]

This from the Bank of England website on why they are implementing QE, as it is even more explicit:

The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged – to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.

It is worth just briefly noting the actual nature of the inflation policy, and the parameters within which the Bank of England works. This is from the Bank of England website:

If the inflation target is missed by more than 1 percentage point on either side - in other words, if the annual rate of CPI inflation is more than 3.0% or less than 1.0% - the Governor of the Bank, as Chairman of the MPC, must write an open letter to the Chancellor explaining the reasons why inflation has increased or fallen to such an extent and what the Bank proposes to do to ensure inflation comes back to the target. This does not mean that the Bank has a target of 1.0 - 3.0%. The target is 2.0%. But if inflation varies by more than 1 percentage point from the target, the Bank has to explain why.

In the meantime, the CPI measure of inflation (the one that the Bank of England is targeting), has not dropped below 2% in the entire period of the QE policy, has not required a letter to be written, and the current rate is a fraction above 2%.



You will also note that the RPI measure of inflation has dropped, but RPI includes housing costs, which are dropping due to low interest rates. I explain the circularity of consideration of the RPI measure as a driver of interest rates (or QE) in more depth here and the problem of the circularity is presumably why it is not used for Bank of England policy guidance. In any case, RPI is not the inflation measure that the bank uses.

As such, under the terms of inflation targeting, it is apparent that the Bank of England is undertaking a policy which is 'unconventional' at a time when they have not even come close to the point where the bank needs to even report any concern over inflation rates. It is evident that there has been, and still is, no justification for the policy of QE if the policy is based upon CPI inflation. However, the policy has been justified on the possibility of future deflation. Again, an answer from Mervyn King from February:

The aim at present, with the concern about inflation being below the target in the medium term, is we are trying to bring the future outlook for inflation back up to the target. That is why we are engaging in the quantitative easing, but we have absolutely no interest or wish to see inflation go above that. [Question 12]

The quote dates from February and, as yet, there is still no evidence of the CPI falling in any way that might justify such an unconventional and untested policy. As I have said, the CPI has not even moved out of the boundaries that require a letter of explanation.

The next interesting point to consider is the method of QE. The official policy of QE allows for purchase of commercial assets or government debt (gilts). However, the implementation of the policy has seen gilts being the asset that is being purchased in (by far) the majority of the cases. The following chart makes the point (from the Bank of England here):



Why purchase government debt? This is the argument presented by Mervyn King:

In order to ease policy, therefore, we have adopted what is a relatively standard approach, which is to buy government securities [gilts] in the market. That way we do not distort private sector yields or take a judgment on which private sector assets we should buy, and this increases the amount of money in the economy. [Question 11]

Contrary to the assertion that buying gilts will not 'distort private sector yields', it is clear that this will not be the case. If people have a choice of investments, the condition of one asset will have an impact upon the other investment, and the Bank's purchase of gilts is specifically designed to make private assets more attractive (or that is the official view) than gilts.

With regards to the argument about which private sector assets to buy, this has been exactly what the Bank of England has been doing with the Special Liquidity Scheme - buying private sector assets. It is not apparent therefore that there is not any squeamishness over buying private sector assets. Also, as you will note, despite this statement, they are still buying a token number of bonds, indicating that it is indeed 'do-able' to buy private assets. In any event, as has been admitted by the Bank of England, this is not a conventional policy, and therefore there are no boundaries to what might be purchased.

A further explanation from the Bank of England is that if they buy gilts, then the sellers will have money to buy other assets (see here, page 96). However, in order to increase the money supply, it really does not matter what the bank spends the money on. Whatever it is used to purchase, the money supply has increased in the economy, as it will land in the hands of someone or some organisation. They will then have a new reserve of cash to use to spend or save. Bearing in mind that the aim of the bank is to prevent deflation, it really does not matter what the money is used for. If we take the earlier imagined example of the Bank of England buying your house, then it is apparent why this is the case.

If you decide to spend the money given to you by the Bank of England for purchase of your house, then the money will be used for the purchase of goods and services, thereby increasing demand for goods and services by £250,000. The amount of goods and services have more money chasing them than before the bank made the purchase and created money, and that is quite literally inflation. Once you have spent the money, the money will either be spent by the recipients or the money or will be deposited as savings in a bank. The money supply in relation to the total output of the economy has increased.

Alternatively, if you decide to save the £250,000, then you will deposit it in the bank. The bank will then likely use that money for fresh lending, which will means somebody else will use it for the purchase of a good or service, thereby again increasing the amount of money chasing goods or services. Even if the money is used to buy government debt (gilts) directly, the government will spend the money and the same thing will occur. The money will be used to pay nurses, who will spend the money on goods or services, or pay for a new road which will mean more expenditure on goods and services.

In other words, whatever the Bank of England purchases, one way or another, it will end up being used to purchase goods or services, and will create inflation in the goods or services for which it has been used. The Bank of England would not buy your house or bother with such a small amount of new currency issuance, but the principle is illustrated in this example.

The point about why it is not important how the money enters the economy is made clearly by Ben Bernanke, with his quote of the idea of using a helicopter to drop freshly printed money into an economy:

In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

In short, however money enters the economy, it will still have the effect of arriving in the hand of somebody and will be available for spending, thereby increasing the supply of money in relation to goods and services.

So why is the Bank of England buying government debt?

When the policy was first proposed, it was at a time when markets were looking at the UK debt issuance with increasing concern, due to the exploding size of the debt. It would also have been evident to the UK government that they were not alone in issuing so much debt, as this process was being replicated around the OECD. In this situation, it was likely that the market for government debt issuance was about to be far more competitive, with the market flooded with debt. As a result, the possibility of lack of sufficient demand for the massive issuance of UK debt was being discussed by some analysts (and in this blog), which would translate into UK bankruptcy and a visit to the IMF. If the UK debt was not sold, the result would be a run on the £GB and national insolvency.

If we look at the nature of the problem, it is apparent that using QE to buy government debt simply does not make sense on any level, except that it is being enacted because it is the only way that government borrowing might be paid for. It is clearly unnecessary to buy gilts, but the purchase of gilts raises exactly the kind of worries that I am expressing here. It will, at the very least, raise concerns that the policy is the monetization of government debt (e.g. Warren Buffet on QE), and that will shake confidence in the economy overall. If it was the only method of increasing the money supply, then it might just make sense, but the problem is that all asset purchases will have the same effect.

Whilst I have presented (I hope) a logical argument against the use of QE for purchase of government debt, it might be argued that the Bank of England is just misguided. They genuinely believe in the threat of deflation, and genuinely believe that buying gilts is the best way to enact QE. However, it is when we view the latest thinking on the so called 'exit strategy' that such a suggestion becomes questionable.

When using the example of purchasing your house, I pointed out that the reversal of a policy would be for the bank to sell the house, and then burn the money to take it out of the money supply. This is a very important point, as the Bank of England will need an exit strategy, and the logical strategy would be to do the equivalent of selling the house - sell the gilts back on to the market. However, it is now apparent that this is not the strategy. This from the Bank of England Quarterly Bulletin for 2009 Q2 for the 'exit strategy':

As the economy recovers, the medium-term outlook for inflation will improve. As in normal times, the Committee will be guided by the medium-term outlook for inflation relative to the inflation target. Given that the inflation target is symmetric, if inflation looks set to rise above the 2% target, then the Committee will want to tighten monetary policy to slow spending and reduce inflation.

Monetary policy could be tightened in a number of ways. It could involve some combination of increases in Bank Rate and sales of assets in order to reduce the supply of money in the economy. Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills. The MPC will decide on the most appropriate way to withdraw the policy stimulus based on the circumstances prevailing at the time.

You will note here that there is no commitment to sell the gilts back into the market, and instead a suggestion to use Bank of England bills. The Bank of England's description of the short-term Bank of England bills is as follows:

The Bills will constitute direct, unsecured, unconditional and general obligations of the Bank of England and will rank pari passu with all other unsecured and unsubordinated indebtedness of the Bank of England from time to time outstanding and without any preference one over the other, by reason of priority of date of sale or otherwise. "Indebtedness" means all indebtedness of the Bank of England in respect of moneys borrowed by the Bank of England and guarantees given by the Bank of England for moneys borrowed by others. The Bills will not be obligations of any person other than the Bank of England.

In other words, the Bank of England is proposing issuance of its own debt in place of selling the gilts. Whilst this might have the effect of reducing the money supply, the question that arises is to the reason why they would not just sell the gilts, and therefore restore the bank balance sheet to something like normality? Why would they want to hang on to the gilts?

The answer quite simply is that the market is already being flooded with gilts, and any move to sell the gilts held by the Bank of England would result in even greater supply, and an even greater risk of a failed bond auction.

What we therefore have is a highly unconventional policy in QE, with no rules or boundaries or precedent, resulting in the purchase of government debt (albeit through intermediaries). The purpose given is to fight a deflation that has not taken place. The method of enactment of the policy is of no consequence to the final result, but nevertheless the Bank of England has gone to considerable lengths to justify why buying government debt is the best way to enact the policy. As Bernanke recognises, a helicopter drop of money would achieve the same impact in fighting deflation. Furthermore, the exit strategy potentially leaves the gilts in the hands of the Bank of England even once the policy is abandoned.

None of this adds up. The only logical conclusion is that the government is being financed through the printing press, and such funding has unhappy precedent. In light of this, I do wonder how Mervyn King and the other officials at the Bank of England might justify this policy. I can only imagine how the discussions might have played out at the outset of the policy. I would guess that the conversations involved expressions from the government such as 'for the good of the country' and 'temporary measures in extreme circumstances'. At the time of implementation of QE, it is easy to see how such action might have momentarily seemed to be essential.

I am also guessing that the officials at the Bank of England are now having sleepless nights. I can not believe that they can not see where this policy is leading. As such, it can only be hoped that they will have the courage of their convictions and refuse to cooperate further. I am hoping that they will see that prolonging the idiocy of current government policy is wrong, and is taking the country towards economic disaster.

It is apparent now that Mervyn King is having severe doubts about the government fiscal policy, and it is to be hoped that this will see him resisting any further extensions of QE. As such, I am hoping the Bank of England has the leadership with the courage to call an end to this.

Mervyn King Identifies the Problem, then Avoids the Solution...

Some of the readers may have seen a Telegraph article that summarises some of the key points from Mervyn King, the Bank of England Governor, from the May Inflation Report. His thinking is very much in accord with much of the mainstream in supporting the efforts of governments and central banks to support their economies. However, there are some contradictions in his points that suggest that he is having grave doubts about what is taking place. In effect he is trying to square a circle. I will quote at some length from his comments:

The scale of the deficit is truly extraordinary. 12.5pc of GDP is not something that anybody would have anticipated even a year or two ago and this reflects the scale of the global downturn. But it also reflects the fact that we came into this crisis with fiscal policy itself on a path that wasn't itself sustainable and a correction was needed.

The speed of which the fiscal stimulus should be withdrawn has to depend on the state of the eocnomy. There is no point in presenting a profile for the reduction of deficits that is independent of the state of the economy.

There will certainly need to be a plan for the lifetime of the next parliament, contingent on the state of the economy, to show how those deficits will be brought down if the economy recovers to reach levels of deficits below those which were shown in the budget figures.

In other words the deficit is very worryingly large, but it has to be endured, and action needs to be taken in the medium term to shrink the deficit. So far, so conventional. However, it is in his later discussion that the underlying contradiction becomes apparent:

To ensure a sustainable recovery and prevent a repetition of the crisis we must reform the international monetary system. The United Kingdom and other deficit countries will now be aiming at more sustainable levels of domestic demand.

If we look at the earlier comment and this comment, it is apparent that there is a contradiction in the argument. On the one hand the suggestion is that the fiscal stimulus is necessary, and on the other that there needs to be a change to 'more sustainable levels of domestic demand'. If we actually view the nature of the objectives of the stimuli, and the underlying reason for the government deficit spending, it is exactly the opposite of sustainable domestic demand.

From this document of the Treasury Select Committee in February, we can find the following quote from Mervyn King (key section highlighted):

I think this goes back to what I call the paradox of policy. I think it does not make sense to engage on a national campaign to raise savings rates in the very short run; we will need to do so once we get out of the crisis. In the short run we have to engage in measures to ensure that spending returns to more normal levels in order to prevent significant falls in output and rises in unemployment. Once we have got through that immediate problem, then the challenge will, indeed, be to raise the national savings rate, both public and private. [answer to question 5]

The question here is the question of what normal might be. Is it debt fuelled spending, which is unsustainable, or is it the reduced spending indicative of sustainability? It does not matter whether the deficit is originating in consumer spending or government spending, the current domestic demand is not sustainable. In both cases, the country is in aggregate consuming more than it produces, and this is not sustainable. Why delay the shift to sustainable demand? Why not make the shift now?

What we are seeing here is a recognition of the underlying problem, but a refusal to act to rectify the problem. It can not be put more simply than this. If we are consuming too much now, we surely need to stop. Now.

To use a metaphor, Mervyn King has diagnosed the illness, but does not have the courage to suggest taking the unpleasant medicine now. Instead, he is proposing letting the illness run on even longer, even though it will do even more damage to the body in the meantime. I just hope that he goes further, and actually has the courage to call a halt. He may actually be in a position to have the influence to actually achieve this.....

More on the Bond Smuggling

I have been keeping an eye on the bond smuggling story (see here and here), and have noted that absolutely nothing is being added to the story. There is still no official word from the US, other than stories repeating the comment that, from pictures seen on the Internet (???), an official suggested that they were fake. As yet, no official report on the authenticity of the bonds. Nothing has come out of Italy.

This story is surprising in the respect of the complete lack of any definitive information from official sources. Bearing in mind the level of speculation about the story, it would be reasonable to expect that some kind of official statement would be made.

I have also been thinking about the breaking of the story. I do not know how the Italian police operate, but usually, whenever there is a major 'bust' the police arrange a press conference. I can think of no larger bust than foiling a $134.5 billion counterfeiting plot. What I would normally expect from such a story is a crowded press room, the chief of police smiling at the press and introducing those who caught the criminals, followed by a sample bond (in a plastic bag) held aloft for the photographers. In short, the bust should have been presented as a triumph. The police are not normally so shy of promoting their success....instead, nothing....

In short, I keep coming back to this story as it is all very odd. I find the ongoing silence to be a continuation of the oddness. In particular, why nothing from the Italian authorities? The only explanation, and it is quite a reasonable explanation in principle, is that there is an ongoing investigation. However, how does that fit with the story of the smugglers being released?

I will continue to update you if there are any developments. However, if there are no developments, then I think that we might conclude that there really is more to this story than meets the eye. After all, why would there be such silence on the largest counterfeiting operation ever?

Note:

You may have noted that I have not been very responsive to comments of late. It is, unfortunately, one of those times when real life is rather busy, and I am therefore extremely short on time. I have also been trying to devote time to the fixed fiat currency idea, which is very long and complex, and have also been preparing a post on QE (hopefully to follow shortly). Apologies for this, and I hope that I will be able to devote more time after a week or so.