Episode 3 - To QE or not to QE

Recorded 5 September 2015


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In this episode we get stuck into a topical subject: the proposal for People's Quantitative Easing (PQE) that has been suggested by the UK Labour leadership contender Jeremy Corbyn.

Background

• Money is routinely created by central and private banks.
• What is helicopter money and why you'd use it?
• Quantitative Easing (QE) is when central bank created money is used to buy bonds, i.e. existing gov debt.
• All economists agree that investment is too low in the UK.

I am sorry - Dave Preston

PQE proposal

24m 15s

• Jeremy Corbyn's policy mentions PQE in passing.
• Richard Murphy's more detailed proposal.
• Criticisms of PQE

Jungle Moon - Yumi Kurosawa

What if?

1h 00m 55s

• Would Corbyn implement PQE?
• If so, what would be the implications.

References mentioned in the discussion

(In reverse chronological order)

Simon Wren-Lewis - 2 Sept 2015 - Helicopter money preferable to QE

Frances Coppola - 2 Sept 2015 - Real purpose of central banks - overview of central banks, MMT, PQE and reality of election cycle

Bill Mitchell - 19 August 2015 - Embrace money financing as the norm?

Simon Wren-Lewis - 16 August 2015 - On drawbacks of Corbyn's QE

Jeremy Corbyn - 22 July 2015 - Economic vision (no mention of PQE!)

Jeremy Corbyn - 22 July 2015 - p6 of this document briefly mentions PQE

Richard Murphy's - 12 March 2015 - Original description of PQE but called Green Investment Fund

A more detailed summary of the our conversation and conclusions can be found here.

People's quantitative easing (PQE)

The People's Quantitative Easing (PQE) proposal that is currently being debated in the UK media is the version proposed by Richard Murphy.  It involves local authorities issuing debt in the form of bonds to fund investment in infrastructure. The bonds would originate from a newly created public investment bank and would be immediately bought up by the Bank of England (BoE) using newly created money. The bonds, now held by the BoE would be effectively cancelled (though complications arise here due to the Lisbon Treaty). In this way, the investment is effectively funded by new money creation by the BoE, albeit through a slightly convoluted process.

Some of the main criticisms of this idea have been:

1. that simply creating money to finance government spending is inflationary
2. the independence of the BoE would be compromised
3. the same outcome could be done by conventional government borrowing, so PQE is a way to dodge persistent misunderstandings about the nature of government debt

In order to evaluate these criticisms and decide whether there is some merit to PQE, it is necessary to understand how the government and the BoE interact when the government spends. In other words how fiscal (spending and taxing) and monetary (inflation, interest rates, etc.) policies interact.

Monetary policy

The BoE is part of the the UK public sector. The remit of the BoE is to keep prices stable, which means controlling inflation. Interestingly, it does not attempt to prevent any inflation at all, but targets a low, positive rate of inflation - currently 2% (set by the government).

To do this, the BoE attempts (with greater or lesser success) to control the amount of money in circulation. (It doesn't directly target the amount of money but rather uses an interest rate target as a proxy). The main method for doing this is altering the amount of money in the reserve accounts of commercial banks. If there is too much money, the BoE sells some financial assets to the banks in exchange for their money. After such an operation the banks have a lower amount of reserves but do hold other assets (often government bonds) in their place. If the BoE estimates that there is too little money available to the economy it adds to the banks' reserves by buying assets from them.

In a sense, government bonds are interchangeable with BoE issued money (reserves). But since it is reserves which are typically used to clear payments between banks, the proportion of money which is held as reserves versus bonds determines (perhaps only loosely) how much money is readily available to the economy. The BoE simply adjusts this proportion as appropriate. It's worth noting that the BoE doesn't create its own bonds, but sells back to the private sector UK government bonds that had been previously bought up in earlier operations.

Fiscal Policy

The government (specifically the Treasury) adds new money to the economy when it spends. In principle, the government could simply leave it at that, i.e. create the money and leave the BoE to somehow drain it from the money supply according to its inflation target. But that would make the job of the BoE very difficult. And in any case, there are EU rules against directly financing government with central bank money creation.

Therefore, the UK government applies a rule to itself called the Full Funding Rule. This rule stipulates that any money added to the economy due to spending must be completely removed. To a large extent this is achieved through taxation but if the government spends more than it collects through taxes (a budget deficit) then the government removes the additional money by selling newly issued bonds. This works in the same way as when the BoE sells bonds to drain bank reserves - money is taken out of the economy - except that when the government does it they are selling newly created bonds. So a government's deficit is associated with an identically sized issuance of bonds which gives the appearance of  borrowing to fund its spending.

But that is not really what the intention is. What all this is supposed to mean is that the government's fiscal policy (spending and taxing) is neutral with respect to the amount of money in circulation, and therefore the BoE can go about it's job of targeting the right amount of money in the economy without any additional complications. 

Quantitative Easing

The recent programme of Quantitative Easing, carried out by the BoE between 2009 and 2012 was an extreme version of the monetary operations described above. The BoE bought £375 billion of government bonds from the private sector and therefore increased bank reserves by the same amount. The intention was to stimulate the economy by enabling banks to lend cheaply and by promoting investment in other non-government assets. A side effect (or possibly an intention) was/is that the cost of issuing bonds for the UK government stayed very low meaning that the very large fiscal deficits could be accommodated more easily. 

In effect, the UK government debt is now £375 billion less than the declared amount (about £1.4 trillion) since that amount is "owed" to part of the public sector. Indeed, this is what the government states when it "consolidates" the accounts of the entire public sector, and the BoE actually returns interest payments it receives to the government so this portion of the debt has no cost. It can also be argued that, since the bonds that the BoE has bought represent past government deficits, historical deficit spending to the tune of £375 billion has effectively been funded by money creation at the BoE. So while QE was a monetary operation, it can be argued that it has a significant effect on fiscal policy.

People's QE

PQE is similar to conventional fiscal operations in some ways and different in other ways. The fact that bonds are used in the first instance to fund the spending is similar to current practices although it is not clear why the bonds need to be from a newly created national investment bank when conventional Treasury bonds would do the same job.

One reason could be that normal government bonds (gilts) can be linked to non-investment spending such as paying a nurse, whereas the new national investment bank bonds are solely for investment spending, such as building a new hospital. This would help clarify the important distinction between these two types of spending.

The major difference is that in PQE the BoE stands ready to buy up any bonds issued to fund investment under the scheme. This makes it look a little like QE in the sense that QE involved the BoE buying up government bonds en masse, and QE arguably funded some government spending in an ex post sense. But there are differences in the rationales for QE and PQE, one being specifically monetary and the other fiscal with direct and specific social outcomes.

In any case, there is an obvious potential downside to the buying up of government bonds by the BoE. In the normal case, government spending is neutralised by taxing and bond issuance and therefore the BoE does not have to consider the effect of the government's fiscal policy when conducting its inflation targeting operations. But if the BoE is charged with buying the bonds used for PQE investments then it is being asked to introduce money into the economy which is not being neutralised. One conclusion that has been drawn by many is that the new money will therefore be inflationary. And perhaps it will, if the BoE do nothing more. But the obvious response from the BoE would be to sell some bonds (possibly original QE bonds) back into the private sector to drain out the added money. This is, after all, the normal response of the BoE when it perceives too much money in the economy. And so, if the net result of the PQE operation is that the government spends and the private sector ends up holding an equivalent amount of government bonds then it doesn't look much different from current practices. It doesn't matter whether bonds were sold by the Treasury or the BoE, the net result is the same. In which case we simply conclude that, as long as we want a central bank charged with keeping prices stable, PQE doesn't end up being any different from what already happens. 

And if we were in "normal times", we could leave it there. But we are not in normal times. At present, inflation in the UK is around 0% which means that the BoE is failing to hit it's +2% inflation target by a whole 2%. This is despite buying up £375 billion of government, flooding banks with the same amount of reserves and maintaining next-to-zero interest rates for 6 years. 

So the most extreme monetary policy used by the BoE appears to be insufficient - under current circumstances - for hitting the targeted level of inflation. One possible reason for this is that the current fiscal policy of targeting deficit reduction is sucking demand out of the economy. In this light, the charge against PQE - that it interfere's with the remit of the BoE's inflation targeting - is no worse than could be levelled against the policies of the current Conservative government.

So it is possible that a simple reversion to "normal", non-austere fiscal policies in which debt and deficit targets are not paramount would produce a sufficient amount of inflation to be in line with the BoE's target. In such a case it would be difficult to justify PQE since it would revert to conventional bond-backed spending, as argued above.

But under the current circumstances, when the tools of monetary policy have been exhausted and still the inflation target is being missed, then some inflation being produced by PQE-style money creation would not only be acceptable but would be positively welcome. In this guise - dropping the need for a new investment bank - this looks like the more general idea of "helicopter money", i.e. creating money and giving it to members of the public.

Summary

PQE, as presented, includes some useful ideas and some unnecessary ones. There doesn't seem to be any need for a new investment bank when conventional Treasury bonds fulfil the same role. And in normal times, when the BoE is more or less able to approximate its inflation target, PQE just ends up looking like the conventional methods of doing fiscal policy (spending neutralised by taxes and bond sales). But in extreme cases when the economy is struggling to produce any inflation and the government/BoE have exhausted all monetary policy options, the money creation/helicopter money aspect of PQE seems entirely reasonable and constructive.

Podcast

If you been affected by any of the issues in this post, listen to this podcast.

Episode 2 - The Deficit Puzzle

Recorded 5 July 2015


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Introduction

Intro music - Money by Von Korf

What is a deficit?

1m03s

• Related blog post
• Difference between government spending and tax revenue
• Deficit is synonymous with government borrowing
• Deficit tends to be considered a 'bad thing'

Empirical data

6m53s

• UK and US governments in deficit >80% of time since WWII
• "Books not balanced" annually or over "business cycle"
• Large net, cumulative deficit - the government debt
• Are deficits really bad or something else going on?

Plenilune - Joram

Spending and saving

12m15s

• Equivalence of spending and income
• Stock of money and velocity of money
• Trade off between unemployment and inflation
• Savings are a leakage of spending from economy
• Banks do not recycle savings

What government debt is

24m46s

• Government recycles savings when it "borrows"
• Financial industry (e.g. banks, pension funds) "save" in government debt
• Debt of currency-issuing governments have zero default risk

Night - Tramo

What if?

32m45s

• What if the public don't want to save?
• What if the government doesn't want to run a deficit?
• Deficit dependent on tax revenue which varies with economic conditions
• Deficit as a measure of private sector savings desires
• Government debt is the net savings of the private sector

Foreign trade

44m43s

• UK has a trade deficit
• Trade deficit is a leakage of demand abroad
• Government recycles money earned by exporting nations by swapping for government debt
• ~25% of UK government debt is held by foreigners

Your reflection in the water - Dave Preston

Can the government pay off its debt?

50m19s

• Public and financial industry want government debt
• Importance of central bank

Rich in loss - Sandeep Bhandari

The deficit puzzle: are government budgets ever balanced?

A government "budget deficit" is the difference between government spending and tax revenue for any given time period (e.g. a year). In the UK it is officially labelled "Public Sector Net Borrowing", because any spending deficit is covered by issuing government debt.

The deficit and debt of the government have been discussed intensively by politicians and the media in the UK over the past 5 years - particularly in the lead up to the recent general election. Most discussion of these issues revolves around the idea that large government deficits and debts are a problem as they represent the government "living beyond it's means" and unjustly burdening the "next generation" with debt. This meme has had enormous success, with all the main parties in the UK accepting the need to reduce spending with an ultimate aim of bringing government finances into a position of surplus (tax > spending) within some stated time frame. A government budget surplus is therefore prized as an indicator of responsible management of the government finances and the economy in general.

Some data

Here's a curious thing. The charts below show the state of the UK and US government finances through the post war period quoted relative to Gross Domestic Product (GDP). For the period 1956-2007 (omitting the Global Financial Crisis (GFC)), the UK government budget was in deficit during 174 of 208 quarters, that is, 84% of the time. On average, the government balance was not zero, but was equal to a deficit of 2.38% of GDP.

For the US government, the period 1947-2007 (omitting WWII and the GFC) experienced a budget deficit for 49 out of 60 years (80%). On average, the US government budget was in deficit equal to 1.5% of GDP for the whole time period and 2.5% of GDP since 1975. Since the US data also include absolute dollar values of the budget position, the net deficit over the period can be calculated at $8 trillion dollars (corrected to FY 2009 dollars), or $16 trillion dollars if WWII and the GFC are included.

UK Public Sector Net Borrowing (1956-2014) as a percentage of GDP (source: ons.gov.uk)

US government budget deficit (1946-2014) as percentage of GDP (source: whitehouse.gov)

To anyone who has been listening to the main political parties or media commentators in the UK over the past 5 years, this should be extremely puzzling. Aren't we told that the "books" should be balanced each year, with governments only spending what is collected in tax? Yet government finances in both the UK and US have been almost entirely in deficit for six decades! A more nuanced view might agree that a budget deficit is to be expected during a recession - when tax revenues fall and social security payments rise. But in such a case, surely the temporary spending deficits are "paid for" by budget surpluses during the "good times". In other words, the books should be balanced "over the business cycle". But again, looking at the historical data, which spans multiple recessions, it is clear that the books are not remotely balanced over any business cycle or longer time scales.

There is a way to explain this, and it paints quite a different picture of the role of government (and government debt) in the economy to that normally offered by mainstream media and politicians. It is, however, pretty basic macroeconomics!

The spending merry-go-round

Let's consider the economy of a single country. The transactions that go on within that country can be called the "domestic economy". Every £ spent by one person or business is a £ earned by another person or business, who then goes on to spend it again, begetting yet more income for someone else. Spending and income are thus two sides of the same coin (pun intended). If spending stops, there are no incomes. If spending increases or decreases, so do incomes. In principle, there is a level of spending which equates to a sufficiently high level of incomes that every person who wants to work can have a job; that is, full employment. Should spending be lower than this amount, some unemployment will occur.

Since each £ gets spent many times in a given time period (e.g. a year), total spending can be considered in terms of an absolute stock of existing money (the "money supply") and the speed at which it is circulated (the "velocity of money"). If the stock of money decreases, then the remaining stock must circulate faster if the same amount of spending (and therefore incomes) is to be maintained. Equally, if the speed at which money changes hands decreases, then more money is required to maintain the same level of spending (and income). 

Incidently, this equivalence of spending and income is one reason why the analogy of the government as a household is flawed. The government's spending adds to national income which in turn increases government revenue (i.e. tax). It's a lucky household wherein income increases with increased spending!

The paradox of thrift

But what if not every £ of income is spent? For example, if I choose to save £100 (under my mattress or in a bank account) then this unspent money can be viewed as being held out of the circulating money stock. Another way of viewing it is as "low-velocity" money: the saved money is now circulating more slowly than the money which is immediately spent. If I save every time I earn some income (e.g. each month) then my savings will grow through time. But if my stock of savings grows through time this must mean that the amount of money in circulation is decreasing (or slowing). So if the private sector (people, business; not government) on aggregate wants to save some of their income, these savings represent a leakage of money from the existing money stock, or a slowing of the circulation rate of money. Either view has the same implication: the level of spending is being continually decreased by the build up of savings. 

This is famously known as "the Paradox of Thrift", the notion - identified by John Maynard Keynes - that, although an act of saving might be rational at the individual level, collective saving will be self-defeating, resulting in lower incomes for all as spending is reduced. As the incomes of citizens and businesses are reduced by the collective attempt to save, so those very savings will need to spent. This may be good news for the resumption of spending and incomes but the consequence is that saving is impossible.

The public bank

Imagine there was some entity in the economy that could take the savings of the populace and spend it in the economy. This sort of recycling would ensure that spending levels, and therefore incomes, are maintained. Of course, an obvious candidate for such a role is a bank. Don't banks take deposits from savers and lend them out to borrowers? Well, no they don't, but even if they did it wouldn't solve our problem. Banks lend to businesses and citizens and so even if saving by one party is matched by borrowing by another, the amounts would cancel out and the private sector as a whole would not be in a net saving position. What we are trying to figure out is how the private sector can save as a whole and yet maintain stable spending/income levels.

But hang on a minute! Haven't we just looked at some data showing that the government pretty much continuously spends more money in to the economy than it taxes away? Could it be that those deficits are what make saving possible? There is a nice symmetry here. The savings of an individual may be expected to increase through their life and then perhaps decrease during, say, retirement. But for the population as a whole, with overlapping generations, we would expect a more or less consistent savings rate to produce a stable stock of total savings. Factor in population growth, economic growth and inflation, and we would expect the total savings of the private sector to increase through time. And as the value of the savings in our bank accounts and pension investments grows through time so does the cumulative value of successive government spending deficits  - the government debt.

Is this symmetry just a coincidence or is there a more explicit link here? Who is it that buys government debt? Well, banks and other financial institutions - particularly pension funds - buy lots of government debt, for at least two reasons. First, government debt pays interest, whereas vast piles of cash do not. In this sense, swapping pounds sterling for UK government bonds is a bit like switching from a current account to a savings account. Secondly, the debt of a government which controls its own currency is regarded as a highly safe, essentially risk-free investment. So the very institutions that host the savings of businesses and citizens (banks, pension funds, etc.) choose to place their savings in government debt. As Frances Coppola recently remarked: governments are really banks!. Not only is government debt the ultimate, safe savings vehicle for the financial sector, but the government also recycles our savings directly back into the economy when it "borrows" and deficits spends in just the way many people (erroneously) think banks do.

So what?

This is a simplistic example featuring just the "leakage" of domestic saving as well as government spending and borrowing. In reality, there are many more inflows to and outflows from the domestic economy including taxation (only implied in the example), overseas trade, and bank credit. But hopefully the example shows that government deficit spending is not necessarily simply a matter of failing to manage the government's finances adequately. Government deficits perform at least two socially desirable functions beyond the funding of government programmes and services: (1) they maintain spending and incomes in the economy in light of private sector savings desires; and (2) the issuance of debt provides a safe and interest-bearing store for our long term savings. Simply put, if the private sector tend to want to save over the long term, then - all other things being equal - the government should be expected to run a long-term budget deficit in order to maintain a stable economy. And the national debt is not only equal to national savings, it IS the national savings.

This perspective is quite different from that we normally hear from politicians who like to couch the deficit only in terms of funding government. I am not sure how they reconcile their view with the historical record of massive, long-term, net deficits. The view described here also explains why the government debt never gets paid off. Why would savers intent on increasing their savings accept repayment of their savings? Will they suddenly decide that they want to spend the money they were saving? No. Government debt that is due repayment simply gets "rolled over" as continued savings.

So if you are one of those that doesn't approve of the government deficit and debt, then maybe the rational thing for you to do would be to help reduce it by cashing in your pension.

Episode 1 - What is money?

Recorded 4 November 2014, then gestated for 6 months!


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Introduction

Intro music - Money by Von Korf

Historical ideas

0m20s

• Barter, debt and IOUs preceded money.
• Eggs, fish, wheat are useful and common.
• But gold is rare so must have come later.

Difference (Calming down)

Functions of money

7m56s

• Medium of exchange - no need to barter
• Unit of account - value other goods, like and egg or a fish
• Store of value - money needs to hold its value
• Divisible - you can divide money up into smaller units, e.g. coins
• Fungible - each gold coin of the same size is equal in value

RDP - Sandeep Bhandari

Accepting money

12m6s

• Why accept money?
• How can you establish a new currency?
• Fiat money - money that isn't worth anything itself, e.g. paper notes.
• Governments will only accept tax payments in the currency approved by that government.
• Taxs comes from monarchs raising money for war, "crowd-funded" via the lords.
• We're now used to being taxed.
• Tax money is used for more positive things than war.
• Other currencies can be important in countries even if not demanded for tax, e.g. US dollar.

Due Acque - Robert Rich

Modern money

20m37s

Fiat money, inflation and gold

• Inflation - prices might increase.
• Gold standard - tie value of fiat money to gold.
• Money supply - creating money too fast can cause inflation.
• Gold discoveries have caused inflation.
• Inflation wasn't the norm prior to WW1.
• Bretton Woods meeting in 1944 and John Maynard Keynes.
• The International Monetary Fund (IMF) and naughty Britain in 1976.
• The collapse of Bretton Woods in 1971 - Nixon ended dollar gold standard.

 The Bank of England and the UK

• Currency (i.e. notes and coins) make up 3% of money in circulation.
• The other 97% are deposits held in bank accounts.
• Banks hold accounts with reserves at the central bank.
• Base money = currency (notes and coins) + bank reserves.
• Broad money = currency (notes and coins) + consumer deposits
• Bank of England Quarterly Bulletin with remarkably frank admissions.
• Vast majority of money is in consumer deposits.
• Bank transfers between consumers and between banks.
• Creation of money occurs when a bank loans money.
• There are rules to regulate money creation.
• It's also constrained by market forces - competition between banks.
• Interests rates are one area of competition.
• Financial crisis caused by these constraints being inadequate.
• David Cameron retracted his very unwise call for consumers to pay of their debts.
• If all debts are paid off, there'd be no more money.
• Can't have money without debt, just as you can't do business without trust.

Rich in loss - Sandeep Bhandari

Other links

An excellent take on debt from anthropologist David Graeber:
http://www.bbc.co.uk/programmes/b054zdp6

The wikipedia page on Bretton Woods:
http://en.wikipedia.org/wiki/Bretton_Woods_system