There has been very little noise around the Bank of England’s continuing Quantitative Easing (QE) programme. For whatever reason it seems a little beneath the media radar. In this article we’ll attempt to explain what’s actually happening.
Is inflation a good thing?
The government sets an inflation target for the BOE. This target is 2%. Why does anybody want inflation? I hear you ask. Most modern economists agree that modest inflation is required for sustainable economic growth. A steady erosion of the purchasing power of money encourages us to continue spending it now rather than later. It encourages continued growth. It also means that even if interest rates go to zero there is still a cost to hoarding cash – the nominal interest rate is effectively below zero.
The Bank tends to try to control inflation using interest rates. This is a very difficult thing to do as it involves a lot of guesswork about the future and the changes take many months to work. If inflation looks set to rise above target, then the Bank raises rates to slow spending and reduce inflation. Similarly, if inflation looks set to fall below 2%, it reduces Bank Rate to boost spending and inflation. In late 2008 spending in the UK slowed sharply so the Bank cut Bank Rate substantially to mitigate against the risk of inflation falling well below target further down the line. This didn’t work.
QE – just another tool?
So here’s where QE comes in. Bank Rate is already at an all-time low of 0.5%. The Bank has effectively run out of room to manoeuvre with interest rates and needs another tool to increase inflation. Now, in order for something to remain valuable it needs to remain scarce. By creating more money the Bank reduces the value of the money already in existence.
Right now the Bank is creating money and using it to buy government debt and a small amount of corporate debt. Here’s what they say:
“The sellers of the assets have more money so may go out and spend it. That will help to boost growth. Or they may buy other assets instead, such as shares or company bonds. That will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off. So they may go out and spend more… banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses.” Bank of England, QE Pamphlet, 2009.
Effects of QE and interest rates
Despite these brave words and the pretty pamphlet the Bank has kindly produced to help explain the situation, banks are repairing balance sheets rather than lending. Those consumers who can afford to repair their balance sheets are also doing so. It doesn’t seem like there’s a lot of extra consumption going on.
What we have seen is an enormous rally in risk assets like equities and this seems far removed from the real economy where companies are still suffering and unemployment is rising. So is the QE money just going into the stock market?
With interest rates at just 0.5% there’s less temptation to keep cash in the bank. It’s just not earning enough interest. Further, with the inflationary effects of QE eroding cash savings people are keen to be in hard assets rather than lose more of their buying power. The pound has been slipping against other major currencies recently too. Add into this mix a rising market that makes those not participating fear missing out on a bumper year and there’s even more pressure to get into the markets.
This is perhaps part of the reason why stock markets have done so well this year despite the clearly awful market conditions.
QE funds government spending
Paul Tostain of Bullionvault puts it like this “The British Government has no money to fund its massive public spending program and ongoing debt repayments, and so it has made itself the only recipient of all the money which it requires the Bank of England to print, and then lend at rock-bottom rates.” October 2009.
Under the gold standard, national governments had to regulate the issue of money by the discipline of convertibility into gold. In other words if you didn’t hold gold to back the money you couldn’t create the money.
And gold can’t just be magicked into existence: “The total amount of gold in the world is 160,000 tonnes and it is worth about $5 trillion. Formed into a cube it would have an edge of 20 metres and would not cover a tennis court. The size of the cube is growing slowly at about 11cm per year, as miners extract more gold from the Earth, and the annual rate of growth in the weight of the cube is 1.5%.” Paul Tostain, Bullionvault, 2009
With the barrier of the gold standard removed long ago there is a great temptation for those who can make money out of thin air to do so. And they often succumb to that temptation. But this debases the money the rest of us hold. They are effectively making more money for themselves at our expense.
Where does money come from?
So where does money normally come from? Well, without going right back to the origins of trade itself, let’s start with banks. They used to keep reserves of gold and give a credit note that could be exchanged for that gold. After a while they realised they didn’t need to hold all the gold since it would be unusual for all the people to want their gold back at once. So the reserves were reduced to a fraction of the total amount outstanding. Knwoing this, if customers lose confidence there can be a run on the bank – as we saw several times recently, starting with Northern Rock.
But there’s actually something a little more incredible going on in banks these days. When you borrow money from a bank you’re not really taking money from the deposits of other customers. And you’re not borrowing money from the bank either. The bank actually creates the money you want to borrow out of thin air. The very fact that you promise to repay the money is what supports its creation. This is a major reason why credit creation has been so vast in recent years.
I would argue, as many before me have, that bubbles would be much smaller and less damaging if credit were limited in the first place. Now back to QE…
QE as a form of theft?
The Chinese made a lot of noise about this earlier in the year. Not that they were particularly concerned about our own QE programme measured in the billions. Their concern is the US money creation running into the trillions. The Chinese are holding a lot of dollars and thus are understandably a little peeved that the americans are debasing their currency and eroding their debts.
Alan Greenspan wrote back in 1966 “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.” Gold and Economic Freedom, 1966.
He was saying that creating new money to fund government spending is a sneaky way to take money from citizens. Taxation would be so much more overt and liable to reduce chances of re-election.
What happens when QE stops?
What happens to this extra money once inflation is on the up again? Well the Bank of England states that it will “put downward pressure on spending and inflation by raising Bank Rate and removing the extra money by selling the assets it previously purchased.” Sounds easy but nobody knows how or if it will work. We just don’t know what market forces will be in operation at the time or how they will interact. A reminder that economics is not as scientific as some would have you believe.
When QE ends and interest rates rise again this will remove the current stimulus to the stock market. Some say that the current rally is just another bubble. But really that’s just how markets operate and the only question is how long they last. The stock market valuations of companies are guesses about the future value of those companies, guesses about their future earnings. When they turn out to be wrong we get corrections and afterwards it all looks so very obvious.
None of this should be interpreted as a tip to time the market. Timing the market is unwise for most people. Don’t try to jump in and out of the market, rather be strict and disciplined with yourself and ensure that you have a balanced portfolio designed to meet your long-term goals.
When you realise where money comes from, that it is created from nothing, you might well wonder why we don’t just use the leaves on the trees instead.
There has been very little noise around the Bank of England’s continuing Quantitative Easing (QE) programme. For whatever reason it seems a little beneath the media radar. In this article we’ll attempt to explain what’s actually happening.
Is inflation a good thing?
The government sets an inflation target for the BOE. This target is 2%. Why does anybody want inflation? I hear you ask. Most modern economists agree that modest inflation is required for sustainable economic growth. A steady erosion of the purchasing power of money encourages us to continue spending it now rather than later. It encourages continued growth. It also means that even if interest rates go to zero there is still a cost to hoarding cash – the nominal interest rate is effectively below zero.
The Bank tends to try to control inflation using interest rates. This is a very difficult thing to do as it involves a lot of guesswork about the future and the changes take many months to work. If inflation looks set to rise above target, then the Bank raises rates to slow spending and reduce inflation. Similarly, if inflation looks set to fall below 2%, it reduces Bank Rate to boost spending and inflation. In late 2008 spending in the UK slowed sharply so the Bank cut Bank Rate substantially to mitigate against the risk of inflation falling well below target further down the line. This didn’t work.
QE – just another tool?
So here’s where QE comes in. Bank Rate is already at an all-time low of 0.5%. The Bank has effectively run out of room to manoeuvre with interest rates and needs another tool to increase inflation. Now, in order for something to remain valuable it needs to remain scarce. By creating more money the Bank reduces the value of the money already in existence.
Right now the Bank is creating money and using it to buy government debt and a small amount of corporate debt. Here’s what they say:
“The sellers of the assets have more money so may go out and spend it. That will help to boost growth. Or they may buy other assets instead, such as shares or company bonds. That will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off. So they may go out and spend more… banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses.”
Bank of England, QE Pamphlet, 2009.
Effects of QE and interest rates
Despite these brave words and the pretty pamphlet the Bank has kindly produced to help explain the situation, banks are repairing balance sheets rather than lending. Those consumers who can afford to repair their balance sheets are also doing so. It doesn’t seem like there’s a lot of extra consumption going on.
What we have seen is an enormous rally in risk assets like equities and this seems far removed from the real economy where companies are still suffering and unemployment is rising. So is the QE money just going into the stock market?
With interest rates at just 0.5% there’s less temptation to keep cash in the bank. It’s just not earning enough interest. Further, with the inflationary effects of QE eroding cash savings people are keen to be in hard assets rather than lose more of their buying power. The pound has been slipping against other major currencies recently too. Add into this mix a rising market that makes those not participating fear missing out on a bumper year and there’s even more pressure to get into the markets.
This is perhaps part of the reason why stock markets have done so well this year despite the clearly awful market conditions.
QE funds government spending
Paul Tostain of Bullionvault puts it like this “The British Government has no money to fund its massive public spending program and ongoing debt repayments, and so it has made itself the only recipient of all the money which it requires the Bank of England to print, and then lend at rock-bottom rates.” October 2009.
Under the gold standard, national governments had to regulate the issue of money by the discipline of convertibility into gold. In other words if you didn’t hold gold to back the money you couldn’t create the money.
And gold can’t just be magicked into existence:
“The total amount of gold in the world is 160,000 tonnes and it is worth about $5 trillion. Formed into a cube it would have an edge of 20 metres and would not cover a tennis court. The size of the cube is growing slowly at about 11cm per year, as miners extract more gold from the Earth, and the annual rate of growth in the weight of the cube is 1.5%.”
Paul Tostain, Bullionvault, 2009
With the barrier of the gold standard removed long ago there is a great temptation for those who can make money out of thin air to do so. And they often succumb to that temptation. But this debases the money the rest of us hold. They are effectively making more money for themselves at our expense.
Where does money come from?
So where does money normally come from? Well, without going right back to the origins of trade itself, let’s start with banks. They used to keep reserves of gold and give a credit note that could be exchanged for that gold. After a while they realised they didn’t need to hold all the gold since it would be unusual for all the people to want their gold back at once. So the reserves were reduced to a fraction of the total amount outstanding. Knwoing this, if customers lose confidence there can be a run on the bank – as we saw several times recently, starting with Northern Rock.
But there’s actually something a little more incredible going on in banks these days. When you borrow money from a bank you’re not really taking money from the deposits of other customers. And you’re not borrowing money from the bank either. The bank actually creates the money you want to borrow out of thin air. The very fact that you promise to repay the money is what supports its creation. This is a major reason why credit creation has been so vast in recent years.
I would argue, as many before me have, that bubbles would be much smaller and less damaging if credit were limited in the first place. Now back to QE…
QE as a form of theft?
The Chinese made a lot of noise about this earlier in the year. Not that they were particularly concerned about our own QE programme measured in the billions. Their concern is the US money creation running into the trillions. The Chinese are holding a lot of dollars and thus are understandably a little peeved that the americans are debasing their currency and eroding their debts.
Alan Greenspan wrote back in 1966:
“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”
Gold and Economic Freedom, 1966.
He was saying that creating new money to fund government spending is a sneaky way to take money from citizens. Taxation would be so much more overt and liable to reduce chances of re-election.
What happens when QE stops?
What happens to this extra money once inflation is on the up again? Well the Bank of England states that it will “put downward pressure on spending and inflation by raising Bank Rate and removing the extra money by selling the assets it previously purchased.” Sounds easy but nobody knows how or if it will work. We just don’t know what market forces will be in operation at the time or how they will interact. A reminder that economics is not as scientific as some would have you believe.
When QE ends and interest rates rise again this will remove the current stimulus to the stock market. Some say that the current rally is just another bubble. But really that’s just how markets operate and the only question is how long they last. The stock market valuations of companies are guesses about the future value of those companies, guesses about their future earnings. When they turn out to be wrong we get corrections and afterwards it all looks so very obvious.
None of this should be interpreted as a tip to time the market. Timing the market is unwise for most people. Don’t try to jump in and out of the market, rather be strict and disciplined with yourself and ensure that you have a balanced portfolio designed to meet your long-term goals.
