Money in the modern world

THE Bank of England (BoE) has recently published two articles in its quarterly bulletin on “Money in the Modern World” and “How Money is Created” (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf).

The first should be compulsory reading in schools because it is simple and clear explanation of what money is all about. The second is a more technical explanation of how money is created – surprise, surprise – the central bank is not fully responsible! The textbooks tell us that money should have three key attributes – a store of value, unit of account and medium of exchange.

The BoE says that money is really an IOU (a debt or obligation from someone). Even the cash we have in our pocket is an IOU (a promissory note from the central bank). Currency is fiat money, meaning money that is irredeemable – you can’t exchange your pound sterling for gold at the Bank of England – you will be given another banknote of the same value.

Of course, the most common form of money is bank deposits, which is the IOU of your bank to the amount of money you put with it. You can use these deposits to make payments (current account) or you can save in savings account or fixed deposits to earn interest as a store of value.

Here’s where it gets really interesting.

The bulk of the money created is by commercial banks, not by the central bank. When commercial banks lend money to its clients, they create deposits. Now the power to do that is not unlimited, because it depends on the banks’ willingness to lend, the willingness of the public to borrow and on legal requirements such as capital ratios and liquidity ratios. But the amount of money that the banks can create through giving out loans can be influenced by monetary policies.

The central bank does this through setting the interest rate (the bank rate) on central bank reserves (the amount of money that the banks have to put with the central bank). Through changing the bank rate, it influences a range of interest rates in the economy, including those on bank loans.

However, there is a lower limit to how much a central bank can reduce interest rates, which is zero or in practice 0.5%. Since the interest rate tool becomes ineffective at the lower limit, they decided to influence not just the price of money (the interest rate) but also the quantity of money.

The European Central Bank in Frankfurt, Germany. The central bank can affect the amount of money directly through purchasing assets or quantitative easing. -AFP

Unconventional monetary policy is unconventional because common sense tells you that you cannot affect simultaneously both the price and the quantity. But that is exactly what the advanced country central banks are doing.

The central bank can also affect the amount of money directly through purchasing assets or quantitative easing (QE).

This is where the central banks say they are not printing money.

QE does this by “by purchasing assets, mainly from non-bank financial companies” (such as pension and insurance funds).

The whole purpose of the more technical article “How Money is Created” is to dispel two misconceptions about how QE works. The article admits that “as a by-product of QE, new central bank reserves are created.”

But it took great pains to explain why “the extra reserves are not ‘free money’ for banks”.

“While banks do earn interest on the newly created reserves, QE also creates an accompanying liability for the bank in the form of the pension fund’s deposit, which the bank will itself typically have to pay interest on.

In other words, QE leaves banks with both a new IOU from the central bank but also a new, equally sized IOU to consumers (in this case, the pension fund), and the interest rates on both of these depend on bank rate.”

The second misconception was “Why the extra reserves are not multiplied up into new loans and broad money?” This is because the banks are the transmission mechanism (new code word for villians) of QE. The pension fund now holds bank deposits instead of government bonds (now held by the central bank). The commercial banks have a corresponding increase in reserves with the central bank.

Importantly, the reserves created in the banking sector do not play a central role. This is because, as explained earlier, banks cannot directly lend out reserves. Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them to consumers in the economy, who do not hold reserves accounts.

When banks make additional loans, they are matched by extra deposits – the amount of reserves does not change. (In other words, it is the banks who are lending or not lending – this has nothing to do with reserve creation).

“QE boosts broad money without directly leading to, or requiring, an increase in lending. On balance, it is therefore possible for QE to increase or to reduce the amount of bank lending in the economy. However these channels are not expected to be key parts of its transmission: instead, QE works by circumventing the banking sector, aiming to increase private sector spending directly.”

There you are. The commercial banks are damned if they lend and damned if they don’t lend because they are “circumvented” by QE.

Can someone explain to me this plain fact – would property prices or stock and bond prices be where they are, if the central banks didn’t engage in QE and doubled or trebled their balance sheet since 2007?

The excess liquidity in the whole world would not have happened without the unconventional monetary policy of the advanced central banks.

That liquidity is unfortunately global, but central banks worry that if banks fail, insolvency is national – namely, they have to bail them out. So, is it surprising that the central banks can’t withdraw QE easily and keep on giving forward guidance which the market has some problems believing in?

Independent central banks would have to do better than writing articles for schoolchildren in absolving themselves from the post-crisis asset bubbles.

• Tan Sri Andrew Sheng is Distinguished Fellow of the Fung Global Institute.
• The views expressed are entirely the writer's own.