When Quantitative Easing was proposed it was an unknown idea, and many thought it would create inflation. Now that the dust has settled, what are we to think? It was promoted as a way of enabling the banks to restart lending again.
First of all, what is Quantitative Easing? Apparently it is the Central Bank buying bonds from commercial banks. Bonds, of course, are tranches of money that Local Authorities or companies have borrowed with set terms of repayment and interest. So when the Central Bank buys these, the borrowers find that their repayments are due to the Central Bank rather than to the commercial banks that they borrowed from. The Central Bank pays for the purchase of the debts by crediting that banks account with the Central Bank. At this point we may well ask “what is the purpose of that?” and “how does it help?”
One answer may lie in the attached quotation from the Macmillan Dictionary of Modern Economics. “Under the new arrangements (1981) all banks and licensed deposit takers are required to maintain a non-operational balance of deposits at the Bank of England equal to 0.5 per cent of ……eligible liabilities’ total; above that they are free to determine their holdings of all types of reserves by their own prudential criteria”.
So Quantitative Easing immediately creates the reserve assets ratio required to justify increased lending.
Here we may pause and reflect on the half of one per cent required. Yes, it used to be 12.5%, but the rules were relaxed in 1971. So the much used formula for showing the banks ability to create money out of thin air, which by multiplying up the deposits resulting from each loan, apparently enabled banks to create ten times the initial loan, is now shown to be false. For if it now applies with only half of one percent the multiplication process would be huge. What really limits a banks ability to lend is the likelihood of repayment. For if they misjudge that, bankruptcy looms, as we now see.
So far, we have achieved the required increase in the non-operational balance of deposits with the Central Bank. Will this enable the banks to lend more, and will that create inflation?
Incidentally, the attached article from “The Economist” shows that the Fed is doing much the same, and making a mint out of it. So we can be sure that the Bank of England is carefully setting the terms so that it makes a profit from the operation.
The commercial banks are licking their wounds. By the process of trading their debts, they have created huge confusion. When the sub-prime began to go sour, they found that none of them knew where the bad debts had landed up. They knew there were debts that were unlikely to be paid, but what with the packaging and repackaging no one knew how much would hit each bank. They became suspicious of each other, and the inter-bank market froze. The process of turning people out of their homes just made it worse, as these properties being auctioned off depressed the market more, pushing more into negative equity. The banks restricted credit, adding to the downturn. Those made jobless could not pay their mortgages, so more re-possessions. A sorry mess!
The damage done to banks balance sheets is unknown, so that the production of audited accounts becomes a huge problem. They have to be cautious. But they also have to maintain confidence, and they are under pressure to lend again to reduce the effect of recession.
If bank lending was the cause of inflation, we would by now have huge inflation. But we can see that, provided there is belief in repayment, no inflation arises from lending as such. In fact, M4 is known to be reducing as new lending is restricted, and old loans are repaid.
So, we can deduce that the process of Quantitative Easing will not of itself cause inflation.
Government expenditure is met from two sources, taxation and borrowing. Both of these use existing money balances, so inflation is kept to a minimum. We can distinguish two types of causes of inflation, physical and subtle. I believe the system we have protects us from the first fairly well. There may be some leakages, for example the government uses Treasury bills to cover short term cash flow differences. Are these all subsumed into borrowing from the public?
Subtle inflation is much more difficult. This is to do with our valuation of money. If enough of us were worried about inflation and bought assets as a store of value (antiques?) then the price of antiques would rise, and the value of money would fall. So this is why the authorities have to be so careful with confidence.
After all, money is not wealth, it is only a token of indebtedness. I like the definition "money is the nothing you get for something before you can get anything".
If a change in the law is required, I believe it should be made illegal for a lender to sell a debt. I would allow him to insure, but responsibility for collection rests with the original lender. This would protect from the confusion caused by the marketing of sub-prime debt to unsuspecting counter parties. It would also allow banker to be paid by reference to repayments rather than new loans.
So, perhaps we can deduce that Quantitative Easing is unlikely to cause physical inflation. However, the very uncertainty may cause inflation by subtle means.
Henry Law comments...
In my view the main inflationary risk is related to the level of government debt and falling tax revenues. The difficulty facing a government in such circumstances is that the substantial tax rise needed to pay off debt will kick the economy back into recession just as soon as it starts to revive, - unless the extra revenue needed were to be raised through land value taxation. Alone of all taxes, LVT can be expected to have a stimulatory effect on the economy. Unfortunately, substantial LVT is not on the agenda of any political party likely to form the next UK government and so we can expect both prolonged recession and a temptation to inflate the debt away as happened in the 1970s.
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