Printing clever weird stuff … aka money

The ECB is warming up to engage in quantitative easing this quarter. Again the newspapers will be filled with stories of money printing. And so it seems an opportune time to again ask ‘what do we mean by money printing?’

The phrase appears pretty self-explanatory, but kind of assumes that we know what money is. But we all do know what money is, right? It is possible that I was late this. So I thought it might be worth skimming through some basics with respect to what money actually might be in case anyone else has become a bit confused along the way. Then a bit on what money printing is. I apologise in advance.

First of all, there is not just one sort of money, but two: Inside Money and Outside Money. The distinction is not trivial.

Inside Money is private sector money endogenous to the financial system; it constitutes the vast majority of what we tend to think of as money (c£1.7tn in the UK if we exclude things that probably need to be excluded), but is more handily remembered as ‘stuff’ that is kept inside banks, and can never ever ever leave them. This is because Inside Money is short-term tradable bank debt (often also known as a bank deposit) effectively sitting on a series of giant interconnected spreadsheets. Put another way, most of what people understand as their own money is just a massive series of interconnected spreadsheets. People will give you real-life things in exchange for you instructing your bank to reduce the number in your spreadsheet cell and increase the number in your counterpart’s spreadsheet cell, but it would be a bit silly to think you could take the actual numbers out of the spreadsheet.

Outside Money on the other hand is stuff that looks like stuff we tend to refer to as money: banknotes with physical form, (but also bank reserves, more on which later). Outside Money is more handily remembered as stuff that can exist outside of banks although most of this stuff still only exists on spreadsheets. How much Outside Money is there in the UK? There are about £70bn notes (and coins), and another £300bn in reserves (spreadsheet Outside Money that only banks can own) in the last weekly Bank of England return (although there are a few other things on the balance sheet that might also qualify, taking the total up to maybe c£400bn).

The trick that any functioning banking system needs to pull off is to make these two sorts of money appear utterly interchangeable (when in fact they are oil and water). Or as Ha-Joon Chang pithily puts it ‘banking is a confidence trick (of a sort), but a socially useful one (if managed well)’. I agree.

What sort of money is being printed when central banks quantitatively ease? Outside Money. Outside Money is the liability of a Central Bank (and HM Treasury), that is to say, like Inside Money, it’s a sort of debt. Crucially, it is a liability of a State that is short-term rather than long-term. It’s short-termness defines its moneyness. What do I mean by short-term? An overnight deposit would be short-term obligation of the State. A ten-year government bond on the other hand would be a long-term obligation of the State.  (The weird thing about the short-term obligations is that they are repayable only in themselves. But don’t get too hung up on this quite yet.)

In fact money, whether Inside or Outside, will always be someone’s debt. If you have deposits at a bank, you are on the creditor of the bank. If you have notes and coins in your pocket you are a creditor of the State. As long as not everyone tries this together your bank should be able to redeem its debt to you (ie, pay you back the Inside Money that you have on deposit in the form of Outside Money) without notice. But in a fiat money world, the state never needs to pay you out. This might make Outside Money sound like a bad deal (forgetting for a moment that Inside Money is in some ways just a sort of ersatz Outside Money).

So what is Outside Money actually good for?

  1. The quick answer is paying taxes. Having a heavily-armed State threatening to exercise its monopoly use of violence against you to extract payment in a currency of its choosing concentrates the mind. Taxes are debts that are invented by the State in a manner that its controllers see fit (the People, the political classes, the Autocrat, whoever). They can be progressive or regressive, life-enhancing or otherwise. But by projecting debt unto the people, the State projects a widespread and regular demand for its Outside Money into an economy.
  2. The long answer is society.

I think that this is pretty amazing.

Secondly, how do Central Banks print this money?

In straightforward quantitative easing (as opposed to quantitative and qualitative easing as seen in Japan) they buy government bonds from people/ firms/ agents. In so doing they take a long-term tradable debt security (aka a bond) out of the market, exchanging it for bank reserves (a Central Bank deposit of sorts). (NB, if financial intermediaries are using these bonds as collateral – that is to say in money-like ways – things possibly get complicated.)

And given that money is always a debt (and it is), we can see that by engaging in quantitative easing, a Central Bank exchanges one State debt (a long term government bond) for another (bank reserves) without actually increasing or decreasing the total debt of the State. What has occurred? The maturity of the State’s debt has been changed.

So money-printing doesn’t change the amount of State liabilities out there, it just shortens their maturity profile. Does this create refinancing risk? I would argue not, given that Outside Money is at once short-term (eg an overnight Central Bank deposit rather than a 10 year government bond) and perpetual (eg unredeemable in anything other than itself). Outside Money is clever weird stuff.

Finally, in saying that QE ‘just’ changes the maturity profile of government liabilities I am not intending to diminish it. Unlike private debt (issued by non-financials to fund expenditure within a household budget constraint), monetary sovereigns issue debt to monetarily sterilise their fiscal expenditures. That is to say that they sell government debt not because they need the money to finance government expenditure but because they don’t want quite so much Outside Money with which they have paid civil servants, government contractors, benefit recipients etc, sloshing around the system, and so they effectively mop it up by selling government bonds. Government bonds cannot be used in quite the way that overnight Outside Money can be (again, assuming that they aren’t used as collateral.) And so quantitative easing represents the desterilisation of past fiscal deficits – no more no less. But perhaps that’s for another day.


PS: Yes, I know that all the above is only questionably applicable to the ECB given that there is an ambiguity over what Inside Money is and what Outside Money is in the Eurozone. This rolling ambiguity is actually an essential characteristic of the Eurozone monetary crisis.


21 thoughts on “Printing clever weird stuff … aka money

  1. Really interesting for a quasi-lay reader such as myself who has only a basic understanding of economics. Thinking back to Econ 101, what is your view on how the money supply interacts with inflation? Is it increases in outside or inside money that increases inflation? Or is it neither?

    • Thanks Joe.

      People tend to relate inflation to changes in money supply via the Quantity Theory of Money equation MV = PQ, where M is the total amount of money, V is velocity of money in final expenditures, P is price level and Q is an index of real value of final expenditures.

      Broad monetarists like Milton Friedman and Tim Congdon would say M is Inside Money.

      People who have been calling for hyperinflation as a result of QE would argue that M is Outside Money.

      Personally, I see the quantity theory of money as an accounting identity with a volatile residual (V) that can be very helpful in describing what is going on in an economy rather than something that is particularly helpful in ascribing causation, or as an inflation forecasting tool, but should probably leave it to the monetarists to fight this out.

    • Great post, Toby.

      Only money that’s spent can be inflationary, not money created. Saved money isn’t driving up any prices. Neither can reserves sitting in the banking system or at the CB. There has to be a mechanism for money to get out into the economy, which is usually bank lending. And bank lending doesn’t increase just because there are lots of reserves – banks don’t lend reserves since loans create new reserves by themselves. Banks usually only lend when there are credit-worthy lenders, and that takes a healthy growing economy and projections of future incomes.

      So generally, money isn’t inflationary because i) it is just deploying underutilized or unemployed resources, and ii) because we save lots of it thereby removing its influence on the market.

      If you’re looking for where most inflation comes from, don’t look at quantities of money, look at commodity prices:

      • Also, I meant to add that it isn’t just government money that has the possibility of being inflationary. If we ever got to a point of full employment and fully productive use of our national capital, then increases in private sector spending, investing (borrowing to spend), or even increases to our trade balance (more exports) can put pressure on prices. Businesses don’t discriminate between which sector is buying their goods when setting prices!

        So fears of government “money printing” are misguided on two fronts: they generally are not inflationary for the reasons I first stated, and secondly, government fiscal actions shouldn’t be the sole focus on any real inflation concerns in the first place.

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  4. Great post!. Two questions. One, is why is paying taxes outside money? I send Uncle Sam a check from my checking account. It effects outside money because my bank’s reserves with the Fed change, but I wrote the check from my bank account. Wouldn’t this represent inside and outside money?
    Other question concerns how a CB does QE. CBs first creates the reserves so that it can buy outstanding bonds in the market and those reserves get substituted on the private bank’s balance sheet for the treasury bonds. But those reserves would never have been created without QE. There only purpose was as an offset to the treasury bonds. So net, net if you assume that the government debt is taken out of “circulation” when it is purchased by the CB the net amount of government liabilities is less. At any rate, since Fed funds deposits with the CB have no real maturity I wouldn’t say the debt maturity has been reduced. Maybe these Fed fund deposits are better thought of as equity? Equity with a rather dubious claim on similar Fed money?

    • Thanks! I think you’re right that Inside and Outside Money shrink via taxation. Here’s the thought:

      1. You get asked for taxes.
      2. You send a cheque which can be drawn against Mega Bank, which owes you money (Inside Money) – eg, your deposit/ checking account is in credit.
      3. The State becomes a creditor of Mega Bank (and your account is correspondingly reduced in size).
      4. Mega Bank, by virtue of being a bank, is an Outside Money creditor to the Central Bank. This is manifest in reserve accounts. And these reserves are Outside Money.
      5. So the State is an Inside Money creditor of Mega Bank, and Mega Bank is an Outside Money creditor of the State.
      6. The State can determine these obligations as equivalent. And hence State holdings of Inside Money are used to control levels of Outside Money.
      7. It is true that for a reduction in a Outside Money to occur in this way, Inside Money must correspondingly reduce.
      8. On a practical basis, none of these steps need to occur: you can collapse steps 3-7 and run either tax/ borrow and spend one-for-one, or slightly out of synch with the State running small balances (positive or negative) of Inside Money. But the underlying requirement in a fiat money system for taxing or borrowing is based on this monetary imperative. That is to say that the motive for taxing and issuing debt is based on the desire to control what money is and how much there is of it.

      I came across this interesting blog on tax last night that I think also has some great points

      On the second question, I guess I would just see reserves as a State liability, and here you see I assume no real separation of the CB from the State. I don’t see that there can be really.

      • Thank you for your response. I think I get your point on the taxes. As to the reserves being just another state liability, it seems to me that as reserves are outside money there’s a difference. The difference is the private sector (i.e. non-government sector) can buy and sell other state liabilities but not reserves. This might not change net government liabilities outstanding, but it could have significant implications for the price (i.e. interest rate) of those assets that only the private sector can purchase.

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  6. That’s a quality article. However I don’t agree with this para:

    “The trick that any functioning banking system needs to pull off is to make these two sorts of money appear utterly interchangeable (when in fact they are oil and water). Or as Ha-Joon Chang pithily puts it ‘banking is a confidence trick (of a sort), but a socially useful one (if managed well)’.”
    So what “socially useful” function is fulfilled by private banks creating or “printing” money given that the central bank can create / print infinitely large amounts of money anytime and at no real cost? Why should private entities reap the profits of seigniorage? If you turn out £20 notes on your own press you get arrested and quite right.

    Moreover, private money creation cannot be done without incurring risks. As Messers Diamond and Rajan said in the abstract of a paper of theirs (link below) and in reference to liquidity / money creation by private banks:

    “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.” If “bank runs” are part and parcel of private money creation, I’m not impressed.

    • Thanks Ralph.

      The Central Bank can create an infinite amount of keystroke money, but I strongly believe that banks – when functioning properly – perform a pretty important and socially useful function, namely capital allocation in a non-centrally-planned manner.

      You might counter that banks have not been well-functioning and I won’t seek to defend every loan decision, but I prefer the system of dispersed lending decisions oriented around estimates of creditworthiness (eg, that the bank understands that there is risk around making a lending decision), to a centrally-administered system of credit provision. In the latter system one’s standing ‘at court’ is more important than one’s creditworthiness. This is a recipe for corruption, no matter how good the initial intentions (see a laundry list of cetrally-administered state development bank corruption scandals in a variety of emerging markets, and probably developed markets also).

      Tangentially, I have found this a pretty gripping read as an account of banking history in Russia (Tsarist and Soviet Union systems)

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