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.

Why is the Debt Management Office no longer part of the Bank of England?

Click-bait of a title, I know. 10.25pm on a Sunday night too. But now that I have scared any potential readers away, I can get down to saying something that I think is quite interesting (without worrying whether it is sufficiently interesting). And it sort of relates to QE.

As a recap, it is worth reflecting (yes, again) on how QE works. While it is only possibly true that no-one knows, it is certainly the case that there is uncertainty and disagreement amongst the principal architects. As Bernanke quipped “the problem with QE is that it works in practice but it doesn’t work in theory”.

I have seen three main competing/ complimentary explanations as to how QE might work which are rather clumsily assembled on the diagram below:

Over the past month the Bank of England has published a couple of empirical studies on what effect a couple of these channels had. The first, on the portfolio balance channel (basically the belief that in buying gilts, the Bank would effectively force institutional investors into riskier assets) which most Central Bankers have relied on in public to articulate the mechanism through which QE translates into easier monetary condition, found that pension funds and insurance companies had increased corporate bond holdings and cash while reducing both gilt and equity holdings versus a counter factual simulation of their behaviour absent QE. This finding doesn’t dismiss the portfolio balance channel, but I read it as a statement that it was pretty disappointing versus the Bank’s expectations.

The second, on the bank lending channel, was pretty dismissive as to any potential empirical support. In the authors’ own words ‘we find no evidence to suggest that QE operated via a traditional bank lending channel’.

This leaves two possible transmission mechanisms: a confidence/ signalling effect, and Everything Else We Don’t Yet Understand (EEWDYU).

One could be forgiven for thinking that Mario Draghi has put in the hours in order to prove that signalling is what it is all about. After all, he delivered the most seismic easing in monetary conditions that Europe has seen in the last decade simply by deploying the phrase “whatever it takes” with a conviction few could doubt. But Europe’s inability to sustain an economic recovery to match its financial market recovery from the depths of the Eurozone crisis puts the idea that signalling is *all that* in doubt.

People seem pretty united around the idea that QE works. So, forgetting how QE might work for a second, let’s recall what QE is. It is basically a massive debt swap, exchanging long-term liabilities (aka gilts) for short-term government liabilities (aka high powered money). This is the case whether we think QE works via the portfolio balance effect, bank lending channel effect, confidence/ signalling effect or EEWDYU. In other words, if QE was worth doing, managing the term structure of the government’s liabilities appears to be a big deal.

Who is responsible for managing the term structure of the government’s liabilities? The UK Debt Management Office – an institution that used to be part of the Bank of England run by charming and capable professionals with whom I might be (I hope only temporarily) unpopular on account of my (very sensible) suggestion that they refinance the War Loan (which I recognise would be an administrative hassle for them although a very good thing for people keen to reduce the national debt and HMT interest payments).

There is also the possibility that QE actually made absolutely no difference whatsoever and has been a massive red herring.

So here’s the thing. If QE works through some mechanism other than a confidence/ signalling effect the rationale for splitting the DMO from the BoE appears defunct. Is it time for a reunion?