What people still get wrong about QE

The idea of QE has been widely discussed in the media since the crash of 2008 but even now, over a decade later, people’s understanding of it is very poor. And when I say people, I include politicians and even economists. The consequences of these misunderstandings are simply enormous. This article will explain what QE really is, what it does and whether or not it should stop.

But before we delve into the nitty-gritty of QE we should first check that we’re all agreed on how the monetary system works. Most people assume that there is a constant pool of money that circulates in the economy forever more and the quantity of it only changes when the government decide to print more of it. Some of the money we use does indeed work in this way but it only constitutes a tiny fraction of our money supply. The bulk of it is made up of what is known as “cheque book money” and it works in a completely different way. It has become increasingly well known that when a bank makes a loan, new cheque book money is created. What is less well known is that when the borrower repays the principal of the loan, it disappears back out of existence. If you’re finding this hard to believe then please read this document published by the Bank of England https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf. This paper contains the words "Just as taking out a new loan creates money, the repayment of bank loans destroys money." - I wish all explanations of our monetary system were this clear. 

So now we can see that the money supply can go up or down in accordance with two rates of flow – the rate of new money creation through new bank loans vs the rate of money destruction through loan repayments. The money supply is thus analogous to the amount of water in a bath where a tap is adding water (new loans) but the plug has been removed and water is flowing out of the bath (loan repayments). I shall refer to this analogy later on as the “bathtub dynamic”.

The prelude to QE

The next thing to consider is what circumstances would lead up to a situation where governments/central bankers might want to do QE in the first place. The answer is the upswing phase of a housing bubble. Millions of people borrowing as much money as they possibly could to buy houses, driven by the belief that house prices are likely to rise at a rate which makes them a good investment. This phase corresponds to a high rate of flow through the taps into the bath. At the same time there will be a high rate of flow out of the bath corresponding to all those mortgage repayments. At some point however, all housing bubbles come to an end. People become less certain that the rate of increase of house prices can be sustained and the enthusiasm for new mortgages takes a nosedive. So the flow of water into the bath will slow to a trickle. But what happens to the flow of water out of the bath? The answer is that it remains high. Mortgages last a long time, decades even. So now we have a situation where, in the absence of any intervention, the water level (i.e. money supply) will start to fall. A falling money supply is painful for an economy in all sorts of ways and central bankers want to avoid it if at all possible… enter QE.

Misconception 1: QE is just “printing money”

If QE was just “printing money” then it would be a permanent thing. I.e. you print the money and that money would remain in the economy forever more and that would be the end of it. QE does indeed create new money but with QE it is very much not the end of it. It is inherently a time limited thing, i.e. the money is created, added to the economy and then at a predefined future time will automatically disappear back out of the economy. The reason for this strange disappearance is all to do with the fact that QE involves the purchasing of bonds…

What is a bond?

A bond is a mechanism for borrowing money. Let us say that someone or some organisation wants to borrow a £1million for 5 years and they are willing to pay interest of say 7% each year for the privilege. What they can do is write out a special document called a bond, which says, “I promise to pay the holder of this document  1 million pounds in 5 years’ time and I will pay 7% (that’s £70,000 each year) along the way” and then hope they can find someone willing to buy that document for 1 million pounds. The person that buys the document will then receive £70,000 a year and at the end of five years the person borrowing the money will have to pay the purchaser the original £1million back. In this example 5 years is known as the “maturity” and the £70,000 per year interest payments are known as the “coupon”. If the organisation wanting to do the borrowing happens to be the government then the bond is referred to as a government bond or gilt. Bonds can be bought and sold like stocks and shares.

So the first step of QE is the central bank creating money out of thin air and using that freshly created money to buy pre-existing government bonds from the financial markets, for example from a pension fund. Say for example they purchased £10Billion worth of bonds that mature in 3 years’ time. When those bonds reach their maturity the original issuer of the bond (i.e. the government) will need to pay back the £10Billion to the holder of the bond (the central bank). One may ask what happens to that money upon repayment, and the answer is that it disappears back out of existence.

So the difference between simply printing money and QE is that with QE there is an automatic, baked in, process by which that money will be “un-printed” at some future date. And the un-printing will be painful for the government of the time – the government will have to deliberately destroy some of its own money, i.e. it would mean collecting £10billion from the taxpayer and instead of using that money to pay doctors, teachers, policemen etc., it will have to destroy that money. There is not only that pain however, there is also the economic effects of removing that money from the money supply – a double whammy of pain. This process is known as “unwinding QE”, and guess what, governments don’t like to do it! What they are much more likely to do instead is some more QE to counteract the expiring QE. I.e. at the moment that £10billion of bonds matures, the government can simultaneously borrow another £10billion by selling £10billion of freshly created government bonds to the private sector and getting the central bank to do £10billion of new QE, i.e. buy another £10billion of bonds from the private sector.

Misconception 2: QE increases the money supply.

Indeed QE can increase the money supply, but it is not guaranteed. If the rate of creation of new money via QE is less that the rate at which the money supply is falling (due to the burst housing bubble) then we could be in a state, where you add new money over some period but end up with less than you started with. Indeed if you watch the former Governor of the Bank of England speaking to a parliamentary committee in 2011: http://www.bbc.co.uk/news/business-15446545 you can see he explains that at that time the UK was in just such a state. He says "What we were doing was injecting money into the economy and what the banking system has been doing is destroying money". "What we were doing [QE] was to partially offset what would otherwise been an even bigger contraction."

Misconception : The money initially simply sits in the banks as reserves and no new money enters the economy until the banks lend it out.

This idea probably comes about because the central bank’s form of money, namely bank reserves, cannot be used directly by the public. So the assumption is that the only way for central bank money to get out into the economy is for banks to make loans. But in fact the central bank can purchase things from, say a pension fund, in a two-step process whereby they give reserves to the bank holding the pension fund’s bank account and instruct the bank to credit the pension fund’s account thereby getting money outside of the banks without a single loan having taken place.

Misconception : It’s failed so let’s stop

Many people (usually with no idea of the bathtub dynamic) have observed the rounds of QE, seen that there have not been great improvements in the economy and have declared things along the lines of “We’ve given QE a try and it didn’t work, let’s stop QE and never do it again”. Unfortunately because water gushing out of the bathtub’s plug hole, you have to have an alternative plan for preventing a contraction of the money supply. Simply stopping QE is not really an option.

Misconception : QE might lead to runaway inflation

If you don’t know about the bathtub dynamic then QE will appear to present a great risk of inflation. Indeed when it was being employed  around 2009 there were many economists warning of hyperinflation around the corner. Over a decade later it has still not materialised. This is not to say that it is completely impossible to create hyperinflation with QE, merely that when you “do the math” you have to take into account the (anti-inflationary) water flowing out of the bath.

The most critical issue of all

Let us consider the question of whether it would be possible to get the money supply stabilised again without relying on QE. This means getting the rate of flow of new money creation to rise up to a level which is at least as much as the rate of flow of money destruction. Unfortunately the high rate of money destruction has been baked in for years to come by the mortgage repayments set up just before the bubble burst. This rate was crazily and unsustainably high. Without QE, this rate cannot be matched again without there being a new bubble in place! Any long term solution to the QE problem has to bear this in mind.

A solution

What we need is to replace the money being lost through mortgage repayments with money that doesn’t disappear and won’t leave future governments burdened with horrible decisions about unwinding. This can be done with genuine (permanent) money printing. The government can, for a few years, spend more than it takes in from taxation and make up the difference with central bank money. They can pay government workers (doctors, teachers policemen etc.) with central bank reserves by handing those reserves to private banks and then instruct those banks to credit the accounts of the workers. The new money thus goes straight into the economy and there is no future unwinding required and no interest to pay.

An even better solution

All this crazy game that central bankers need to play in order to get a stable money supply is a direct consequence of our monetary system in which bank loans create money and repayments destroy it. The system we have, known as fractional reserve banking, was however not humanity’s only choice for a way of designing money. Indeed I would suggest that that our current system has come about more through historical accident than by design. If money was being introduced for the first time today, nobody in their right minds would select our current system. If you asked the man in the street how money worked, they would probably suggest that there was some pool of money that circulates in the economy forever unless a government decided to print more of it. This “naive” idea is in fact perfectly workable and is known as full reserve banking. No more bathtub dynamic. Under full reserve banking, the amount of money in the economy does not change when there is a boom or a bust so there would never be any need to stop the money supply falling. It simply cannot fall. Switching to full reserve banking would no doubt take a lot of preparation and re-education of bankers, so could not be done overnight but it’s something we should start investigating for the future.