The central bank is trying to stimulate the economy by encouraging banks to lend money and people and businesses to borrow money. Lowering the base interest rate almost to zero has not worked. Quantitative easing has not worked despite increasing dramatically the amount of money commercial bank have in their reserve accounts at the central bank.
So, in desperation, some have suggested that they try negative interest rate. By this they mean that banks would have to pay interest on the money they keep in their reserve accounts at the Bank of England.
The rational given for this is that it will encourage banks to lend these reserves instead of 'hoarding' them. This reveals a misunderstanding of reserve banking. Bank cannot easily lend this money, except to each other, as reserves can only move between reserve accounts, and only banks and the government have reserve accounts. The only way that reserves can actually leave the bank of England is after conversion into notes and coins. This is unlikely to be much of a stimulus given that they notes and coins form such a small proportion of the money supply. Banks would probably choose just to hang onto the notes in any case since at least they don't pay interest on them. It would be good times for potential bank robbers as mountains of cash accumulated in bank vaults.
Another way that banks can get rid of reserved and so avoid negative interest rates is to buy assets from the government/central bank which is pays with using reserves. This is like reverse quantitative easing so would presumably be resisted by central banks. It does however suggest a mechanism of reversing quantitative easing which could be useful in future.
Rather than increasing demand, what negative interest rate would do is act as another tax, further reducing demand. I have already pointed out that quantitative easing, where the central bank buys interest bearing securities from the private sector, is effectively tax because it diverts interest income from the private sector (who previously own the securities) to the government/central bank, the new owners of the securities. A negative interest rate on reserves has the same effect since (private) banks would be paying interest to the central bank which then remits it to the government, as it does all its profits. Not so clever.
Tuesday 26 February 2013
Sunday 24 February 2013
Reality (2): the nature of money
In this post I continue to discuss elements of macroeconomics that are beyond dispute. One of these is our monetary system. While this is complicated it was designed by humans so should be readily understood. What is remarkable is that not only do very few ordinary people understand the monetary system, most of those working in or writing about the financial sector do not appear to fully understand it. This is a consequence of the highly misleading fact way that it is taught at University and described by economists.
The first important fact to appreciate is that most of the electronic money that is used by the private sector is created by private banks, NOT by the central bank or government. This money, which experts call bank money, is created when a bank makes a loan. When it does this it adds a number to your bank account using a computer. At the same time it gets you to sign a contract requiring you to pay that money back by some future date. When this loan is paid back the money disappears. This is analogous to how matter is created out of nothing but has a counterpart anti-matter. When the two come together nothing remains.
Central banks also create electronic money but this money, called bank reserves, is present at far lower amounts than commercial bank money. The relationship between central bank reserves and bank money is not well understood. Central bank reserves never actually leave the central bank account system. Instead they move between those who have accounts at the central bank, namely the government and licensed banks. Their primary role is to settle payments between private banks, and between the government and private banks.
When customers with accounts at the same bank exchange money all that happens is their accounts recording their bank money go up and down accordingly. No central bank reserves are involved. However when customers with accounts at different banks exchange money then the banks transfer central bank reserves between their respective accounts at the central bank to effect these payments. In essence banks have reserves to enable them to settle payments between their respective customers. They also use reserves when they issue notes and coins to customers. When they obtain cash from the central bank their reserve account is marked down by that amount, and vica versa.
Only central banks can create bank reserves, and they can do this unlimited amounts. The amount of money in reserve accounts bears little relationship to the amount of spendable money in the economy. Some central banks require banks to hold a minimum amount of reserves, equivalent for example to 10% of the value of bank deposits that they hold. Students are usually taught that this requirement enables the central bank to indirectly control the total amount of money in the economy just by changing the amount of reserves. This is wrong. In practice central banks always lend banks whatever reserves they need to meet these reserve requirements (if they exist) or to make payments between each other. They do this because failure to do so would cause the payment system and hence the economy to collapse. What central banks do try to control is the interest that banks have to pay to borrow more reserves. When a bank makes a loan of BANK money it is possible that, if that money is transferred to a customer at another bank it will need to borrow reserves to settle the transaction. Therefore the interest rate that banks set for that loan will be influenced by and always be higher than the interest rate that it would have to pay to borrow reserves.
The fact that almost all the money that is spent in the economy is bank money created by banks out of nothing when they make loans has important implications.
1. We effectively rent most of our money from private banks.
2. The amount of money circulating in the economy is determined by the balance between the rate that banks make new loans and the rate that old loans are repaid. If people take out fewer loans or increase the rate at which they repay existing loans then the money supply shrinks which reduces economic activity. This is why the government has been trying so hard to persuade people to take out more loans.
3. Increasing the amount of central bank reserves does increase the amount of money in the economy but changes in bank lending have much bigger effect on the amount of money. Since 2008 central banks have been increasing reserves by huge amounts but this has barely compensated for the reduction in the amount of bank money as people stop taking out new loans and continue to pay back existing ones.
4. As the economy grows the level of private debt grows since all bank money created to support growth has a corresponding debt. In fact in the past 40 years the level of private debt has grown much faster than the growth in economies. It should be obvious that it is not sustainable for private sector debt to grow faster than the economy as measured by GDP because the interest costs of this debt are paid for out of total income or GDP. Nevertheless policymakers allowed this to happen, and only a tiny handful of economists pointed out the fact that this would end in tears. By 2007 this debt level reached over 300% of GDP before, as predicted by economists outside the mainstream, the credit bubble collapsed.
5. Growth collapsed largely because the private sector switched from increasing their borrowing year by year, which they had done for up to 40 years non-stop, to paying down their debts. Unfortunately because of the fact that most money is created through bank lending, this resulted in a decrease in the money supply and has suppressed economic growth. That is why government are desperately trying to reverse this and encourage borrowing.
6. Given this scenario described above, and the fact that private sector debt levels are still so high, it seems foolish to try to restore growth by encouraging the private sector to once again increase its debt levels, especially when economies are shrinking because of cuts in government spending.
The first important fact to appreciate is that most of the electronic money that is used by the private sector is created by private banks, NOT by the central bank or government. This money, which experts call bank money, is created when a bank makes a loan. When it does this it adds a number to your bank account using a computer. At the same time it gets you to sign a contract requiring you to pay that money back by some future date. When this loan is paid back the money disappears. This is analogous to how matter is created out of nothing but has a counterpart anti-matter. When the two come together nothing remains.
Central banks also create electronic money but this money, called bank reserves, is present at far lower amounts than commercial bank money. The relationship between central bank reserves and bank money is not well understood. Central bank reserves never actually leave the central bank account system. Instead they move between those who have accounts at the central bank, namely the government and licensed banks. Their primary role is to settle payments between private banks, and between the government and private banks.
When customers with accounts at the same bank exchange money all that happens is their accounts recording their bank money go up and down accordingly. No central bank reserves are involved. However when customers with accounts at different banks exchange money then the banks transfer central bank reserves between their respective accounts at the central bank to effect these payments. In essence banks have reserves to enable them to settle payments between their respective customers. They also use reserves when they issue notes and coins to customers. When they obtain cash from the central bank their reserve account is marked down by that amount, and vica versa.
Only central banks can create bank reserves, and they can do this unlimited amounts. The amount of money in reserve accounts bears little relationship to the amount of spendable money in the economy. Some central banks require banks to hold a minimum amount of reserves, equivalent for example to 10% of the value of bank deposits that they hold. Students are usually taught that this requirement enables the central bank to indirectly control the total amount of money in the economy just by changing the amount of reserves. This is wrong. In practice central banks always lend banks whatever reserves they need to meet these reserve requirements (if they exist) or to make payments between each other. They do this because failure to do so would cause the payment system and hence the economy to collapse. What central banks do try to control is the interest that banks have to pay to borrow more reserves. When a bank makes a loan of BANK money it is possible that, if that money is transferred to a customer at another bank it will need to borrow reserves to settle the transaction. Therefore the interest rate that banks set for that loan will be influenced by and always be higher than the interest rate that it would have to pay to borrow reserves.
The fact that almost all the money that is spent in the economy is bank money created by banks out of nothing when they make loans has important implications.
1. We effectively rent most of our money from private banks.
2. The amount of money circulating in the economy is determined by the balance between the rate that banks make new loans and the rate that old loans are repaid. If people take out fewer loans or increase the rate at which they repay existing loans then the money supply shrinks which reduces economic activity. This is why the government has been trying so hard to persuade people to take out more loans.
3. Increasing the amount of central bank reserves does increase the amount of money in the economy but changes in bank lending have much bigger effect on the amount of money. Since 2008 central banks have been increasing reserves by huge amounts but this has barely compensated for the reduction in the amount of bank money as people stop taking out new loans and continue to pay back existing ones.
4. As the economy grows the level of private debt grows since all bank money created to support growth has a corresponding debt. In fact in the past 40 years the level of private debt has grown much faster than the growth in economies. It should be obvious that it is not sustainable for private sector debt to grow faster than the economy as measured by GDP because the interest costs of this debt are paid for out of total income or GDP. Nevertheless policymakers allowed this to happen, and only a tiny handful of economists pointed out the fact that this would end in tears. By 2007 this debt level reached over 300% of GDP before, as predicted by economists outside the mainstream, the credit bubble collapsed.
5. Growth collapsed largely because the private sector switched from increasing their borrowing year by year, which they had done for up to 40 years non-stop, to paying down their debts. Unfortunately because of the fact that most money is created through bank lending, this resulted in a decrease in the money supply and has suppressed economic growth. That is why government are desperately trying to reverse this and encourage borrowing.
6. Given this scenario described above, and the fact that private sector debt levels are still so high, it seems foolish to try to restore growth by encouraging the private sector to once again increase its debt levels, especially when economies are shrinking because of cuts in government spending.
Saturday 23 February 2013
The problem of net exporters
One of the main sources of imbalances in the world economy are the countries who aggressively pursue a policy of becoming and remaining net exporters. These include countries such as Germany and China.
With floating exchange rates net exporting will eventually lead to an appreciation in the exchange rate, which by changing relative costs of exports and imports will reduce the surplus. Sometimes countries determined to remain net exporters try to prevent exchange rate appreciation by keeping the money that they received in payment for their goods in the importing countries. That is a self-defeating policy since it means that people in exporting countries are working hard to producing goods, sending them off to other countries, and receiving no real benefit in return other than a financial claim. All they have is some money in the importing country, but what use is that? It would make more sense for them to get something in return from those countries, such as imports of goods. In modern fiat currency systems exports are only of any real benefit if the proceeds are use to purchase imports. Countries that are net exporters are working hard and exporting the benefits.
If net exports are a cost, why do so many countries pursue net export policies? The short answer is the IMF. This organisation was set up to help countries that were temporarily short of the foreign currency reserves they need to purchase essential imports or pay back loans. When countries have run into problem in the past the IMF has lent them money under very strict conditions, which include a requirement that government sacrifice control over the budgets and impose austerity on their economies. Bitter experience of the hardship and humiliation that this resulted in has meant that many countries are determined to avoid ever having to seek help from the IMF ever again by building up large foreign exchange reserves. This is best achieved by being a net exporter and not repatriating earning from imports, building up large foreign currency reserves.
Other countries like to be net exporters because they believe it is prudent for both the private sector and the government sector to be in surplus, and this is only possible if they are net exporters. Germany is good example of this. Germany works very hard at maintaining its net exports by suppressing wage increase amongst its workers which keeps imports down by suppressing domestic consumption. Ironically it is the German people that stand to lose the most from this policy of aggressive net exporting since they are effectively creating things that other countries are using in return for a financial claim which will become worth less or even worthless as their currency appreciates or the importers default on these debt. Not so clever.
With floating exchange rates net exporting will eventually lead to an appreciation in the exchange rate, which by changing relative costs of exports and imports will reduce the surplus. Sometimes countries determined to remain net exporters try to prevent exchange rate appreciation by keeping the money that they received in payment for their goods in the importing countries. That is a self-defeating policy since it means that people in exporting countries are working hard to producing goods, sending them off to other countries, and receiving no real benefit in return other than a financial claim. All they have is some money in the importing country, but what use is that? It would make more sense for them to get something in return from those countries, such as imports of goods. In modern fiat currency systems exports are only of any real benefit if the proceeds are use to purchase imports. Countries that are net exporters are working hard and exporting the benefits.
If net exports are a cost, why do so many countries pursue net export policies? The short answer is the IMF. This organisation was set up to help countries that were temporarily short of the foreign currency reserves they need to purchase essential imports or pay back loans. When countries have run into problem in the past the IMF has lent them money under very strict conditions, which include a requirement that government sacrifice control over the budgets and impose austerity on their economies. Bitter experience of the hardship and humiliation that this resulted in has meant that many countries are determined to avoid ever having to seek help from the IMF ever again by building up large foreign exchange reserves. This is best achieved by being a net exporter and not repatriating earning from imports, building up large foreign currency reserves.
Other countries like to be net exporters because they believe it is prudent for both the private sector and the government sector to be in surplus, and this is only possible if they are net exporters. Germany is good example of this. Germany works very hard at maintaining its net exports by suppressing wage increase amongst its workers which keeps imports down by suppressing domestic consumption. Ironically it is the German people that stand to lose the most from this policy of aggressive net exporting since they are effectively creating things that other countries are using in return for a financial claim which will become worth less or even worthless as their currency appreciates or the importers default on these debt. Not so clever.
Sunday 3 February 2013
Reality (1): Money has to come from somewhere and go somewhere
There is much that is debatable in macroeconomics but some facts are beyond dispute. One such fact is that the flows of money between three different sectors of any economy with a given currency have to add up to zero. Understanding this and its implications is incredibly important.
These sectors are the domestic government sector, the domestic private sector, and the external sector or 'rest of the world'. The reason that the balance of these sectors must add up to zero is simply that there is nowhere else for the money to go. If any one sector has a surplus then at least one of the two sectors must have a deficit.
We often hear references to the balances of two of these sectors, namely the government sector and the external sector. When people discuss the government deficit or surplus they are referring to the difference between the amount of money flowing out of the public sector (through spending) and the amount flowing in (through tax revenue). Government debt is just the sum of the accumulated past annual deficits (minuses surpluses).
When people discuss current account deficit or surplus with the external sector they are referring to the difference between the money received from exports or remittances and money spent on purchasing imports. Saying there is a current account deficit is equivalent to saying that the external sector has a surplus.
What is seldom, if ever, explicitly discussed is the financial balance of the third sector, which is the domestic private sector, comprising individuals, households, and companies. This can obviously also have a surplus or deficit.
As noted a key fact is that financial flows between the three sectors will always balance each other.
What this means is that if a country is a net importer (i.e. the external sector has a surplus) then at least one of the other two sectors must run a deficit. Either the government must have a budget deficit or the private sector has to run a deficit.
Since it is widely felt that it is bad for the government to run a deficit and accumulate debts, when there is a government deficit policymakers frantically try to reduce it by increasing taxes or cutting government spending. The problem with this is that, because of the sectors must balance, this forces the private sector to run a deficit.
This is potentially dangerous. It is not sustainable for the private sector to run deficits as it will eventually lead to insolvency and financial collapse.
This contrasts with government deficits, which are sustainable indefinitely in modern economies since the state issues its own currency and, unlike the private sector, can never run out of it. That is the defining feature of modern fiat currency systems. Indeed it seems logical that if the government creates money then it needs to run a deficit as this is the only way for the private sector as a whole to accumulate money (i.e. save).
Unfortunately there is widespread belief that public sector deficits are not sustainable and have to be eliminated. That is simply not the case. Indeed most governments run deficits most years. Surpluses are rare. On the rare occasions when the US government has tried to run surpluses for several years they have always precipitated financial collapse of the private sector and depressions. It is repeated public sector SURPLUSES that are not sustainable, as this forces the private sector to run repeated deficits.
The only way that they government sector can avoid deficits and the private sector simultaneously run surpluses is for the country to be a net exporter. In other words for the government and the private sector to have surpluses the external sector has to run a large deficit. The problem with that approach is that not all countries can be net exporters. Globally exports and imports have to balance to zero as, until we connect with alien life, there is nowhere else for exports to go! So if some countries are net exporters that forces other countries to be net importers. Because many countries (e.g. China, Germany, Koreas, and until recently Japan) actually have policies committing themselves to being net exporters this forces other countries to be net importers. Most large developed countries (Germany excepted) are net importers. It follows that in these countries, which include the USA and the UK, it is necessary essay for governments to run deficits to match the external sector surplus. If they don't they will be forcing their domestic private sector into deficit.
In summary, the requirement for money flows between sectors to balance means that in countries that are net importers governments need to run deficits in order to ensure that the domestic private sector does not become insolvent.
These sectors are the domestic government sector, the domestic private sector, and the external sector or 'rest of the world'. The reason that the balance of these sectors must add up to zero is simply that there is nowhere else for the money to go. If any one sector has a surplus then at least one of the two sectors must have a deficit.
We often hear references to the balances of two of these sectors, namely the government sector and the external sector. When people discuss the government deficit or surplus they are referring to the difference between the amount of money flowing out of the public sector (through spending) and the amount flowing in (through tax revenue). Government debt is just the sum of the accumulated past annual deficits (minuses surpluses).
When people discuss current account deficit or surplus with the external sector they are referring to the difference between the money received from exports or remittances and money spent on purchasing imports. Saying there is a current account deficit is equivalent to saying that the external sector has a surplus.
What is seldom, if ever, explicitly discussed is the financial balance of the third sector, which is the domestic private sector, comprising individuals, households, and companies. This can obviously also have a surplus or deficit.
As noted a key fact is that financial flows between the three sectors will always balance each other.
What this means is that if a country is a net importer (i.e. the external sector has a surplus) then at least one of the other two sectors must run a deficit. Either the government must have a budget deficit or the private sector has to run a deficit.
Since it is widely felt that it is bad for the government to run a deficit and accumulate debts, when there is a government deficit policymakers frantically try to reduce it by increasing taxes or cutting government spending. The problem with this is that, because of the sectors must balance, this forces the private sector to run a deficit.
This is potentially dangerous. It is not sustainable for the private sector to run deficits as it will eventually lead to insolvency and financial collapse.
This contrasts with government deficits, which are sustainable indefinitely in modern economies since the state issues its own currency and, unlike the private sector, can never run out of it. That is the defining feature of modern fiat currency systems. Indeed it seems logical that if the government creates money then it needs to run a deficit as this is the only way for the private sector as a whole to accumulate money (i.e. save).
Unfortunately there is widespread belief that public sector deficits are not sustainable and have to be eliminated. That is simply not the case. Indeed most governments run deficits most years. Surpluses are rare. On the rare occasions when the US government has tried to run surpluses for several years they have always precipitated financial collapse of the private sector and depressions. It is repeated public sector SURPLUSES that are not sustainable, as this forces the private sector to run repeated deficits.
The only way that they government sector can avoid deficits and the private sector simultaneously run surpluses is for the country to be a net exporter. In other words for the government and the private sector to have surpluses the external sector has to run a large deficit. The problem with that approach is that not all countries can be net exporters. Globally exports and imports have to balance to zero as, until we connect with alien life, there is nowhere else for exports to go! So if some countries are net exporters that forces other countries to be net importers. Because many countries (e.g. China, Germany, Koreas, and until recently Japan) actually have policies committing themselves to being net exporters this forces other countries to be net importers. Most large developed countries (Germany excepted) are net importers. It follows that in these countries, which include the USA and the UK, it is necessary essay for governments to run deficits to match the external sector surplus. If they don't they will be forcing their domestic private sector into deficit.
In summary, the requirement for money flows between sectors to balance means that in countries that are net importers governments need to run deficits in order to ensure that the domestic private sector does not become insolvent.
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