The truth about Quantitative Easing
Governments have been "manufacturing" money for as long as there has been cash. Since 1950 the amount of money in circulation has doubled every 15 years or at a rate of 5.7% per annum. The excuse for this has always been that the extra money was needed to accommodate growth and inflation. However, what it did was to provide the State with a regular source of new money year on year. The first organization that gets to use any new money is the State. After it has passed into circulation most new cash flows back to the Exchequer through the taxation system. Having the ability to create another 5.7% of money every year was a considerable boost to the Government. In the early 1980's the Government component of GDP was about 33%. If a churn factor of three is accepted on any new money, then introducing 5.7% of new cash into the economy was in fact about 17% of GDP. In other words, it represented about half the money that the State was expending in the early 1980's.
After the recession of the early 90's the business world was a different place. Recovery was very slow in the mid 90's but then there was a rapid increase in the value of stocks and shares largely in the electronic and internet sector. There was also a rapid increase in the value of property. Both of these were a good indicator of monetary inflation. There should have been a massive recession in 2000/2001 as a result of the dot com collapse when more than $1 trillion was wiped off stocks in a year, but the recession never happened. It never happened because Alan Greenspan, George Bush, Gordon Brown, Tony Blair along with many others elected to flood their economies with additional cash. Recessions have historically happened every 7 years but in 2000 nothing happened. The Afghanistan war and the Gulf war distracted the public who never questioned what was happening and instead relished their sudden new found wealth. Personal debt then grew by a factor of four and house prices increased by a factor of three. The stock market grew by about 2.5 times. It was only because there was such a huge amount of spare cash that the stock market, personal debt and house prices were able to grow this rapidly. If the quantity of money that entered circulation between 1997 and 2007 increased three fold then the quantity of new money that entered circulation was about 12.5% per annum over that period. As the process had started at 5.7% per annum then it must have ramped up to 15% per annum well before 2007. However, this additional cash had to be taken out of circulation otherwise it would have appeared as inflation. This was done by artificially lowering interest rates and taking the controls off borrowing. This resulted in the new money being taken out of circulation.
A few months ago the Bank of England's Monetary Policy Committee voted to expand its policy of "quantitative easing" to £200bn in the financial year 2009 to 2010. That is almost three times the amount agreed in March 2009, when the Bank of England thought that £75bn would suffice, although even then it thought it might need to take the total up to £150bn by the end of the financial year. Given that negative interest rates are very hard to engineer and official rates were already as close to zero as was practicable the Bank had to work out how to inject more money into the economy to encourage spending. Their only option was "Quantitative Easing". Money is not just about the notes and coins that are in circulation. It also includes electronic money which is easy to generate. The term "quantitative" refers simply to the fact that the Bank is directly increasing the quantity of money in the economy rather than using interest rates as a control mechanism. The "easing" part means that the Bank wants to make the money easily available to people and businesses so that they will take it out of circulation. If the amount of money that is currently being printing is about 15% of GDP (£200 billion out of an economy of £1.3 trillion), and if a churn factor of 3 is accepted then this new money represents not far off half of the GDP of the UK. In other words, the extra £200 billion increases to £600 billion as it passes repeatedly through the taxation process. This is another way of saying that the public sector is being largely supported by new money. The trouble is that the stock market, housing market and personal debt are not soaking up this extra cash at the rate that they used to so the British Government is having to buy back its own IOU's or gilts. That is why all the world's financial institutions and central banks are so desperate to get borrowing going again. A reduction in monetary velocity is only making matters worse.
Quantitative Easing is an activity that it clearly visible. However, the British Government always has and still is borrowing money from a number of sources. There are many higher purchase agreements in place otherwise known as PPP and PFI projects. Money is borrowed for companies like Rail Track that is owned by the State but which the State is adamant is in the private sector. A number of major Government projects have been slowed down and payments have been deferred wherever possible. In itself, the interest due on all this borrowing is considerable. When the total amount of money that the British Government is borrowing is added to the amount that "Quantitative Easing" is generating the total is in excess of £250 billion per annum. The British Government is now responsible for close to 60% of GDP. As the public sector does not generate wealth but just expends it this means that if the taxation component of GDP is removed from the headline figure then the untaxed GDP of the UK is just £540 billion. This is just another way of saying that half the Without Tax GDP of the UK is borrowed or printed. This is clearly an unsustainable figure.
The official explanation for the poor state of the British economy in 2009 is that the "recession" has caused a drop in tax receipts and resulted in an increase in the amount of social spending due to an increase in unemployment. However, according to the official statistics the increase in the number of unemployed people is only a few hundred thousand out of a working population of 31 million. This goes nowhere close to explaining where half the GDP of the country has gone. The reason that this is important is that officially all that is required is for the economy to recover so that tax receipts lift and for employment to pick up and then everything will be well. The reality is that the British Government has been printing more and more money above the historical rate of 5.7% since 1995. The annual rate of 15% of GDP must have been reached in 2005. The only difference is that prior to 2007 the money was disseminated and absorbed into the stock market, the housing market and into private debt which took it out of circulation. Today these outlets are not available and so the State is using the new money to directly fund its own activities which is why "Quantitative Easing" is not having the desired effect. The idea was that the new money would be spent and flow into the economy, but the main effect has been to boost the capital markets, i.e. shares and corporate bonds. When these rise rapidly, this is always a good indication that monetary inflation is taking place. This explains the remarkable recovery in the stock markets in the latter half of 2009. Part of the initial idea was that companies would be able to raise funds to spend on new investment, and that the benefit would trickle down into the rest of the economy. Unfortunately for the Government the new money is only affecting part of the population and is largely missing the private sector
The Bank of England has chosen to create "central bank money" by offering money to holders of government securities, or gilts, at twice weekly "reverse auctions". Bodies such as pension funds are offered a very good price for their gilts, and they sell them to the Bank of England. The money that, say, the pension funds receive is then banked at one of the commercial banks who hold the money on behalf of the Bank of England. The idea is to generate inflation because deflation is now the real danger. The Bank is worried that demand in the economy is so weak that inflation will not go back to its 2 per cent target. In reality all that will happen is that the created money will allow State spending to continue unabated but at the cost of damaging the long term prospects of the UK.
The Bank's appetite for huge quantities of gilts has pushed their price higher and thus depresses their yield. As pension funds and other investors considered the pitifully small returns offered on gilts they became ever more inclined to invest in blue-chip shares or top rated company bonds. Even the banks have been able to raise extra cash through the issuing of new shares, and some heavily indebted companies that thought they might go under have been able to persuade their bondholders to swap their debts for shares. There has even been a revival in the market for mortgage-backed securities. The stock market has risen dramatically, speculation is once more rampant and house prices have started to increase. These are all symptomatic of monetary inflation and the problem is not going to go away despite what logic might say because the supply of newly created money can never be stopped.
Quantitative Easing is helping some big companies who have access to the capital markets, but it has been of little benefit to smaller firms and first-time home buyers, who rely on bank finance. The Bank of England suggested in the early days of the policy in March 2009 that the banks would lend more as they found themselves with more money but this has not happened. Several large companies are now paying off their debts rather than increasing spending on new plant and machinery, or on hiring new staff.
The trouble is that the politicians do not seem to have worked out what has really happened and are still seeking to blame the banks. The commercial banks have done nothing wrong. They did exactly what was expected of them. They worked perfectly. They disposed of the fresh money that the central banks were printing. They had to be irresponsible in who they lent the money to otherwise they would not have got rid of it. It eventually reached the point where the only way that they could rid of all the new money was to give it to people who could never afford the repayments, and to businesses that were on the point of collapse and which were only surviving as a result of low interest rates, and because the economy was floating on a sea of new money. The political establishment and the central banks could do nothing, although all the warning signs were there, otherwise they would had to have found another way to dispose of the surplus cash. Instead, they chose to remain silent and to watch a disaster unfold. In fact, they made matters worse by repeatedly issuing false inflation data to justify keeping interest rates artificially low. The trouble is that the banks have now realized that their very existence is threatened and in playing this game they have been accepting responsibility for the actions of irresponsible governments. Understandably, they are now reluctant to accept the risk associated with handling this new money. For the political establishment to blame the banks was not a wise thing to do as they need the banks to dispose of their newly created cash. Pushing the banks into a corner and haranguing them was not the way to achieve that objective.
Having a number of major banks effectively go bankrupt in 2007 and 2008 was a short-term benefit to the Government as it allowed the State to use additional money to bail out the banks and gave the State another place in which to deposit some of the surplus cash that it had created. The money that the British Government has lent to the banks is lent at a very high rate of interest that is far above bank rate. People are complaining that bank charges are excessive but if the money that the State is lending the Banks is expensive then they have to pass that cost on to borrowers even if the bank rate is low. Strangely, the Treasury does not seem to have worked out that it cannot charge the banks a very high rate of interest on the money that it is lending to them and still expect the cost of borrowing for the public and business to reflect bank rate. What this policy is doing is allowing the State to hold down its own borrowing costs while allowing it to obtain a high rate of return on some of its newly printed money.
The conclusion therefore is that there is not and never has been anything wrong with the banking sector. Unfortunately, for them they did exactly what was expected of them without understanding of the long-term consequences of their actions. The reliance of the State on the banking sector is the main reason why the State cannot allow any major bank to fail. The State needs the banks to get rid of the cash that it is printing and it also needs the banks to collect the interest on the money that it is lending to them. The State needs the banks much more than the banks need the State. Without the banking sector to launder all this newly created money the British economy would have collapsed a long time ago. The only question is how long can the cycle continue. If the UK loses its AAA status then the British Government will have to print 20% more money every year.
This is the classic end of a monetary bubble - nobody wins and everybody loses. The final collapse is imminent although most people have yet to realise it. Very few people can imagine what it will be like to live in a country when its economy implodes. The wealth of the nation is almost exhausted and the only option left for the British Government is to borrow money at an increasingly high cost or to print money. As there is little demand for Gilt's the British Government has no option other than to buy its own IOU's.
If the total amount of debt owed by the population, the businesses and the government of the UK are combined it exceeds the value of all the fixed assets of the UK. In fact it does not matter what set of data is used the UK plc is technically bankrupt. If the total government, private and commercial debt of the UK is totalled and divided by the population then the amount of debt is over £100,000 for every man, woman and child in the country. This scale of borrowing can never be repaid. The money has effectively run out and yet the propensity of the Government to spend is still increasing. However, State spending will eventually have to decline and it would be better if the reduction were to be controlled. However, politicians are not interested in preparing for the future. Their only interest is in maintaining their popularity for as long as they are in power or more correctly, so that they can remain in power. The truth is an inconvenience that needs to be hidden behind new 'policies'.
There are not many sources of wealth left that the British Government can still access. This can be seen by the great effort and fuss that was made about closing down off shore banking operations and tax havens. The actual sums involved were pathetically small in the totality of the world economy and yet there has been a huge political furore over the subject. More importantly, offshore banking has always been very beneficial to the UK as much of the money was handled in London so profits were taken on these funds in the end. However, for the British Government ever little bit of cash is useful. This is why Gordon Brown sold the UK's gold stocks at completely the wrong time in that particular cycle. The gold was there and it helped to solve the problem that he was dealing with at the time.
The British Government has already found that it is getting increasingly hard to borrow more funds. Printing more money is the only option left but it will just cause the currency to fall in value. The world price of food will inevitably rise in the next few years due to changes in the global environment, increasing population and the increasing use of bio fuels. The price of energy will also increase as the pound falls in value and because "Peak Oil" has almost certainly passed. It is therefore inevitable that most people's standard of living will have to decline very rapidly over the next five to ten years. History tells us that the State will draw what resources it can to itself to ensure that the centre remains functional for as long as possible. There has never been an example of an economy that collapsed in an orderly manner. The end is always sudden and very unpleasant and accompanied by a dramatic drop in the standard of living for the whole population.
Published: December 2009