Muddled Thinking Watch #2: The Bank of England is wrong… in its claims QE creates no inflationary pressure writes Andrew Lilico

Andrew Lilico writes in the UK’s Daily Telegraph with some impressive sounding credentials such as as “ an Economist with Europe Economics” , “ a member of the Shadow Monetary Policy Committee” and formerly “the Chief Economist of Policy Exchange.”

http://blogs.telegraph.co.uk/finance/andrewlilico/100026809/the-bank-of-england-is-wrong-and-inconsistent-in-its-clams-that-qe-creates-no-inflatiionary-pressure/

Yet he seems to have some very odd views indeed. He writes :
“because bank loans (and thus broad money creation) are constrained by the need to have adequate reserves relative to deposits, to support lending banks must attract new deposits or loans of reserves from other banks. ” 

Yet, there are no reserve requirements for UK commercial banks. See  http://en.wikipedia.org/wiki/Reserve_requirement

Lillico writes:
“Banks can’t simply make as many extra loans as they feel like, without limit.”

Well they can! They probably don’t feel like making loans that are too risky though, but providing the loans are considered sound there is really no limit. If a commercial bank ever needs to borrow extra reserves, there is no reason they can’t use their performing loans and other assets as collateral. They usually have the opposite problem though, They usually are awash with reserves and in normal times convert these to gilts and other securities.

A misunderstanding of what money is and how banks create loans  leads to a misunderstanding of QE  too.

If we look into our bank accounts we see ££ but they aren’t quite the same as banknote type ££. They are the IOUs of the commercial bank. The banknotes are the IOUs of the BoE. Bonds or Gilts are also the IOUs of the Treasury, which is just another arm of government, so swapping one for another. ££ for gilts doesn’t have that much affect on the economy.

Commercial Banks have reserve accounts at the BoE where they keep their BoE ££ but they don’t lend them out to the general public. UK banks have no reserve requirements  but they do have capital requirements. The rationale is simple. Any bank can create any loan, in any currency, providing that it has the capital base to guarantee any IOUs which it issues. It doesn’t have to have  any of that currency in its reserves! If it is in good shape it can buy or borrow whatever currency it needs, when it needs it. If it needs it.

Banks create loans by crediting their IOUs to the borrower’s account. They don’t need BoE ££ to do that. Of course, their own IOUs have to be guaranteed against BoE ££. Their account holders may demand them, but that only happens in a small percentage of cases, except in times when there is a run on the bank and customers en masse demand BoE notes from their accounts.

Runs on banks aren’t caused by suspicions that they are running short of reserves. They happen when the suspicion is the bank is about to go bust!

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One response to “Muddled Thinking Watch #2: The Bank of England is wrong… in its claims QE creates no inflationary pressure writes Andrew Lilico

  1. Pingback: Last week, something remarkable happened. The Bank of England let the cat out of the bag. In a paper called “Money Creation in the Modern Economy“, co-authored by three economists from the Bank’s Monetary Analysis Directorate, they stated outright t

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