Tag Archives: Interest rate

Goodbye to £5 and £10 notes?

The  Bank of England’s chief economist Andy Haldane’s speech. caused some raised  eyebrows recently. It sounds like he knows we’re in for some tough economic times ahead. Things are so desperate that it  might require the abolition of cash in the economy!  People will be forced to hold money in banks and see its value dwindle.

As Andy Haldane has put it “A more radical proposal still would be to remove the ZLB (zero lower bound) constraint entirely by abolishing paper currency.”

We could perhaps begrudgingly say Andy Haldane has shown political and economic courage in saying this. If we are being charitable we could credit Mr Haldane for highlighting the intellectual bankruptcy of most mainstream modern economic thinking. If we wished to be less charitable we’d have to say the idea of abolishing cash is about as stupid as it gets!

I hope it is the former and that cash won’t be abolished. But this isn’t the first time we’ve heard this silly argument argument from monetarist economists and in particular from Kenneth Rogoff. See  here  and  here. That they feel the need to make it shows they still haven’t really grasped that interest rates can’t have the controlling  effect they think they have on the wider economy.

When intelligent men like Rogoff and Haldane have silly ideas, political ideology is usually to blame. The main argument for banning cash, other than to hinder criminals and tax-dodgers, which is no stronger an argument now than it has ever been, is to facilitate sharply negative interest rates. But if we want to stimulate the economy, as we do right now, there’s an obvious and much easier alternative: ie loosen fiscal policy. Increase government spending and reduce levels of taxation.

The only reason to suggest something as outlandish as banning printed currency is that you believe this alternative to be impossible. Or, rather impossible according to one’s own political ideology.

Monetarism all sounds fine – superficially. When times are good interest rates are increased to slow the economy down. When times are bad they are lowered to stimulate lending and get it moving again. There’s no need for government to be involved at all. They can concentrate on balancing the books like any good business should.

Except that every stimulus leads to the build up of private debt in the economy. This build up slows down economic activity, and so we later have to have another reduction in interest rates. Then another and yet another after that . If we get it all wrong then there can even be a giant crash in the economy when those who’ve taken on too much private debt go bust and cause their creditors to go bust too.

So, eventually we arrive at the situation, as we have now, where interest rates in much of the western world  are close to zero and they need to go negative according to the theory to stimulate the economy again. Economists with more intelligence are saying “Whoa! There must be something wrong with the theory”. Others with less insight are saying “But this is just the special case of the zero lower bound” and those with no insight at all, or are stupefied by their own political ideology, are ploughing on regardless and calling for the abolition of cash!

Leaving aside the argument that many of us quite like the convenience of using cash, it’s much quicker than messing about with credit cards at the petrol station for example, it is a genuinely bad idea to go down the road of negative interest rates which will lead to an ever increasing build up of private debt in the economy.

Mainstream (ie Neo -Classical and Monetarist in outlook) economists didn’t spot the onset of the GFC because they didn’t  know where to look for the warning signals. The role of private debt in leading to booms and busts was denied. Expanding the “money supply” was the only standard remedy for stimulating economic activity and the risk of creating asset bubbles was largely ignored with disastrous consequences.

I may come back to the question of private debt in the economy later but for now I’ll just reference Prof Steve Keen’s excellent blog on the perils of debt deflation.

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Money, Government Bonds, and Quantitative Easing

Quantitative Easing is considered, by many, to be a euphemism for printing money. Is there just possibly a germ of truth in that statement? Why is it done?What exactly does it mean?

In normal times, central banks try to increase the amount of lending and activity in the economy  by cutting interest rates which encourages people to spend, not save. However, when interest rates are close to zero and can go no lower, another  option for a central bank is to lend money into the economy, by which they usually mean the commercial banks, directly. That is  supposed to be the motivation for quantitative easing (QE).

The way the central bank does this is by buying assets – usually government bonds – using money it has simply created “out of thin air” .The institutions selling those bonds , either commercial banks or other financial institutions, will then have extra money in their accounts, so boosting the money supply. That is the mainstream theory

It was used first by  in Japan to help it out of a period of deflation following an asset bubble collapse in the 1990s.

Let us just go through the steps of what happens when a government issues, say, $1 billion of new bonds and then re-purchases them. That in a nutshell is QE – although usually just the last step is considered. A government issues (prints!) the bonds. They are sold for $1 billion at auction. The government can then claim, somewhat dubiously as we will see, their $1 billion is real and hasn’t been printed. The financial institutions have their bonds. The government decides to buy them back. There would be no point in using the original $1 billion so
Government prints another $1 billion. The government gets back the bonds. As they are an IOU all they can do is tear them up. The financial institutions then have back their $1 billion, plus no doubt a little extra to keep them
sweet, so there’s no net change as far as they are concerned. The bonds no longer exist and all that is apparent is the government, somewhat to their embarrassment, have funded their deficit by printing money after all!

But is all what it seems?

Let’s start from the beginning with our understanding of what money is. Nearly all modern money is fiat based. It is not backed by anything tangible like Gold or silver. It isn’t pegged to any foreign currency and can be worth more or less against other currencies one day than the next. It has a value because of the power of governments to impose taxation and insist on payment in that currency.

All money is printed. Or, it is an electronic version of that. So the term ‘printed’ can mean either one or the other. Look in your wallet and you’ll possible have a $100 dollars or so of printed government money. They are just IOUs. You’ll maybe have a thousand dollars or so in your bank account. They are just electronic government IOUs. Basically they are the same thing.

So what is a bond? Anyone can issue a bond which is just an IOU with interest included. If the issuer sells a bond, there will be a promise to pay a certain amount at some future date. Depending on the credit worthiness of the issuer and the prevailing, and anticipated future,level of interest rates at the time, the bond will have some value which is less than the face value of the bond.For instance, I could issue a ten year bond for $200 and maybe expect to sell it for $100. That would give my creditors approximately a 7% return on their investment. That bond would be trade able during its lifetime and at some intermediate point will have a value of $150.

Governments too issue bonds. The more credit worthy the government, the less risk of their defaulting on their commitment and so the higher price they can expect to receive on issue. These are usually decided by a process of auction. When governments are in full control of their own sovereign currencies there is zero risk of involuntary default. There isn’t zero risk of inflation though, and so the issue price will probably still be less than the face value of the bond. Although there have been instances of that not being the case. It is possible to have negative interest rates. In that case investors are effectively paying a fee for someone else to look after their money.

Government bonds are still known as ‘Gilt-edged securities’ in the UK. At one time they were printed pieces of paper with golden edges. On some bonds, coupons were attached which could be handed in for the payment of interest.
The term coupon is still used for payment of interest on a bond.

The conventional wisdom is that it would be highly irresponsible for Governments to finance their budget deficits by printing money. It is not considered acceptable for Governments to spend new money into existence. There is a different argument when it comes to lending money into existence. That’s different of course! We may come back to how commercial banks by arrangement with reserve banks can create money ‘out of thin air’ in a later posting.

That argument does, of course, depend on whether bonds are not just another form of money. If we look at one piece of paper which is a bond, we have to ask if it is really different from another piece which is in the form of a banknote. One will have an interest rate associated with it but what if that interest rate is very low as would be the case presently? What if that interest rate were so close to zero that it hardly mattered? In that case it can be seen there is no functional difference between a bond and a banknote.If one is printed money then they are both printed money. The level of interest is just a detail.

Quantitative easing, the buying of bonds, and other securities by Government, is just an exchange of one form of money for another. Its all done in bank accounts in reality. There are probably no pieces of paper involved. A customer of a central bank has money in bonds when it is in one type of bank account. The process of QE means shifting out the money to another account which is currency based. The process will tend to reduce the level of interest rates but if they are near zero to start with, probably not by much. The overall effect on the economy will be small. Especially when the financial institutions choose to sit on their assets, rather than lend them out,  as they previously decided to do. Contrary to initial fears QE has not led to runaway inflation in countries where it is being used.

Yes, printing money has occurred: it happened when the bonds were first issued, which is considered quite normal, not when they are being re-bought.