Tag Archives: IOU

Why not give control of the fiscal deficit to the Bank of England?

In a democratic society, I would argue that decisions regarding interest rates, both long and short term, should be made by the elected government. They used to be. However, for nearly 20 years, short term rates in the UK have been set by the BoE. The level of short term interest rates is important and it can be adjusted to stimulate a slowing economy or slow an overstimulated economy. But there are other adjustments that can be made too.

Just as a pilot has all the control levers at his disposal when he’s flying a plane (if he, or she, does hand over to the co-pilot it would be all the controls not just one) then all the controls need to be either in the hands of government or the hands of the central bank.

But just who has the controls when it comes to controversial policy decisions like QE? Does an  independent Bank of England decide, all on its own, to buy up £375 billion of government securities from the private financial sector? I don’t think so!

QE is no big deal. That’s not a common view, I’ll agree, but from a scientific perspective, there seems to be no reason why the issue of government , or the BoE if you prefer, IOUs in the form of cash should be any more or less inflationary to the economic system than the issue of IOUs in the form of gilts (treasury bonds). If it is necessary to buy back gilts from the private sector to control longer term interest rates then that’s what needs to happen.

So why not give control of the fiscal deficit to the BoE too? The BoE could calculate the best combination of fiscal and monetary policy, including whatever level of QE is needed, and tell the government what it needs to do. Arguably the government could decide to raise income tax a bit here or reduce VAT a bit there , etc, but it would not have complete control of fiscal policy as it now does.

This is not my favoured option BTW. But, if the pilot is going to hand over the (macroeconomic) controls to his or her co-pilot it should be all the controls and not just one.

Can commercial banks create money out of thin air?

If the title of this posting is Googled there will be many hits suggesting that banks are able to do just this.

For instance according to Michael Kumhof Deputy Division Chief, Modeling Unit, Research Department, International Monetary Fund “The key function of banks is money creation, not intermediation.”

Some banks are also able to issue their own banknotes (or bills in the US). For instance Scottish banknotes, designated in £ sterling,  can be issued by several of their commercial banks and are readily accepted there.  But, maybe less so in England!  Normally UK banknotes are issued by the Bank of England. The Bank of England is the reserve bank of the UK,  part of the UK government and the issuer of the £ sterling currency.

When commercial banks issue loans they credit the bank accounts of the borrower and but they don’t debit their own reserves. The bank has the asset to the amount of the loan, and the borrower assumes the liability of repayment.

Of course, there are rules, which vary from country to country, which govern the lending practices, and ability to print banknotes, of the commercial banks. There is often, but not always, a requirement for the commercial bank to maintain a certain level of reserves. However, subject to these rules, the commercial banks can borrow as they need to provide commercial loans. They borrow at a low rate of interest, either from the reserve bank or their depositors, and lend out at a higher rate. The difference between the two rates provides the banks with their profit margin and also acts as an insurance against a default on the loan.

But if they feel they don’t need to borrow anything they don’t. They just write out an IOU which we all tend to think of as if it were the same as a government IOU.

Government, or their reserve banks, set interest rates as a matter of policy to regulate lending. The conventional, but erroneous, wisdom,  is that money can be created by the Reserve bank,  in printed  form or by keystroke,  and lent out via  the commercial banks  to regulate the level of activity in an economy.   It is is not considered that this should be done to directly fund additional government spending though. That needs to be done via the process of printing or creating treasury bonds. Somehow, for reasons which don’t appear to be quite logical, the economic mainstream don’t consider printing bonds to be the same as printing money.

Swapping money for bonds, or vice versa, doesn’t really change anything much at all , as has been recently seen through the so-called process of Quantitative Easing so maybe something of a rethink is called for on this point.

However, regardless of any inconsistency, the process works reasonably well in normal times but less well when interest rates are deliberately reduced to ultra low levels. The control knob can’t be turned any further.

Does this mean the commercial banks,  too,  are also acting as currency issuers rather than users? Are the Scottish banks assuming the role of a currency issuer when they print banknotes?

No, they aren’t.  Apart from being able to borrow directly from the reserve bank, individuals can do the same thing. They can issue IOUs as they please which in principle can be traded by a third party. Casinos can issue £5 chips, which are their IOUs, for use on , say, a roulette table. They, too, in principle could be traded on an open market. Of course, if the casino were considered a credit risk the chips would lose their value. Scottish banknotes could lose their value too if the issuing bank was considered to be in risk of default. Similarly, any bank customer with a bank account full of newly created credits would need to have all payments cleared using those credits. It is possible that they would be refused, by another bank, if the issuing bank were considered to be at risk of default.

It’s the financial viability of the issuing institution which guarantees any written IOU. Conventional theories involving banking multipliers are bunk! That’s not how it works.

So, in conclusion,  the “thin air” expression is somewhat misleading. Commercial banks aren’t doing anything special at all. The only issuer of a currency is the government, or governments in the case of the Euro,  via their Reserve bank. Everyone else is a user, and cannot , unless they are in the counterfeiting business, create their own extra units of that currency.

Further reading:


PS This posting has generated more heat than any other with 23 comments so far. I think I now understand the  problem better than I first did, so I’d like to thank everyone for their contributions. It seems to me that there needs to be a recognition that what we see in our bank accounts, at the commercial banks, isn’t quite the same thing as money. The figures actually do refer to bank IOUs which can of course be always swapped for government printed banknotes, which are certainly money,  providing the bank is solvent.
Similarly what the bank creates isn’t quite money. They generate their own IOUs or asset/liability pairs in the same way as anyone else can.  Should they be prevented from doing this? I’d have to say no. Anyone has the right to issue an IOU.  But, that of course is a political and not an economic question.

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.