Your humble narrator is in the Wall Street Journal again today talking about Labour’s proposed policy of People’s Quantitative Easing.
Politicians frequently make economic rods for their own backs. When good things happen on their watch they claim the credit for them, whether they are responsible for them or not. This, however, leaves them open to getting the blame for the bad things that happen on their watch, whether they are responsible for them or not.
A good recent example was George Osborne’s recent claim that inflation at a 12 year record low showed that “the Government’s long term economic plan is working”. Unless my copy of the coalition’s economic plan is missing a few pages, record low inflation is not part of it. Indeed, for a government still borrowing over £90 billion a year, it might be quite bad news.
Government debt is a stock with a certain nominal value, say, £1 trillion. And if national income in a year is, say, £1 trillion then government debt is 100% of GDP.
If, one year, there was a vast inflation so that nominal GDP doubled to £2 trillion (real GDP is unaffected, there are still as many goods and services, this is a purely monetary effect) while that stock of debt remains unchanged at £1 trillion then government debt as a share of GDP has fallen to 50%. By contrast, a collapse in nominal GDP of 50% over the year would leave that stock of debt at 200% of GDP.
So, whatever it means for the man or woman in the street, for a heavily indebted government a slowing of inflation is a real headache. With the election approaching, Osborne will be grateful for the fact he can now declare the ‘cost of living crisis’ over, at least temporarily. But it’s not the way he’d have wanted it.
I’ve recently written for Save Our Savers attempting to square the massive expansion of Britain’s monetary base since March 2009 with the fact that inflation has now been within the Bank of England’s target range of 2% (+/- 1%) since June 2012. Here I’d like to expand a little.
Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009
Source:The Bank of England, series Notes in circulation – RPWB55A, and Reserve Balances – RPWB56A
This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.
Source:The Bank of England, series Notes in circulation (RPWB55A) and Reserve Balances (RPWB56A) (M0), and Monthly amounts outstanding of M4 (monetary financial institutions’ sterling M4 liabilities to private sector) (in sterling millions) seasonally adjusted (LPMAUYN) (M4)
This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.
The chart above shows the ratio of M0 to M4 since May 2006; how many pounds of broad money each pound of narrow money is supporting. From 25:1 between May 2006 and March 2009, it slumped via successive bouts of Quantitative Easing to about 6:1 since September 2012.
Now, on the one hand banks might stick to this new, lower ratio. Chastened by their experiences with mortgage backed assets they might desire a permanently lower reserve to asset ratio and all QE will have been is a vast recapitalisation of banks.
On the other hand, as ‘recovery’ kicks in they might start to increase their reserve to asset ratio. They might not scale the giddy heights of 25:1 again, but they will be multiplying out from a monetary base which has tripled in size. Britain’s monetary base is now £362 billion and M4 is about six times that, £2.2 trillion. But if renewed confidence in the banking sector saw banks return to higher ratios, the resulting M4 figures would be as follows:
Here, we are told, the Bank of England will be able to ‘drain’ this liquidity from the system. It would do this by reversing QE; selling bonds to banks and effectively destroying the base money it receives in return. But a massive increase in the supply of bonds relative to the demand for them will lower their price. This is the same as raising their yield and this is the same as raising a key interest rate.
It is worth pondering for a moment the scale of bond sales and consequent rise in interest rates which might be necessary to drain this base money from the financial system. We must hope either that the economy can stand it or that banks keep holding these reserves.
This article originally appeared at The Cobden Centre