IS MONETARY ACTIVISM THE NEW OPIATE-OF-CHOICE?
Revised 10th February 2015
For quite some time it’s been my intention to investigate the nature of contemporary money. The results of that investigation are set out here, and I hope readers find it interesting despite its unusual (but necessary) length. As ever, your comments will be much appreciated.
This investigation has led me to some very disturbing conclusions. The contemporary monetary system has become progressively more detached from the underlying “real” economy of labour, resources, goods and services. Just as the pre-2008 credit bubble detached debt from any real prospect of repayment at value, subsequent monetary activism has tended to undermine the concept of money as a “store of value”.
To explain this a little further, we need to look at the years prior to the 2008 financial crisis as an era of progressively more reckless “debt activism”. This occurred both narrowly (in the increasingly reckless proliferation of dangerous forms of debt) and more broadly, as economies used debt to create “growth”. The latter tendency was evident across the board, with America, China, Britain, Spain, Ireland, Greece and Iceland being conspicuous examples of basing supposed economic “expansion” on the recycling, through consumption, of escalating amounts of debt.
Since 2008, and although debt levels have continued to rise – indeed, the global debt mountain has grown by a further US$ 57 trillion since then – much of the global economy has resorted to another gimmick – monetary activism, which seems to have replaced reckless borrowing as the new drug-of-choice for a global economy.
Basically, the post-2008 systemic problems have been (a) a lack of growth, and (b) a severe overhang of debt. The immediate problem with excessive debt is the cost of servicing it, and this virtually forced central banks into policies designed to squeeze interest rates downwards.
This has been applied both to policy rates (through ZIRP, or ‘zero interest rate policies’) and to market rates (through yield-depressing strategies based around using monetary policy to inflate capital markets). Though central banks might have hoped (if so, mistakenly) that this mix of monetary activism might also restore growth, the real aim has been to enable the system to co-exist with excessive debt.
In doing this, the authorities seem to have replaced (or supplemented) a debt bubble with a money bubble. If this is so, it suggests that we face another, potentially even nastier crunch. In other words, we may have compounded reckless distortion of debt with equally reckless distortion of money itself.
Small wonder that a letter-writer told the Financial Times that, whilst he now understood the concept of QE (quantitative easing), he no longer understood the concept of money.
This poses two obvious questions. First, is money losing its traditional role as “a store of value” by becoming a tool of manipulation instead? Second, has reducing the price of money (interest rates) involved undermining its value as well?
This, however, is to anticipate. First, we need to look at various interpretations of what money is and how it works.
Most people probably assume that money is a pretty simple topic, further assuming that it is supplied by the government. Neither assumption is correct. Money is an extremely complex issue, so much so that it forms a distinct and increasingly important sub-discipline within economics. Money is not created by government alone, though the state obviously has an extremely important part to play.
Let’s start by noting that, today, almost all of the world’s financial systems run on fiat money. That is, money does not have intrinsic value, and neither is it convertible on demand into a commodity with intrinsic value, such as gold. Ultimately, fiat (meaning “command”) money has value simply because the government says it has. Its acceptability rests on the “full faith and credit” of the state.
This means that we accept and use money because we trust the government and, more broadly, the financial system. This is a comparatively new situation – Britain may have abandoned the “gold standard” in 1931, but convertibility continued, on a global basis until Richard Nixon “slammed the gold window” in 1971.
Critics, of course, would argue that a monetary system based entirely on trust has put the entire financial system at risk because such trust has proved to be misplaced.
The purpose of money
Traditionally, money is said to have three characteristics. It is “a means of exchange”, “a unit of account” and “a store of value”. The latter point is debatable, to say the least – in terms of purchasing power, the pound sterling lost 94% of its value between 1964 and 2014, and the purchasing value of the American dollar declined by 87% over the same period.
According to the central banks’ own explanations, the vast majority of the money in a modern economy is “loaned into existence” by the commercial banks. Today, central bankers tell us, the banks do not “leverage up” from reserves (“fractional reserve banking”), and neither do they need to take in deposits before they can lend. If a bank lends someone £1,000, that action “creates” the money. (Likewise, money is “destroyed” when a debt is repaid). This occurs as matched transactions – when a bank lends someone money and puts it into his account, it creates a “liability” (the customer’s account) and a matching “asset” (the customer’s debt to the bank). For the customer, the terminology is reversed, his account being an “asset” and the debt his “liability”.
The amount of money that banks “lend into existence” is not infinite, but is determined by market forces and regulatory oversight. By setting interest rates, the central bank influences how much money the banks can afford to create whilst remaining profitable. In recent times, the fall in interest rates to virtually zero has negated the rate-setting tool, and it is this which has prompted central banks to “create” money in the form of “quantitative easing” (QE).
Divisions of opinion
Opinions are starkly divided about the current system. At one end of the spectrum are those who lament the passing of the gold standard, and who point at cumulative loss of value through inflation in making a case for “sound money”. At the other end lies “modern monetary theory” (MMT), sometimes called “neo-chartalism”, which views the money-creating process in a very different way, and which, as we shall see, goes on to make some assertions which can seem, according to taste, either enlightening, counter-intuitive or plain bonkers.
My own view is that money has value only in terms of what it can buy. My work distinguishes between two economies, the “real” economy of goods, services, labour and resources, and the “financial” economy of money and debt. In this interpretation, money is a “claim” on the products of the real economy, and so is debt, since debt is ‘a claim on future money’. If the creation of these monetary “claims” exceeds what the real economy can deliver, the value of money must fall, because the stock of money and debt contains “excess claims”, meaning claims which the real economy is unable to honour. If and when this happens, the “excess claims” have to be destroyed, in one way or another, typically through inflation (“soft default”) but sometimes through outright repudiation (“hard default”).
Money today – an official view
What, then, is money? As the Bank of England (BoE) explained it in a recent paper, there are really two kinds of money. The first of these is “base money”, which comprises currency (notes and coins), plus the central bank reserves of the commercial banks. “Broad money”, on the other hand, is the total amount which individuals and companies (which collectively can be called “consumers”) are able to spend. This “broad money” consists of currency and commercial bank deposits, with the latter accounting for the overwhelming majority (in Britain, 97%) of the money circulating in the economy.
To understand this in slightly more detail, we need to appreciate that the monetary system consists of equal amounts of assets and liabilities. In order to lend £1,000 to customer A, a commercial bank does not (as you might suppose) need first to take in a deposit of £1,000 from customer B. The bank can lend £1,000 to A just by deciding to do so, and by this decision the bank creates the £1,000 simply by crediting it to A’s account.
Clearly, commercial bank deposits are the dominating component of broad money. This money is not, as you might suppose, supplied by the government. Rather, the BoE explains, it is simply lent into existence by the commercial banks themselves.
To put some figures on this, “broad money”, known to the BoE as “M4EX“, totalled £1,715bn at the end of 2013, comprising currency of £67bn and commercial bank deposits of £1,648bn. “Base money”, meanwhile, totalled £365bn at the same date, consisting of commercial bank deposits and currency. For context, British economic output (GDP) in 2013 was £1,713bn.
Rational, or reckless?
At first glance – and especially to a general public which nowadays views banks with profound mistrust – the idea of most of the country’s circulating money being lent into existence by bankers sounds a bit like letting a schoolboy loose in a chocolate factory. In practice, according to the BoE, this does not give the banks an open-ended ability to create as much money as they like.
There are two main caps on banks’ ability to create money. The first of these is market forces. In order to create an excessive amount of money, a bank would have to undertake equally excessive lending, and market forces imply that this would involve attracting borrowers by offering interest rates so low that profitability would be undermined, whilst macro-prudential considerations further suggest that issues both of liquidity and of solvency would come into play.
The second limit on money creation is the base rate operated by the central bank. If this rate is lowered, commercial banks can create a larger amount of money whilst remaining profitable. At the same time, reducing the cost of debt should increase customer demand for credit. Conversely, raising base rate cramps the banks’ ability to lend new money into existence whilst remaining profitable.
Thus described, central bank control seems extremely arms-length, and as such raises two red flags and a lot more questions. The first red flag is the assumption that banks are run rationally, and this seems a somewhat naïve assumption, because there certainly seem to have been instances of banks being managed by – let me put it this way – people of somewhat limited competence.
Second, the assumption (famously made by Alan Greenspan) that banks always put shareholder interests first seems doubtful. Recent events might suggest instead that banks prioritise senior remuneration over both dividends and risk management.
Even where banks are managed by competent people who put shareholder interests first, things can go wrong. For a start, bank assets (in other words, loans to customers) tend to be long-term, whilst deposits (the liability flip-side of these assets, for the banks collectively) are shorter-term. As well as seeking to profit from the margin between lender and depositor rates, banks are in the business of arbitraging long-dated assets and shorter-dated liabilities. One can easily see how even the most astute banker could get this arbitrage wrong.
The regulatory approach
The way in which central banks describe the creation of money might give the impression that the system is virtually ‘hands-off’, which could indeed be worrying given the failings of the banking system in recent years. Fortunately, there is a complementary “second string” to central banks’ oversight of the financial system.
This “second string” is the regulatory framework, which consists of two elements – the “microprudential”, which addresses risk at the level of the individual bank, and the “macroprudential”, where the focus is on systemic risk.
Both individually and collectively, banks are exposed to two distinct types of risk. The first is “solvency” risk, where losses on a bank’s assets (its loans to customers) could result in these assets becoming worth less than its liabilities (its obligations to depositors). The second is “liquidity” risk, where a bank, though solvent, is insufficiently liquid to satisfy demands that depositors may make upon it.
To guard against these risks, the regulatory authorities impose both capital and liquidity requirements. Capital requirements dictate the amount of risk-absorbing capital that banks must hold, whereas liquidity rules focus on the ratio of liquidity to overall liabilities.
In both cases, regulators have accepted a need to make qualitative as well as quantitative judgements. For example, two otherwise-identical banks might have differing asset or liability profiles. High-risk assets might require a higher capital ratio, whilst reliance on short-term funding has implications for liquidity risk.
To this end, regulators have developed a reliance on the “risk-weighting” of assets. Though logical, this process involves the subjective application of risk to different asset classes, and these judgments are capable of error. This weakness was typified by the under-weighting of mortgage risk in the pre-crash years.
Of course, when policy rates reach a “lower bound” – in layman’s terms, when they have already been reduced as near to zero as makes no difference – the central bank’s key rate-varying tool becomes ineffective. This is where central banks resort to a policy known as “quantitative easing” (QE) or “asset purchasing”. As its advocates explain it, QE involves the central bank using newly-created money to purchase assets (almost invariably bonds, which are tradable debt paper), principally from investment institutions.
By creating additional demand for bonds, this raises their price. As the interest rate (“yield”) of a bond is its (fixed) annual payment (“coupon”) expressed as a percentage of its price, increasing bond prices pushes market interest rates downwards, carrying out by proxy a lowering of rates that, in more normal circumstances, would be undertaken simply by reducing the central bank’s policy rate. Proponents of QE deny that it involves “printing money”, and claim (through the principle of matched assets and liabilities) that it is no more than “a balance sheet operation”.
Critics are entitled to claim that, even if QE does not amount to “printing money”, it has at least two potential drawbacks. First, it can inculcate complacency about money, undermining its role as a “store of value”. Second, it seems almost undeniable that QE has contributed to the widening of inequalities within the economy.
Money off the leash?
Opinions about the current monetary system range from “sound money” conservatism at one end of the spectrum to the radicalism of MMT at the other. The conservative view is a pretty straightforward belief that money’s primary characteristic should be retention of value, and that anything which puts the emphasis elsewhere plays fast and loose with this fundamental role.
The radical view, as exemplified by MMT, looks at money in a quite different way. The basis of MMT is that fiat money, wholly controlled by the state, cannot be viewed in the same way as traditional forms of money. For one thing, a government cannot go bankrupt in a currency that it creates and controls itself.
This idea can be traced back to a 1924 work by Georg Friedrich Knapp, whose thesis (known as “chartalism”) advocated replacing the then-prevalent gold standard with paper money. The central argument here is that government does not need to tie the value of money to gold, or to concern itself overmuch with the quantity of money, because it can create money, or tax it away, through the fiscal system. If the government wishes to stimulate the economy, it spends more than it takes in through taxation, an interpretation more generally associated with Keynes. Indeed, there seems little doubt that Knapp and chartalism helped influence Keynes’ work.
From the view that taxation is a lever for stimulating or restraining an economy, it is not too much of a stretch to contend that this is the main purpose of taxation – in other words, that tax is used as a tool of monetary policy, and not principally as a way of funding government expenditures. If this is so, it can be argued that governments should almost always run deficits, and standard GDP equations can seem to demonstrate that the private sector can only run a surplus if the state maintains a deficit.
What MMT describes, then, is a government which: can engineer policy through its control of money; cannot go bankrupt in its own currency; and is not reliant on taxation to fund its expenditure. Presumably, then, neither fiscal deficits nor public debt are particularly important, and governments need not worry, either, about the cost of future welfare commitments.
If I have summarised MMT correctly, it is certainly at stark variance with standard practice, where governments attribute huge importance to deficits and debt. This said, some critics of current policy worry that central banks may be moving towards a more MMT-based stance, at least in the sense that money’s role as a “store of value” is being undermined by its use as a policy tool.
Let’s be clear on one point here. Acceptance of the mathematics of MMT means accepting that MMT is an accurate description of the contemporary monetary system. It does not, however, mean that we must endorse the efficacy of the system thus described. In short, MMT may provide an excellent guide to a deeply flawed system
Those of us who worry about monetary activism note how central banks, having lost the ability to apply further stimulus through rate-lowering, have resorted instead to QE, the effect of which has been to inflate bond markets and thereby lower market interest rates. Those who have enjoyed the bond market surge of recent times may be failing to question the value of the money in which they may ultimately be repaid. Meanwhile, buying government bonds (debt), from institutions which then go straight out and buy newly-issued government bonds, can be depicted as paying off debt with newly-created money, however hotly central banks deny this accusation of “debt monetisation”.
From this, it follows that a “race-to-the-bottom” currency war might be one logical consequence of the current fashion in monetary activism.
It is at least arguable that the bond market has become detached from the underlying fundamentals, which should be rooted in the NPV (net present value) of future income streams, appropriately discounted to capture the time value of money in the future. If one buys bonds solely on the basis of how much further their price may be pushed upwards by central bank policy, the implication is that one is speculating, not investing. Whilst speculation (rather than investment) can be a perfectly appropriate way for an investor to behave, it does seem a bizzarre way to conduct monetary policy.
Points of reference
Our understanding of money seems to be in a state of flux, with the debate polarised between those who emphasise the fundamental “store of value” role of money, and those who, instead, see fiat money as a malleable component of monetary policy. If you agree with the latter school of thought, you can take a relaxed view of the future, in which debt, deficits and austerity are outmoded considerations. If you are of the former persuasion, however, you might worry that central banks are positioning us for a disaster in which money loses all credibility as a store of value.
My response is to fall back on three, I hope well-founded, observations.
First, it is perfectly possible for the value of money to be destroyed, in ways that the official line about balanced assets and liabilities apparently fails to take into account. If a bank decides to lend money to Mr A, and creates money for this purpose, assets and liabilities do indeed match – Mr A has an asset (say, £200,000 in his bank account) matched by a liability (his £200,000 debt to the bank). But what if he spends this money buying a property which then falls in value to, say, £150,000? It seems pretty clear that £50,000 has been “lost” or “destroyed” somewhere. Unless you believe that Greece (for instance) really can repay all of its debts at full value, the same logic can be applied to macro-scale debt as well.
My second observation, linked to this, is that money has no intrinsic value. This is certainly true of fiat money, which you cannot eat or put into your fuel tank, but is true, too, even of commodity money like gold, which you cannot eat either, and whose value also rests fundamentally on your ability to exchange it for items having utility. By this standard, then, real wealth lies in physical items (like land, machinery, resources, food and labour), though this definition of value clearly extends, also, to “quasi-physical” assets like intellectual property, human capital and brands.
This leads me to my third observation, which is that the ultimate role of money is as a proxy for the “real” economy. Specifically, money has value to the extent that it can be exchanged for what I call “things with utility“. Whatever happens to money, a farm has value in producing food, a mine has value in supplying minerals, and a house has value in providing somewhere to live.
Conclusions – dangerous territory
I conclude, then, that we are in very dangerous territory. Current monetary policy is dominated by the imperative of manipulating interest rates downwards, accomplished in part by inflating capital markets. As well as creating a gigantic bubble, this policy risks undermining the role of money as a store of value. Conservatives are probably right to say that this courts disaster, because the value of a currency depends fundamentally on the relationship between money on the one hand and, on the other, “things with utility”.
I further believe that monetary activism can all too often be a futile attempt to create wealth and growth where they do not actually exist.
In short, a system which reduces the price of money (interest rates) close to zero may be doing exactly the same thing to the value of money.
We may simply have replaced the folly which created the crash with a new folly which compounds its consequences.