It is quite amusing really watching the way orthodox economists who know the game is up work like gymnasts to avoid actually spelling out directly what the facts are but spill the beans anyway. Last week (April 23, 2020), an ‘external member’ of the Bank of England’s Monetary Policy Committee, one – Gertjan Vlieghe – gave a speech – Monetary policy and the Bank of England’s balance sheet. If the message was taken seriously, then the way monetary economics and macroeconomics is taught in our universities should change dramatically. At present, there is only one textbook that seriously caters for the message that is inherent in the speech – Macroeconomics (Mitchell, Wray and Watts). The speech leaves out important insights but essentially allows the reader to appreciate what Modern Monetary Theory (MMT) has been on about, in part, for 25 years.
Here are some past blog posts I have written on this topic. You will not find anything that the Bank of England official said in his speech that wasn’t covered in these blog posts (among many others).
That is especially the case with the earlier posts – written in 2009, for example.
One wonders why it takes more than a decade for officials in central banks to tell the public what is actually going on rather than what the defunct macroeconomists have led everyone to believe.
The point is that revealing these things is an important step in allowing the public to understand better policy choices – and see, clearly, why, in the current climate, any talk of going back to austerity to ‘pay’ for the coronavirus stimulus packages is nonsensical and damaging.
1. Deficit spending 101 – Part 1 (February 21, 2009).
2. Deficit spending 101 – Part 2 (February 23, 2009).
3. Deficit spending 101 – Part 3 (March 2, 2009).
4. Quantitative easing 101 (March 13, 2009).
5. Will we really pay higher interest rates? April 8th, 2009 (April 8, 2009).
6. Will we really pay higher interest rates? April 8th, 2009 (April 21, 2009).
8. Operational design arising from modern monetary theory (September 20, 2009).
9. Building bank reserves will not expand credit (December 13, 2009).
10. Building bank reserves is not inflationary (December 14, 2009).
11. On voluntary constraints that undermine public purpose (December 25, 2009).
12. The consolidated government – treasury and central bank (August 20, 2010).
13. The role of bank deposits in Modern Monetary Theory (May 26, 2011).
14. New central bank initiative shows governments are not financially constrained (January 24, 2012).
15. The ECB cannot go broke – get over it (May 11, 2012).
16. The sham of central bank independence (December 23, 2014).
17. Bank of England finally catches on – mainstream monetary theory is erroneous (June 1, 2015).
18. On money printing and bond issuance – Part 1 (August 26, 2019).
19. On money printing and bond issuance – Part 2 (August 27, 2019).
The important parts of the Bank of England official’s speech
In terms of the UK government’s response to the coronavirus, we read that:
Fiscal policy is best placed to target the most affected sectors, and the government has rapidly launched a wide range of programmes to help both firms and households who have been directly affected.
Which is why, in part, we advocate the primacy of fiscal policy interventions.
Monetary policy changes are uncertain in impact, cannot be spatially or cohort-targetted, and may fuel asset price bubbles. It is clear they cannot prevent recession in the same way as direct fiscal stimulus can always do if there is sufficient political will.
He presented this graph which shows that since the GFC, the Bank of England has been swapping bank reserves (light below) for its holdings of government bonds, which it has been buying in the secondary bond market.
This balance sheet pattern is repeated across many central banks now as they have been effectively ‘funding’ government deficits through their various public bond purchasing policies. They have been saying one thing (that they are not doing that) while doing exactly that.
The Speech recognises that:
By definition, only the central bank can provide central bank deposit accounts. So only the central bank can provide reserves.
He talks about “purchasing government bonds financed by ‘printing’ reserves” and qualifies that statement with:
I using … (sic) … “printing” figuratively here as the transaction is entirely electronic. I use it here simply because many commentators use this terminology to refer to this type of transaction.
So he is not challenging the ‘framing’ and the ‘language’ of the conceptualisation of reserves being swapped for bonds – an entirely digital transaction – as being ‘monetary printing’ despite the ideological baggage that that last term carries.
He knows that the “many commentators” who use this sort of terminology actually misuse it deliberately to evoke emotional memories of wheelbarrows and crazed central bankers in basements running printing presses.
That, in turn, is then used as a scare campaign to continue to issue corporate welfare in the form of government debt to the non-government sector to match deficits, when it would be much simpler and involve less costly administrative machinery for the treasury to just instruct its central bank to credit bank accounts to facilitate government spending (as it does now) without matching deficits with bond-issuance.
The Bank of England official then describes how reserve maintenance (liquidity management) is used to maintain short-term interest rates at the levels the central bank desires.
He then talks about QE:
1. “the central bank purchases government bonds, financed by issuing reserves” – “involves the same basic balance sheet transaction as conventional monetary policy: buy government bonds, sell (or create …) reserves. It is just on a larger scale.”
2. “The central bank is no longer trying to balance reserve supply with the reserve demand from the banks” – in other words, the QE program creates excess reserves as a deliberate consequence. He calls the ‘excess’ “ample reserves” – gymnastics.
3. And, “The fact that central banks pay interest on reserves (IOR) is very important. If reserves did not earn interest, then the supply by central banks of ample reserves beyond what banks need at any given level of interest rates, would push the short- term interest rate to zero …”
This is core MMT but students in monetary economics do not learn about these dynamics typically.
4. Paying a support rate on excess reserves, means that “the macroeconomic impact of ample reserves is probably quite small” – so QE is ineffective.
5. Now it gets interesting:
This willingness by banks to hold even quite large amounts of reserves is crucial. It means that the (old) textbook idea that there is some mechanical link between reserves, broad monetary conditions and inflation is just not right.
He then cites two research papers – one from 2014 (a Bank of England paper) and one from 2019 (an unpublished LSE paper).
But, of course, MMT economists have been writing about this for 25 years. No other monetary or macroeconomist was writing about this and they still teach the money multipier as core pedagogy.
The world is catching up with MMT – but slowly and without recognition.
But abandoning the monetary multiplier is an extremely significant step along the way to ditching the main elements of mainstream macroeconomics.
It means that:
1. All the hoopla about expanding bank resereves causing inflation through money supply expansion is inapplicable.
2. All the claims about crowding out, which is a principle argument against the use of fiscal deficits, is inapplicable.
3. The whole mainstream conception of the banking system and its interface with the real economy, is inapplicable.
He does move on to talk about the “Ways and Means” account that the Bank of England keeps for H.M. Treasury.
You will recall that on April 9, 2020, this announcement from the British Treasury was released – HM Treasury and Bank of England announce temporary extension of the Ways and Means facility.
Cover blown is what it told the British people.
Effectively, the ‘Ways and Means’ account is an overdraft that the Treasury has with its central bank that allows it to spend freely without satisfying the usual accounting and administrative practices (ex post) relating to bond issuance.
The announcement on April 9 said that the Bank of England would increase the available funds in that overdraft account if the Treasury needed to spend large sums quickly.
The language was all “temporary and short-term” and that the “government will continue to use the markets as its primary source of financing, and its response to Covid-19 will be fully funded by additional borrowing through normal debt management operations” but the reality was obvious.
They can increase fiscal deficits without recourse to the markets ‘matching’ the deficits with debt-issuance any time they like.
So what does the Bank of England official say about this?
He wants readers to confine their understanding of the Ways and Means account as a “short-term cash management tool”:
Rather than the central bank buying bonds, the central bank can lend directly to the government. If you think of a government bond as fundamentally a loan to the government, you can see that, mechanically, it is really just a very similar transaction again as QE and conventional monetary policy: government liabilities on the left, reserves on the right … The main difference from QE is that the initiative of drawing down (and repaying) the facility lies with the government, not the Bank Executive or the MPC.
So he is really saying that QE bond programs amount to the central bank providing ‘funding’ support for government deficits indirectly rather than through the primary debt-issuance process.
And allowing the Treasury to draw down funds in the Ways and Means account is a more direct but equivalent transaction.
We should note, of course, that government spending occurs in the same way, however, these administrative, institutional and accounting conventions and practices are exercises.
The Treasury instructs the central bank to credit bank accounts in the non-government sector on its behalf.
Every hour of every day.
That is how spending occurs.
All these other administrative type conventions do not alter that fact.
Further, what he doesn’t say about QE is that it provides instant capital gains to government bond holders. So, for example, primary dealers bid for the government bonds in the primary auction. They know they will then be able to offload them to the Bank of England ‘next day’ at a higher price than they purchased the debt for.
So just debiting a Ways and Means account and crediting some account of a procurement supplier is quite different to going through the whole hoopla of conducting primary bond auctions and then purchasing the bonds in the secondary market.
And now the ideology part:
The reason the W&M facility is not generally used is that the DMO seeks to use the market for its financing and cash management needs.
The DMO is the British Government’s – Debt Management Office – which was created in 1998 as part of the sham that pretended the Bank of England was now independent of government. It is just a branch of Treasury.
Prior to that, the Bank of England used to conduct all the debt operations on behalf of the government and often participated directly in the primary issuance process.
Many governments deployed the same tactic as an ideologically-motivated decision to promote the pecuniary interests of bond markets and to make it politically more difficult for governments to issue debt.
They knew that if the government had to match their deficit spending with bond-issuance, the debt ratio would become a central topic of conversation and that would limit deficits.
This was one of the legacies that the disastrous Blair Labour government left Britain. A smokescreen to limit government policy that might help the workers and the disadvantaged!
The Ways and Means process survived, however, to smooth out “government cash flows” – as a back up.
Such a back-up is rarely needed except in periods of sharp unexpected deviations from the financing plan.
That is, when the government knows it needs the Bank to credit bank accounts fast and hasn’t time to go through the ‘smoke and mirrors’ process of issuing debt.
The important consideration here, as far as monetary policy is concerned, is that due to the short term nature of these W&M cash management transactions, they do not in any way affect the MPC’s ability of doing its job of meeting the inflation target.
And, they would not affect the policy process if they were not short-term.
Then we move on to the real issue – “Monetary Financing?”
More ‘smoke and mirrors’:
We say we are not doing monetary financing according to our definition21, and someone else says we are in fact doing monetary financing according to a different definition. That is an argument about definitions, rather than about what we are doing.
The Governor of the Bank of England had told the Financial Times on April 5, 2020 – when the Ways and Means announcement was made – that monetary financing involves:
… a permanent expansion of the central bank balance sheet with the aim of funding the government …
What is permanent?
Who can know the aim?
They have been buying up government debt on and off for years now – see the graph above – is that not ‘permament’.
Central banks around the world continue to talk of ‘normalising’ their balance sheets (that is, getting rid of all the debt they have purchased from governemnts) but realise that the process is fraught in terms of asset values in the non-government sector.
Are their holdings not permanent?
They could easily just type some zeros into their accounts and write off all the debt. But they still would have been ‘funding’ the deficits.
Smoke and mirrors!
But we learn more:
One rather mechanical definition is that monetary financing means financing fiscal spending with central bank money rather than by issuing government bonds. The problem is … this description fits most central bank monetary policy operations, in the UK and elsewhere. When a central bank issues reserves, the main counterpart asset on the central bank balance sheet is generally some form of government financing.
Cover blown 2.0
But clinging to the ‘mainstream’ life rafts he says:
… even though in a strict sense some part of government spending is always financed with central bank money, it is not the same as saying that this part of government borrowing is costless.
Where are we up to – CB 3.0?
1. Government issues debt and pays interest to the non-government debt holder.
2. Government doesn’t issue debt, central bank creates reserves and has to pay a support rate on excess reserves not drained from the non-government sector as in Option 1.
Doesn’t this mean that the ‘cost’ of the deficits is the interest on excess reserves?
Cost is a loaded term.
The true cost of a government spending program is the extra real resources that are consumed in the process of policy execution.
But using the term in his way, what he is really saying is that the Bank of England is forced to pay interest on excess reserves if it wants to maintain a non-zero policy rate.
Apart from allowing the policy rate to go to zero (the preferred MMT position), the central bank could issue its own ‘debt’ instrument to drain the reserves, which I do not recommend.
Then reality is presented:
Is it ok for the central bank to finance some, but not too much? How much is too much? Before the crisis, central bank money (notes and reserves) in the UK was about 12% of government debt. Now it is 26% of government debt. In Japan it is 42% of government debt. There is no clear threshold beyond which monetary financing is “too much”, as long as investors believe government finances are sustainable without resorting to inflation. And, given the low levels of government bond yields and break-even inflation rates in the UK, investors clearly do believe that government finances are sustainable without resorting to inflation.
And not to mention the ECB funding the whole Eurozone show at the moment.
And it doesn’t really matter what investors think. They are supplicants.
What matters is whether the deficits are proportional to the non-government spending gaps (different between income and spending) and that total spending doesn’t outpace the productive capacity of the economy.
The bond investors are irrelevant to that process.
He also pulls the rug out from the “short-term” is safe, “permanent” is dangerous myth:
Can we say that a temporary operation is fine, but a permanent one is not? That is problematic too. We carried out several rounds of QE operations after the financial crisis, expecting them to be unwound some years later as the economy improved sufficiently. But the economy did not improve sufficiently, the neutral rate of interest fell more persistently than we expected, with the result that the amount of gilts we own has so far not been reduced.
As I noted above.
And then, while teetering on the balance bar (that long wooden beam that gymnasts always look like they are about to fall off and hurt themselves) we get the trump card:
… Weimar Republic or Zimbabwe …
But, thankfully, he equivocates because, presumably, he doesn’t want to align with the crazies who think the government shouldn’t be taking steps to defend the economic interests of its citizens. There will always be an Austrian economist somewhere in the ‘bushes’.
The equivocation only goes so far though and fails to reveal an understanding of what actually happened in Weimar and Zimbabwe.
The teaching programs in monetary economics and macroeconomics should be radically altered in universities around the world.
Even central bank officials are now, effectively, providing the arguments for that recommendation.
That is enough for today!
(c) Copyright 2020 William Mitchell. All Rights Reserved.