Monday, 11 July 2022

No, QE did not lead to inflation: an explainer

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.
Milton Friedman 

I have seen the above quote a few times recently explaining inflation. Inflation, is a bit more complicated than Friedman put it. But more importantly, I think the quote can be a bit misleading. This is because a lot of people associate inflation with printing money. 

The most famous example of this is the Weimar Republic which printed large quantities of bank notes in order to pay reparations for WW1.  As a result, a loaf of bread in Berlin that cost 160 Marks in 1922 would cost 200,000,000,000 Marks in 1923.

When QE (Quantitative Easing) was proposed in 2009, some people were worried that this would result in inflation. After all isn't QE just a fancy way of saying we created money out of thin air? Some people think as QE has continued, it is in part responsible for the inflation we are currently seeing.

To understand why this view is incorrect, we need to understand how money is created. It is a common misunderstanding that money is backed by gold. This can come as a surprise to most people (a lot of conspiracy theorists actually start out with this fact).

So what is money? Well, the best way to think about money is debt. Lets say I wrote on a signed piece of paper I.O.U 1 pint. and I gave it to my you in the pub. The next day, you wanted to pay someone else, but you don't have anything else on you other than the I.O.U. Now because I am an upstanding and trustworthy citizen, this person would trust that I make good on promise of a pint, so accepted the IOU as payment (I have another blog on why trust is important for money - even Bitcoin!). In fact, this I.O.U could keep going round and round until someone came to eventually get a pint off me. 

What we have done here, is create money out of thin air.

During the middle ages in Britain, this is essentially how money worked. They would use a stick (usually hazelwood) and split it in half, one to the debtor and one to the creditor. Once the debt was paid (you gave them a ye auld homebrewed pint of ale) then the sticks would be destroyed. But because the split sticks were unique, you could trade them with other people in the same way the I.O.U was traded in the above example.

As most of the lending these days is done via banks, it "creates" most of the money we see today. Commercial banks don't print physical paper money but it is important to note that physical paper money only accounts for 3% of all money, the rest is held electronically by commercial banks. 

A common misconception is that banks get deposits in and lend them out (some even blame economists for this misconception). Banks, however, can lend without having the exact deposits to match in the same way that I can write an I.O.U for a pint without actually having the pint on me in that moment.

Now before you go all end of Fight Club on me, this does not mean the Bank of England has no control on this process. 

Your eyes may glaze over with a lot of financial jargon here but I will try and explain everything.

When the Bank of England sets it's interest rate, what it is actually doing is setting a repurchasing agreement rate with commercial banks AKA the repo rate. Commercial banks often want to borrow over the short term because they want to stabilise their reserve ratios. A reserve ratio is the amount they lend out to what they have in reserves. These reserves need to be "liquid" meaning they can be exchanged very quickly (cash is extremely liquid and can be traded straight away whereas a house is not as it would takes time to sell)

So a reserve ratio of 20% would mean a bank will have £20 in cash say to every £100 they lend out. This is important because banks that have very low reserve ratios expose themselves to a lot of risks such as bank runs.

So when the Bank of England lowers interest rates, what they are actually doing is lowering the rate at which commercial banks can borrow over the short-term which means banks are more likely to increase loans and hence...increase the money supply.*

So where does Q.E. come into this? Well Q.E. is a way of getting banks to lend out more when interest rates can't get any lower. Economists call this the "zero-lower bound" which is a stupid name, But after the financial crisis we hit the zero-lower bound in the UK and we needed to stimulate the economy. Basically, if you put rates any lower than 0%, like -1% you are paying commercial banks to borrow from you in order to get them to lend (this has actually happened in some countries). 

An alternative method to get commercial banks to lend more is to buy bonds off them. The Bank of England would credit banks with the cash which meant the liquid cash reserves of commercial banks increased. This commercial bank an incentive to lend out more to increase economic activity. The Bank simply created the cash out of thin air here, just as I did with the I.O.U. Once the bond is due, the cash is repaid to the bank and then gets destroyed (not literally, it is all done via something like Excel).

I can understand this is lot to get your head round, and I am not saying Q.E. is perfect. But what I want you to take away from this blog is that Q.E. is not some totally weird thing in terms of money creation, we have been doing it for decades with the central bank controlling interests rates. 

The idea that Q.E. is inflationary is largely down to people not understanding how money is created in the first place. 

* John Barrdear from the Bank of England helpfully pointed out that there are other ways the interest rate affects output, so I don't want to give the impression that central banks aim is to control the money supply here (most of us have moved on from the 80s). 

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