Money creation : easing your concerns (possibly)

The post-crisis age has seen central banks’ role in macroeconomic management expand greatly. Almost every year since 2008, there has been a new form of Quantitative Easing (QE) announced by either the Federal Reserve, the Bank of England or the European Central Bank. Yet, as real wage growth accelerates in the United States and the United Kingdom, we are seeing an end to this drawn out deviation from conventional monetary policy. This has been made clear by consistent interest rate increases by the Federal Reserve; the Fed’s balance sheet – i.e. the total stock of Fed-created funds in the financial system – has entered its second year of contraction. Furthermore, the Federal Funds Rate (the interest rate, controlled by the Federal Reserve, at which commercial banks can lend to one another overnight) has gone from a low of 0.25% in 2015 to 2.25% today, with a further increase to 2.5% expected this December.

For those who are unsure, QE is the process by which the central bank of a country creates money and uses it to purchase financial assets primarily from institutional investors. This purchase entails a massive transfer of newly created money to the private sector, which, in theory, should stimulate lending and economic growth. Now, the central bank then holds these assets, usually government bonds, on its balance sheet (repurchasing as some are repaid) as the economy recovers. Once growth, inflation and confidence have returned, they resell their assets back to the private sector, and destroy the money they make from doing so.

If learning about QE for you invoked disturbing images of hyperinflation in Zimbabwe and Weimar Germany, then you have company – and a lot of it. Across the Western world politicians decried QE and tried to block it. Some, such as Republican Representative Steve Chabot feared the “inflationary” and “devaluing” effect of the policy, whilst others, such as Texas Governor Rick Perry, had a deep seated aversion to the government “printing money”.

Once we learn however, how the private banking system actually works, QE becomes a lot less scary. What is so often missed is that the vast majority (97% in the UK’s case), of money in circulation is created by banks. Not the central bank, but banks – your high street Barclays or Nat-west. They create new money every time they make a loan.

To see why this is the case, observe an example: say you go to the bank deposit $100 of cash, it will credit your account with $100. Now, let’s say it keeps 10% of this, so $10, on reserve in case it needs it and lends out the other $90. When this happens, whoever has received the loan has their bank account credited $90. That’s it – money has been created. We started off with $100 and now, there is a total of $190, across your bank account and the borrower’s. Now you may think, ‘we can’t both spend it, because I have lent my money to the other’, but this isn’t true. What is in both accounts are IOUs from the bank – saying that it promises to give them cash on demand. As long as the bank stays operating, the account holders are free to spend these IOUs exactly as if they were cash – and as they spend and the money circulates from bank to bank, we see ever more ‘bank IOUs’ created and the money supply enlarge. (For those who are interested, Positive Money provides a much better explanation of this in a 6-part video series on YouTube)

Now, here’s the crucial bit – since our monetary system is virtually dominated by bank-created money, it is extremely vulnerable to banking crises. During the Financial Crisis and its aftermath, as banks scaled down lending dramatically, the money supply contracted immensely. The main method of money creation was faltering – so central banks had to step in and do what banks were not doing – create money. This came in the form of QE, and many believed it was crucial in avoiding a 1930s style Depression.

So, if they were being consistent, politicians who criticised the Federal Reserve for QE out of opposition to ‘money creation’ would have also criticised the fractional reserve banking system. Indeed, they should have criticised the latter more harshly than the former, for it creates vastly more money than the Fed does. Yet consistency in politicians is a lot to ask for these days.

None of this is to say QE has been perfect. It has been over-used and has had some discernibly malign consequences. It has inflated the price of financial assets, simultaneously increasing wealth inequality and threatening financial stability. Furthermore, it has pushed interest rates to artificial lows – if you bought a German Government 10 Year bond today, you would receive an annual interest rate of 0.35%. Since pension funds rely on government bonds for income but require a 7-8% yearly return to serve all of their participants’ needs, this has seriously compromised future retirement savings.

For better or for worse, our economy is fueled by fractional reserve banking. When this system falters therefore, some form of QE is necessary. But keep in mind that it’s nothing really new or unusual, but effectively what the private sector does every single day – and on an enormously larger scale.