The People’s Quantitative Easing (PQE) proposal that is currently being debated in the UK media is the version proposed by Richard Murphy. It involves local authorities issuing debt in the form of bonds to fund investment in infrastructure. The bonds would originate from a newly created public investment bank and would be immediately bought up by the Bank of England (BoE) using newly created money. The bonds, now held by the BoE would be effectively cancelled (though complications arise here due to the Lisbon Treaty). In this way, the investment is effectively funded by new money creation by the BoE, albeit through a slightly convoluted process.
Some of the main criticisms of this idea have been:
- that simply creating money to finance government spending is inflationary
- the independence of the BoE would be compromised
- the same outcome could be done by conventional government borrowing, so PQE is a way to dodge persistent misunderstandings about the nature of government debt
In order to evaluate these criticisms and decide whether there is some merit to PQE, it is necessary to understand how the government and the BoE interact when the government spends. In other words how fiscal (spending and taxing) and monetary (inflation, interest rates, etc.) policies interact.
The BoE is part of the the UK public sector. The remit of the BoE is to keep prices stable, which means controlling inflation. Interestingly, it does not attempt to prevent any inflation at all, but targets a low, positive rate of inflation - currently 2% (set by the government).
To do this, the BoE attempts (with greater or lesser success) to control the amount of money in circulation. (It doesn’t directly target the amount of money but rather uses an interest rate target as a proxy). The main method for doing this is altering the amount of money in the reserve accounts of commercial banks. If there is too much money, the BoE sells some financial assets to the banks in exchange for their money. After such an operation the banks have a lower amount of reserves but do hold other assets (often government bonds) in their place. If the BoE estimates that there is too little money available to the economy it adds to the banks’ reserves by buying assets from them.
In a sense, government bonds are interchangeable with BoE issued money (reserves). But since it is reserves which are typically used to clear payments between banks, the proportion of money which is held as reserves versus bonds determines (perhaps only loosely) how much money is readily available to the economy. The BoE simply adjusts this proportion as appropriate. It’s worth noting that the BoE doesn’t create its own bonds, but sells back to the private sector UK government bonds that had been previously bought up in earlier operations.
The government (specifically the Treasury) adds new money to the economy when it spends. In principle, the government could simply leave it at that, i.e. create the money and leave the BoE to somehow drain it from the money supply according to its inflation target. But that would make the job of the BoE very difficult. And in any case, there are EU rules against directly financing government with central bank money creation.
Therefore, the UK government applies a rule to itself called the Full Funding Rule. This rule stipulates that any money added to the economy due to spending must be completely removed. To a large extent this is achieved through taxation but if the government spends more than it collects through taxes (a budget deficit) then the government removes the additional money by selling newly issued bonds. This works in the same way as when the BoE sells bonds to drain bank reserves - money is taken out of the economy - except that when the government does it they are selling newly created bonds. So a government’s deficit is associated with an identically sized issuance of bonds which gives the appearance of borrowing to fund its spending.
But that is not really what the intention is. What all this is supposed to mean is that the government’s fiscal policy (spending and taxing) is neutral with respect to the amount of money in circulation, and therefore the BoE can go about it’s job of targeting the right amount of money in the economy without any additional complications.
The recent programme of Quantitative Easing, carried out by the BoE between 2009 and 2012 was an extreme version of the monetary operations described above. The BoE bought £375 billion of government bonds from the private sector and therefore increased bank reserves by the same amount. The intention was to stimulate the economy by enabling banks to lend cheaply and by promoting investment in other non-government assets. A side effect (or possibly an intention) was/is that the cost of issuing bonds for the UK government stayed very low meaning that the very large fiscal deficits could be accommodated more easily.
In effect, the UK government debt is now £375 billion less than the declared amount (about £1.4 trillion) since that amount is “owed” to part of the public sector. Indeed, this is what the government states when it “consolidates” the accounts of the entire public sector, and the BoE actually returns interest payments it receives to the government so this portion of the debt has no cost. It can also be argued that, since the bonds that the BoE has bought represent past government deficits, historical deficit spending to the tune of £375 billion has effectively been funded by money creation at the BoE. So while QE was a monetary operation, it can be argued that it has a significant effect on fiscal policy.
PQE is similar to conventional fiscal operations in some ways and different in other ways. The fact that bonds are used in the first instance to fund the spending is similar to current practices although it is not clear why the bonds need to be from a newly created national investment bank when conventional Treasury bonds would do the same job.
One reason could be that normal government bonds (gilts) can be linked to non-investment spending such as paying a nurse, whereas the new national investment bank bonds are solely for investment spending, such as building a new hospital. This would help clarify the important distinction between these two types of spending.
The major difference is that in PQE the BoE stands ready to buy up any bonds issued to fund investment under the scheme. This makes it look a little like QE in the sense that QE involved the BoE buying up government bonds en masse, and QE arguably funded some government spending in an ex post sense. But there are differences in the rationales for QE and PQE, one being specifically monetary and the other fiscal with direct and specific social outcomes.
In any case, there is an obvious potential downside to the buying up of government bonds by the BoE. In the normal case, government spending is neutralised by taxing and bond issuance and therefore the BoE does not have to consider the effect of the government’s fiscal policy when conducting its inflation targeting operations. But if the BoE is charged with buying the bonds used for PQE investments then it is being asked to introduce money into the economy which is not being neutralised. One conclusion that has been drawn by many is that the new money will therefore be inflationary. And perhaps it will, if the BoE do nothing more. But the obvious response from the BoE would be to sell some bonds (possibly original QE bonds) back into the private sector to drain out the added money. This is, after all, the normal response of the BoE when it perceives too much money in the economy. And so, if the net result of the PQE operation is that the government spends and the private sector ends up holding an equivalent amount of government bonds then it doesn’t look much different from current practices. It doesn’t matter whether bonds were sold by the Treasury or the BoE, the net result is the same. In which case we simply conclude that, as long as we want a central bank charged with keeping prices stable, PQE doesn’t end up being any different from what already happens.
And if we were in “normal times”, we could leave it there. But we are not in normal times. At present, inflation in the UK is around 0% which means that the BoE is failing to hit it’s +2% inflation target by a whole 2%. This is despite buying up £375 billion of government, flooding banks with the same amount of reserves and maintaining next-to-zero interest rates for 6 years.
So the most extreme monetary policy used by the BoE appears to be insufficient - under current circumstances - for hitting the targeted level of inflation. One possible reason for this is that the current fiscal policy of targeting deficit reduction is sucking demand out of the economy. In this light, the charge against PQE - that it interfere’s with the remit of the BoE’s inflation targeting - is no worse than could be levelled against the policies of the current Conservative government.
So it is possible that a simple reversion to “normal”, non-austere fiscal policies in which debt and deficit targets are not paramount would produce a sufficient amount of inflation to be in line with the BoE’s target. In such a case it would be difficult to justify PQE since it would revert to conventional bond-backed spending, as argued above.
But under the current circumstances, when the tools of monetary policy have been exhausted and still the inflation target is being missed, then some inflation being produced by PQE-style money creation would not only be acceptable but would be positively welcome. In this guise - dropping the need for a new investment bank - this looks like the more general idea of “helicopter money”, i.e. creating money and giving it to members of the public.
PQE, as presented, includes some useful ideas and some unnecessary ones. There doesn’t seem to be any need for a new investment bank when conventional Treasury bonds fulfil the same role. And in normal times, when the BoE is more or less able to approximate its inflation target, PQE just ends up looking like the conventional methods of doing fiscal policy (spending neutralised by taxes and bond sales). But in extreme cases when the economy is struggling to produce any inflation and the government/BoE have exhausted all monetary policy options, the money creation/helicopter money aspect of PQE seems entirely reasonable and constructive.
If you been affected by any of the issues in this post, listen to this podcast.
Originally posted on rationalintuition.net.