Would you like to be a millionaire? Of course you would – who wouldn’t, right? Actually the answer to this question may be more complicated than you might think (see for instance Sgroi et al (2017) on the economics of happiness: see linked article below), but, generally speaking, most people would answer positively to this question.
What if I told you, however, that you could become a millionaire (actually, scratch that – think big – make that “trillionaire”) overnight and be deeply unhappy about it? If you don’t believe me see what happened to Zimbabwe 10 years ago, when irresponsible money printing and fiscal easing drove the country’s economy to staggering hyperinflation (see the blogs A remnant of hyperinflation in Zimbabwe and Fancy a hundred trillion dollar note?. At the peak of the crisis, prices were increasing by a factor of 130 each year. I have in my office a 100 trillion Zimbabwean dollar note (see below) which I show in my lectures when I talk about hyperinflation to my first year Economics for Business students (if you are one of them, make sure not to miss it next February at UEA!). How much is this 100 trillion note worth? Nothing (except, may be, for collectors). It has been withdrawn from circulation as it ended up not even being worth the cost of the paper on which it was printed.
The Zimbabwean economy managed to pull itself out of this spiral of economic death, partly by informally replacing its hyperinflationary currency with the US greenback, and partly by keeping its fiscal spending under control and reverting to more sane economic policy making. That lasted until 2013, after which the government launched a Zimbabwean digital currency (known as “Zollar”) that had a nominal value set equal to a US dollar; and forced its exporters to exchange their greenbacks for Zollars. It then started spending these USD to finance a very ambitious and unsustainable programme of fiscal expansion.
The Economist published yesterday a story that shows the results of this policy – wild price increases and empty supermarket shelves are both back. According to the newspaper’s report:
At a supermarket in Harare, Zimbabwe’s capital, the finance minister is staring aghast at a pack of nappies. ‘This is absolutely ridiculous!’, exclaims Mthuli Ncube. ‘$49!’ A manager says it cost $23 two weeks ago, before pointing out other eye-watering items such as $20 Coco Pops. […] Over the past two weeks zollars have been trading at as little as 17 cents to the dollar. The devaluation has led to a surge in prices—and not just in imported goods like nappies. Football fans attending the Zimbabwe v Democratic Republic of Congo game on October 16th were shocked to learn that ticket prices had doubled on match day.
How long will it take for the 100 trillion Zollar to make its appearance again? We shall find out. I am sure Zimbabweans will be less than thrilled!
Articles and Report
- A fist full of zollars: Zimbabwe’s shops are empty and prices are soaring
The Economist (28/10/18)
- Shelves Empty as Specter of Hyperinflation Stalks Zimbabwe
Bloomberg, Paul Wallace, Godfrey Marawanyika and Desmond Kumbuka (12/10/18)
- imbabwe currency crisis: No cash, no bread, no KFC
BBC News, Andrew Harding (12/10/18)
- Hyperinflation in Zimbabwe: money demand, seigniorage and aid shocks
Journal of Applied Economics, Tara McIndoe-Calder (Volume 50, Issue 15, 18/9/17)
- Understanding Happiness
A CAGE Policy Report: Social Market Foundation, Daniel Sgroi, Thomas Hills, Gus O’Donnell, Andrew Oswald and Eugenio Proto (January 2017)
- Using an AS/AD diagram, explain the concept of hyperinflation. How can irresponsible fiscal policy-making lead to hyperinflation?
- What are the effects of hyperinflation on the people who live in the affected countries? Search the web for examples and case studies, and use them to support your answer.
- Once it has started, what policies can be used to fight hyperinflation? Use examples to support your answer.
- How does speculation affect hyperinflation?
‘There is no magic money tree’, said Theresa May on several occasions during the 2017 election campaign. The statement was used to justify austerity policies and to criticise calls for increased government expenditure.
But, in one sense, money is indeed fruit of the magic money tree. There is no fixed stock of money, geared to the stock of gold or some other commodity. Money is created – as if by magic. And most of broad money is not created by government or the central bank. Rather it is created by banks as they use deposits as the basis for granting loans, which become money as they are redeposited in the banking system. Banks are doing this magic all the time – creating more and more money trees as the forest grows. As the Bank of England Quarterly Bulletin explains:
Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.
However, most of the country’s MPs are unaware of this process of money creation. As the linked Guardian article below states:
Responding to a survey commissioned by Positive Money just before the June election, 85% were unaware that new money was created every time a commercial bank extended a loan, while 70% thought that only the government had the power to create new money.
And yet the role of money and monetary policy is central to many debates in Parliament about the economy. It is disturbing to think that policy debates could be based on misunderstanding. Perhaps MPs would do well to study basic monetary economics! After all, credit creation is not a difficult topic.
Positive Money poll
- Do central banks create money and, if so, what form(s) does it take?
- Explain how credit creation works.
- What determines the amount of credit that banks create?
- How can the central bank influence the amount of credit created?
- Distinguish between narrow and broad money supply.
- What is the relationship between government spending and broad money supply (M4 in the UK)?
- Why is there no simple money multiplier whereby total broad money supply is a simple and predictable multiple of narrow money?
- What determines the relationship between money supply and real output?
- Does it matter what type of lending is financed by money creation?
- Comment on the statement: “The argument marshalled against social investment such as education, welfare and public services, that it is unaffordable because there is no magic money tree, is nonsensical.”
- Could quantitative easing be used to finance social investment? Would there be any dangers in the process?
The US Federal Reserve, like many other central banks, engaged in massive quantitative easing in the wake of the financial crisis of 2007/8. Over three rounds, QE1, QE2 and QE3, it accumulated $4.5 trillion of assets – mainly government bonds and mortgage-backed securities (see chart below: click here for a PowerPoint). But, unlike its counterparts in the UK, the eurozone and Japan, it has long ceased its programme of asset purchases.. In October 2014, it announced that QE was at an end. All that would be done in future would be to replace existing holdings of assets as they matured, keeping total holdings roughly constant.
But now this policy is set to change. The Fed is about to embark on a programme of ‘quantitative tightening’, already being dubbed ‘QT’. This involves the Fed reducing its holdings of assets, mainly government bonds and government-backed mortgage-related securities.
This, however, for the time being will not include selling its holding of bonds or mortgage-backed securities. Rather, it will simply mean not buying new assets to replace ones when they mature, or only replacing part of the them. This was discussed by the 75 participants at the joint meeting of the Federal Open Market Committee (FOMC) and Board of Governors on 14–15 March.
As the minutes put it: “Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner.”
A more active form of QT would involve selling assets before maturity and thus reducing the size of the Fed’s balance sheet more rapidly. But either way, reducing assets would put downward pressure on the money supply and support the higher interest rates planned by the FOMC.
The question is whether there is enough liquidity elsewhere in the system and enough demand for credit, and willingness of the banking system to supply credit, to allow a sufficient growth in broad money – sufficient, that is, to support continued growth in the economy. The answer to that question depends on confidence. The Fed, not surprisingly, is keen not to damage confidence and hence prefers a gradualist approach to reducing its holdings of assets bought during the various rounds of quantitative easing.
Fed’s asset shift to pose new test of economy’s recovery, resilience Reuters, Howard Schneider and Richard Leong (6/4/17)
Federal Reserve likely to begin cutting back $4.5 trillion balance sheet this year Washington Post, Ana Swanson (5/4/17)
Why the Fed’s debate about shrinking its balance sheet really, really matters Money Observer, Russ Mould (7/4/17)
The Fed and ECB keep a cautious eye on the exit Financial Times (7/4/17)
Get ready for the Fed’s next scary policy change CBS Money Watch, Anthony Mirhaydari (5/4/17)
The Fed wants to start shrinking its $4.5 trillion balance sheet later this year Business Insider, Akin Oyedele (5/4/17)
Inside the Fed’s March Meeting: The Annotated Minutes Bloomberg, Luke Kawa, Matthew Boesler and Alex Harris (5/4/17)
QE was great for asset prices – will ‘QT’ smash them? The Financial Review (Australia), Patrick Commins (7/4/17)
Shrinking the Fed’s balance sheet Brookings, Ben Bernanke (26/1/17)
Selected data Board of Governors of the Federal Reserve System
- Distinguish between active and passive QT.
- If QE is a form of expansionary monetary policy, is QT a form of contractionary monetary policy?
- Could QT take place alongside an expansion of broad money?
- What dangers lie in the Fed scaling back its holdings of government (Treasury) bonds and mortgage-backed securities?
- Why is it unlikely that the Fed will reduce its holdings of securities to pre-crisis levels?
- Why are the Bank of England, the ECB and the Bank of Japan still pursuing a policy of QE?
- What are the implications for exchange rates of QT in the USA and QE elsewhere?
- Find out data for the monetary base, for narrow money (M1) and broader money (M2) in the USA. Are narrow and/or broad money correlated with Federal Reserve asset holdings?
Seven years ago (on 5 March 2009), the Bank of England reduced interest rates to a record low of 0.5%. This was in response to a deepening recession. It mirrored action taken by other central banks across the world as they all sought to stimulate their economies, which were reeling from the financial crisis.
Record low interest rates, combined with expansionary fiscal policy, were hoped to be enough to restore rates of growth to levels experienced before the crisis. But they weren’t. One by one countries increased narrow money through bouts of quantitative easing.
But as worries grew about higher government deficits, brought about by the expansionary fiscal policies and by falling tax receipts as incomes and spending fell, so fiscal policy became progressively tighter. Thus more and more emphasis was put on monetary policy as the means of stimulating aggregate demand and boosting economic growth.
Ultra low interest rates and QE were no longer a short-term measure. They persisted as growth rates remained sluggish. The problem was that the higher narrow money supply was not leading to the hoped-for credit creation and growth in consumption and investment. The extra money was being used for buying assets, such as shares and houses, not being spent on goods, services, plant and equipment. The money multiplier fell dramatically in many countries (see chart 1 for the case of the UK: click here for a PowerPoint) and there was virtually no growth in credit creation. Broad money in the UK (M4) has actually fallen since 2008 (see chart 2: click here for a PowerPoint), as it has in various other countries.
Additional monetary measures were put in place, including various schemes to provide money to banks for direct lending to companies or individuals. Central banks increasingly resorted to zero or negative interest rates paid to banks for deposits: see the blog posts Down down deeper and down, or a new Status Quo? and When a piggy bank pays a better rate. But still bank lending has stubbornly failed to take off.
Some indication that the ’emergency’ was coming to an end occurred in December 2015 when the US Federal Reserve raised interest rates by 0.25 percentage points. However, many commentators felt that that was too soon, especially in the light of slowing Chinese economic growth. Indeed, the Chinese authorities themselves have been engaging in a large scale QE programme and other measures to arrest this fall in growth.
Although it cut interest rates in 2009 (to 1% by May 2009), the ECB was more cautious than other central banks in the first few years after 2008 and even raised interest rates in 2011 (to 1.5% by July of that year). However, more recently it has been more aggressive in its monetary policy. It has progressively cut interest rates (see chart 3: click here for a PowerPoint) and announced in January 2015 that it was introducing a programme of QE, involving €60 billion of asset purchases for at least 18 months from March 2015. In December 2015, it announced that it would extend this programme for another six months.
The latest move by the ECB was on March 10, when it took three further sets of measures to boost the flagging eurozone economy. It cut interest rates, including cutting the deposit rate paid to banks from –0.3% to –0.4% and the main refinancing rate from –0.05% to –0%; it increased its monthly quantitative easing from €60 billion to €80 billion; and it announced unlimited four-year loans to banks at near-zero interest rates.
It would seem that the emergency continues!
QE, inflation and the BoE’s unreliable boyfriend: seven years of record low rates The Guardian, Katie Allen (5/3/16)
The End of Alchemy: Money, Banking and the Future of the Global Economy by Mervyn King – review The Observer, John Kampfner (14/3/16)
How ‘negative interest rates’ marked the end of central bank dominance The Telegraph, Peter Spence (21/2/16)
ECB stimulus surprise sends stock markets sliding BBC News (10/3/16)
5 Takeaways From the ECB Meeting The Wall Street Journal, Paul Hannon (10/3/16)
ECB cuts interest rates to zero amid fears of fresh economic crash The Guardian, Katie Allen and Jill Treanor (10/3/16)
Economists mixed on ECB stimulus CNBC, Elizabeth Schulze (10/3/16)
ECB’s Draghi plays his last card to stave off deflation The Telegraph, Ambrose Evans-Pritchard (10/3/16)
ECB cuts rates to new low and expands QE Financial Times, Claire Jones (10/3/16)
Is QE a saviour, necessary evil or the road to perdition? The Telegraph, Roger Bootle (20/3/16)
Monetary policy decisions ECB Press Release (10/3/16)
Introductory statement to the press conference (with Q&A) ECB Press Conference, Mario Draghi and Vítor Constâncio (10/3/16)
ECB Press Conference webcast ECB, Mario Draghi
- What are meant by narrow and broad money?
- What is the relationship between narrow and broad money? What determines the amount that broad money will increase when narrow money increases?
- Explain what is meant by (a) the credit multiplier and (b) the money multiplier.
- Explain how the process of quantitative easing is supposed to result in an increase in aggregate demand. How reliable is this mechanism?
- Find out and explain what happened to the euro/dollar exchange rate when Mario Draghi made the announcement of the ECB’s monetary measures on 10 March.
- Is there a conflict for central banks between trying to strengthen banks’ liquidity and reserves and trying to stimulate bank lending? Explain.
- Why are “the ECB’s policies likely to destroy half of Germany’s 1500 savings and co-operative banks over the next five years”? (See the Telegraph article.
- What are the disadvantages of quantitative easing?
- What are the arguments for and against backing up monetary policy with expansionary fiscal policy? Consider different forms that this fiscal policy might take.
Mario Draghi, the ECB President, has indicated that the ECB is prepared to engage in further monetary stimulus. This is because of continuing weaknesses in the global economy and in particular in emerging markets.
Although the ECB at its meeting in Malta on 22 October decided to keep both interest rates and asset purchases (€60 billion per month) at current levels, Mario Draghi stated at the press conference that, at its next meeting on December 3rd, the ECB would be prepared to cut interest rates and re-examine the size, composition and duration of its quantitative easing programme. He stopped short, however, of saying that interest rates would definitely be cut or quantitative easing definitely increased. He said the following:
“The Governing Council has been closely monitoring incoming information since our meeting in early September. While euro area domestic demand remains resilient, concerns over growth prospects in emerging markets and possible repercussions for the economy from developments in financial and commodity markets continue to signal downside risks to the outlook for growth and inflation. Most notably, the strength and persistence of the factors that are currently slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis.
In this context, the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available. The Governing Council is willing and able to act by using all the instruments available within its mandate if warranted in order to maintain an appropriate degree of monetary accommodation.”
Mario Draghi also argued that monetary policy should be supported by fiscal policy and structural policies (mirroring Japan’s three arrows). Structural policies should include actions to improve the business environment, including the provision of an adequate public infrastructure. This is vital to “increase productive investment, boost job creation and raise productivity”.
As far as fiscal policies are concerned, these “should support the economic recovery, while remaining in compliance with the EU’s fiscal rules”. In other words, fiscal policy should be expansionary, while staying within the limits set by the Stability and Growth Pact.
His words had immediate effects in markets. Eurozone government bond yields dropped to record lows and the euro depreciated 3% against the US dollar over the following 24 hours.
ECB Press Conference on YouTube, Mario Draghi (22/10/15)
Draghi reloads bazooka FT Markets, Ferdinando Guigliano (22/10/15)
Mario Draghi: ECB prepared to cut interest rates and expand QE The Guardian, Heather Stewart (22/10/15)
Draghi signals ECB ready to extend QE Financial Times, Claire Jones and Elaine Moore (22/10/15)
Dovish Mario Draghi sends bond yields to new lows Financial Times, Katie Martin (23/10/15)
What Draghi Said on QE, Policy Outlook, Global Risks and Inflation Bloomberg, Deborah Hyde (22/10/15)
ECB set to ‘re-examine’ stimulus policy at next meeting BBC News (22/10/15)
The global economy warrants a big dose of caution The Guardian, Larry Elliott (25/10/15)
ECB Press Conference
Introductory statement to the press conference (with Q&A) ECB, Mario Draghi (President of the ECB), Vítor Constâncio (Vice-President of the ECB) (22/10/15)
- Why is the ECB considering further expansionary monetary policy?
- What monetary measures can a central bank use to stimulate aggregate demand?
- Explain the effects of Mario Draghi’s announcement on bond and foreign exchange markets.
- What are the objectives of ECB monetary policy according to the its mandate?
- Should the ECB consider using quantitative easing to provide direct funding for infrastructure projects?
- What constraints does the EU’s Stability and Growth Pact impose on eurozone countries?
- What are the arguments for and against (a) the Bank of England and (b) the US Federal Reserve engaging in further QE?
- If the ECB does engage in an expanded QE programme, what will determine its effectiveness?