The BBC podcast linked below looks at the use of quantitative easing since 2009 and especially the most recent round since the onset of the pandemic.
Although QE was a major contributor to reducing the depth of the recession in 2009–10, it was barely used from 2013 to 2020 (except for a short period in late 2016/early 2017). The Coalition and Conservative governments were keen to get the deficit down. In justifying pay restraint and curbing government expenditure, Prime Ministers David Cameron and Theresa May both argued that there ‘was no magic money tree’.
But with the severely dampening effect of the lockdown measures from March 2020, the government embarked on a large round of expenditure, including the furlough scheme and support for businesses.
The resulting rise in the budget deficit was accompanied by a new round of QE from the beginning of April. The stock of assets purchased by the Bank of England rose from £445 billion (the approximate level it had been since March 2017) to £740 billion by December 2020 and is planned to reach £895 billion by the end of 2021.
So with the effective funding of the government’s deficits by the creation of new money, does this mean that there is indeed a ‘magic money tree’ or, indeed, a ‘magic money forest’? And if so, is it desirable? Is it simply stoking up problems for the future? Or will, as modern monetary theorists maintain, the extra money, if carefully spent, lead to faster growth and a reducing deficit, with low interest rates making it easy to service the debt?
The podcast explores these issues. There is then a longer list of questions than normal relating to the topics raised in the podcast.
- Which of the following are stocks and which are flows?
(c) The total amount people save each month
(d) The money held in savings accounts
(e) Public-sector net debt
(f) Public-sector net borrowing
(g) National income
(h) Injections into the circular flow of income
(i) Aggregate demand
- How do banks create money?
- What is the role of the Debt Management Office in the sale of gilts?
- Describe the birth of QE.
- Is raising asset prices the best means of stimulating the economy? What are the disadvantages of this form of monetary expansion?
- What are the possible exit routes from QE and what problems could occur from reducing the central bank’s stock of assets?
- Is the use of QE in the current Covid-19 crisis directly related to fiscal policy? Or is this use of monetary policy simply a means of hitting the inflation target?
- What are the disadvantages of having interest rates at ultra-low levels?
- Does it matter if the stock of government debt rises substantially if the gilts are at ultra-low fixed interest rates?
- What are the intergenerational effects of substantial QE? Does it depend on how debt is financed?
- How do the policy recommendations of modern monetary theorists differ from those of more conventional macroeconomists?
- In an era of ultra-low interest rates, does fiscal policy have a greater role to play than monetary policy?
With the imposition of a new lockdown in England from 5 November to 2 December and in Wales from 3 October to 9 November, and with strong restrictions in Scotland and Northern Ireland, the UK economy is set to return to negative growth – a W-shaped GDP growth curve.
With the closure of leisure facilities and non-essential shops in England and Wales, spending is likely to fall. Without support, many businesses would fail and potential output would fall. In terms of aggregate demand and supply, both would decline, as the diagram below illustrates. (Click here for a PowerPoint.)
The aggregate demand curve shifts from AD1 to AD2 as consumption and investment fall. Exports also fall as demand is hit by the pandemic in other countries. The fall in aggregate supply is represented partly by a movement along the short-run aggregate supply curve (SRAS) as demand falls for businesses which remain open (such as transport services). Largely it is represented by a leftward shift in the curve from SRAS1 to SRAS2 as businesses such as non-essential shops and those in the hospitality and leisure sector are forced to close. What happens to the long-run supply curve depends on the extent to which businesses reopen when the lockdown and any other subsequent restrictions preventing their reopening are over. It also depends on the extent to which other firms spring up or existing firms grow to replace the business of those that have closed. The continuing rise in online retailing is an example.
With the prospect of falling GDP and rising unemployment, the UK government and the Bank of England have responded by giving a fiscal and monetary boost. We examine each in turn.
In March, the Chancellor introduced the furlough scheme, whereby employees temporarily laid off would receive 80% of their wages through a government grant to their employers. This scheme was due to end on 31 October, to be replaced by the less generous Job Support Scheme (see the blog, The new UK Job Support Scheme: how much will it slow the rise in unemployment?). However, the Chancellor first announced that the original furlough scheme would be extended until 2 December for England and then, on 5 November, to the end of March 2021 for the whole of the UK. He also announced that the self-employed income support grant would increase from 55% to 80% of average profits up to £7500.
In addition, the government announced cash grants of up to £3000 per month for businesses which are closed (worth more than £1 billion per month), extra money to local authorities to support businesses and an extension of existing loan schemes for business. Furthermore, the government is extending the scheme whereby people can claim a repayment ‘holiday’ for up to 6 months for mortgages, personal loans and car finance.
The government hopes that the boost to aggregate demand will help to slow, or even reverse, the predicted decline in GDP. What is more, by people being put on furlough rather than being laid off, it hopes to slow the rise in unemployment.
At the meeting of the Bank of England’s Monetary Policy Committee on 4 November, further expansionary monetary policy was announced. Rather than lowering Bank Rate from its current historically low rate of 0.1%, perhaps to a negative figure, it was decided to engage in further quantitative easing.
An additional £150 billion of government bonds will be purchased under the asset purchase facility (APF). This will bring the total vale of bonds purchased since the start of the pandemic to £450 billion (including £20 billion of corporate bonds) and to £895 billion since 2009 when QE was first introduced in response to the recession following the financial crisis of 2007–8.
The existing programme of asset purchases should be complete by the end of December this year. The Bank of England expects the additional £150 billion of purchases to begin in January 2021 and be completed within a year.
UK quantitative easing since the first round in March 2009 is shown in the chart above. The reserve liabilities represent the newly created money for the purchase of assets under the APF programme. (There are approximately £30 billion of other reserve liabilities outside the APF programme.) The grey area shows projected reserve liabilities to the end of the newly announced programme of purchases, by which time, as stated above, the total will be £895 billion. This, of course, assumes that the Bank does not announce any further QE, which it could well do if the recovery falters.
Justifying the decision, the MPC meeting’s minutes state that:
There are signs that consumer spending has softened across a range of high-frequency indicators, while investment intentions have remained weak. …The fall in activity over 2020 has reflected a decline in both demand and supply. Overall, there is judged to be a material amount of spare capacity in the economy.
How effective these fiscal and monetary policy measures will be in mitigating the effects of the Covid restrictions remains to be seen. A lot will depend on how successful the lockdown and other restrictions are in slowing the virus, how quickly a vaccine is developed and deployed, whether a Brexit deal is secured, and the confidence of both consumers, businesses and financial markets that the economy will bounce back in 2021. As the MPC’s minutes state:
The outlook for the economy remains unusually uncertain. It depends on the evolution of the pandemic and measures taken to protect public health, as well as the nature of, and transition to, the new trading arrangements between the European Union and the United Kingdom. It also depends on the responses of households, businesses and financial markets to these developments.
- Covid: Rishi Sunak to extend furlough scheme to end of March
BBC News (6/11/20)
- Furlough extended until March and self-employed support boosted again
MSE News, Callum Mason (6/11/20)
- Number on furlough in UK may double during England lockdown
The Guardian, Richard Partington (3/11/20)
- ‘We wouldn’t manage without it’: business owners on the furlough extension
The Guardian, Molly Blackall and Mattha Busby (6/11/20)
- Sunak’s abrupt turn on UK furlough scheme draws criticism from sceptics
Financial Times, Delphine Strauss (6/11/20)
- Coronavirus: Bank of England unleashes further £150bn of support for economy
Sky News, James Sillars (5/11/20)
- Bank of England boss pledges to do ‘everything we can’
BBC News, Szu Ping Chan (6/11/20)
- Savers are spared negative rates but the magic money tree delivers £150bn more QE: What the Bank of England’s charts tell us about the economy
This is Money, Simon Lambert (5/11/20)
- Covid-19 and the victory of quantitative easing
The Spectator, Bruce Anderson (26/10/20)
- Will the Bank of England’s reliance on quantitative easing work for the UK economy?
The Conversation, Ghulam Sorwar (9/11/20)
- With a W-shaped recession looming and debt piling up, the government should start issuing GDP-linked bonds
LSE British Politics and Policy blogs, Costas Milas (6/11/20)
- Illustrate the effects of expansionary fiscal and monetary policy on (a) a short-run aggregate supply and demand diagram; (b) a long-run aggregate supply and demand diagram.
- In the context of the fiscal and monetary policy measures examined in this blog, what will determine the amount that the curves shift?
- Illustrate on a Keynesian 45° line diagram the effects of (a) the lockdown and (b) the fiscal and monetary policy measures adopted by the government and Bank of England.
- If people move from full-time to part-time working, how is this reflected in the unemployment statistics? What is this type of unemployment called?
- How does quantitative easing through asset purchases work through the economy to affect output and employment? In other words, what is the transmission mechanism of the policy?
- What determines the effectiveness of quantitative easing?
- Under what circumstances will increasing the money supply affect (a) real output and (b) prices alone?
- Why might quantitative easing benefit the rich more than the poor?
- How could the government use quantitative easing to finance its budget deficit?
Is there a ‘magic money tree’? Is it desirable for central banks to create money to finance government deficits?
The standard thinking of conservative governments around the world is that creating money to finance deficits will be inflationary. Rather, governments should attempt to reduce deficits. This will reduce the problem of government expenditure crowding out private expenditure and reduce the burden placed on future generations of having to finance higher government debt.
If deficits rise because of government response to an emergency, such as supporting people and businesses during the Covid-19 pandemic, then, as soon as the problem begins to wane, governments should attempt to reduce the higher deficits by raising taxes or cutting government expenditure. This was the approach of many governments, including the Coalition and Conservative governments in the UK from 2010, as econommies began to recover from the 2007/8 financial crisis.
‘Modern Monetary Theory‘ challenges these arguments. Advocates of the theory support the use of higher deficits financed by monetary expansion if the money is spent on things that increase potential output as well as actual output. Examples include spending on R&D, education, infrastructure, health and housing.
Modern monetary theorists still accept that excess demand will lead to inflation. Governments should therefore avoid excessive deficits and central banks should avoid creating excessive amounts of money. But, they argue that inflation caused by excess demand has not been a problem for many years in most countries. Instead, we have a problem of too little investment and too little spending generally. There is plenty of scope, they maintain, for expanding demand. This, if carefully directed, can lead to productivity growth and an expansion of aggregate supply to match the rise in aggregate demand.
Government deficits, they argue, are not intrinsically bad. Government debt is someone else’s assets, whether in the form of government bonds, savings certificates, Treasury bills or other instruments. Provided the debt can be serviced at low interest rates, there is no problem for the government and the spending it generates can be managed to allow economies to function at near full capacity.
The following videos and articles look at modern monetary theory and assess its relevance. Not surprisingly, they differ in their support of the theory!
- Modern monetary theory: the rise of economists who say huge government debt is not a problem
The Conversation, John Whittaker (7/7/20)
- Modern Monetary Theory: How MMT is challenging the economic establishment
ABC News, Gareth Hutchens (20/7/20)
- What is Modern Monetary Theory and is it THE answer?
Sydney Morning Herald, Jessica Irvine (2/7/20)
- MMT: what is modern monetary theory and will it work?
MoneyWeek, Stuart Watkins (14/7/20)
- MMT: the magic money tree bears fruit
MoneyWeek, Stuart Watkins (17/7/20)
- Modern Monetary Theory is no Magic Money Tree
Adam Smith Institute, Matt Kilcoyne (20/5/20)
- “Modern Monetary Theory” Goes Mainstream
Forbes, Nathan Lewis (10/7/20)
- How Boris Johnson’s Conservatives have become Magic Money Tree huggers
The Scotsman, Bill Jamieson (16/7/20)
- Ignore the impacts of debt-fuelled stimulus at your peril
Livewire, David Rosenbloom (14/7/20)
- Modern Monetary Theory, explained
Vox.com, Dylan Matthews (16/4/19)
- Compare traditional Keynesian economics and modern monetary theory.
- Using the equation of exchange, MV = PY, what would a modern monetary theorist say about the effect of an expansion of M on the other variables?
- What is the role of fiscal policy in modern monetary theory?
- What evidence might suggest that money supply has been unduly restricted?
- When, according to modern monetary theory, is a rising government deficit (a) not a problem; (b) a problem?
- Is there any truth in the saying, ‘There’s no such thing as a magic money tree’?
- Provide a critique of modern monetary theory.
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?