Behind the scenes, quietly, arguably even slyly, the Government and the Bank of England are executing plans to add up to a trillion pounds to the UK’s underlying public sector debt. It is an initiative that, if allowed to proceed, will mean doing the very thing governments are usually very keen to promise to avoid: burdening future generations with devastating debt. The permanent austerity that is likely to ensue will further increase inequality and inflict the economic pain of dealing with the 2008 Financial Crash and the COVID pandemic all over again. Even more disastrously, our ability to deal collectively with escalating crises such as the climate emergency will be crippled.
Similar programmes are under-way in the US and planned in the EU, though, at least in the EU, the scheme has been contested by leading economists. The initiative is called “Quantitative Tightening” (QT), and it is a dogmatic attempt to reverse the Quantitative Easing (QE) that was a core element of many governments’ response to the Financial Crash and COVID crisis. Our futures are to be sacrificed in an attempt to refute once and for all the existence of any “magic money trees”, by destroying the extra money and state purchasing power created by QE in the first place.
The basics
To understand QT we first have to grasp what it is trying to undo, which is Quantitative Easing (QE). QE involves a government’s central bank creating new money electronically, and then using it to buy debt, usually the government’s own debts. For example, as a result of QE the Bank of England now owns roughly a quarter of UK public sector debt.
Money itself, of course, is just a transferable claim on resources. A government can create money (“fiat currency” in the jargon) by simply issuing it and mandating that the money must be accepted as a form of payment anywhere that the government’s authority prevails. Note also that a government cannot receive such money back in payments, i.e. through taxation or any other receipts, unless the money has somehow been created in the first place: logically money creation must precede a government receiving any income in its own issued currency. The total value of such fiat currency in circulation then becomes simply equal to the total value of all the goods and services purchasable anywhere that the currency has to be accepted.
Importantly, money creation therefore doesn’t itself create value. Money is a claim on resources, but it isn’t in itself those real resources (as explained here: “Tulips and cryptocurrencies: is speculation theft” , to identify money with the resources it can claim is to fall into the error of thinking known as “reification fallacy”: confusing a representation of a thing with the thing itself). Therefore, when a government issues money it does not in any way directly increase the resources of the governed society. Instead what happens is a redistribution of purchasing power. A government that issues new money increases its own purchasing power at the expense of everyone else. Consider a highly simplified (and not very realistic) example, where a government doubles the issued money overnight, and uses it for its own spending (e.g. perhaps to buy back its own debts). As the resources to which the doubled amount of money can lay claim have not increased, that would halve the value of each unit of money now in circulation, but the government would still have increased its own purchasing power, by an amount equal to the size of the original money supply, which the government has now doubled, but halved due to the way the extra money has devalued each unit of money now in circulation. The government would therefore gain purchasing power equal to half of that of the original money supply, while everyone else’s purchasing power would have been reduced by the same amount.
There is no such thing as a “free lunch” but, when it comes to governments with their own fiat currencies, there is very much a “magic money tree”.
The problem of inflation
However, this is one clear disadvantage to magic money trees that is already implicit in what we have just discussed. The devaluation of money that follows from the creation of new money goes by another name: inflation. Nevertheless, there is a converse of inflation that can be even more damaging, negative inflation, or “deflation” in the jargon. Deflation can send an economy into a downward vicious circle, a “deflationary spiral” in the jargon, as few will buy anything today if they can anticipate it being cheaper tomorrow. It is for this reason that the consensus among economists is that a small amount of inflation is actually beneficial, which is why institutions such as the Bank of England have annual inflation targets normally of around 2%.
Of course, that is a situation far from the one in which we find ourselves at the time of writing. In times not so very long ago though, such as just after the financial crash, or during the peak of the COVID pandemic, it was deflation that was more of the clear and present danger. In that context the inflationary effects of money creation, through schemes such as QE, will be offset by deflation, possibly entirely, so any such “inflation” will not even be noticeable.
In a crisis, where the crisis is deflationary or at least the inflationary risk is low, the possibility of a government, provided it can and will be held democratically accountable for its actions, simply creating new money should be considered just as seriously as the other, generally more readily recognised, forms of fund raising: taxation or borrowing. In fact, if money creation is necessary to head off deflation, it should be taken more seriously. As Ben Bernanke, then a member of the Board of Governors the of the Federal Reserve System, later its chair, said of the American system in 2002, in a speech about countering the dangers of deflation, which he saw as the major cause of the Great Depression of the 1930s: “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” Exactly the same argument can be made for the central bank of any nation with its own fiat currency. A further key consideration here, though, is that to respond to a crisis we usually need to act collectively, and the way we act collectively, especially in a crisis, is usually through our governments, and that any such collective action therefore needs the government to rapidly expand its ability to claim resources by increasing its purchasing power, and that one way a government can instantly increase its purchasing is simply by issuing new money.
Furthermore, although the immediate effect of a government creating new money is to increase the purchasing power of that government, at the expense of everyone else who holds that currency, that situation is almost certain not to last long. After all, the government will have created the new money because it needs to spend it fairly rapidly. As the government spends that additional purchasing power the created money, or resources bought with that money, will spread back out again through the economy. Ideally, in an economic crisis, this would result in redistribution to help the poorest and worst affected. Indeed, it is arguably the redistributive potential of money creation that makes the political left instinctively more sympathetic to money creation than the right.
Unfortunately, though, in this instance the exact way of doing money creation, through the mechanism of Quantitative Easing, also had implications that were redistributive, but in the opposite direction, from the poorest to the richest, so increasing inequality. That’s because the government used the money it created to buy back its own debts from the wealthy institutions that already owned those debts, such as banks and pension funds. Those institutions, flush with cash but now with fewer government debts in which to invest, spent that money on other investments, such as in share buying, property buying or offering more mortgages. The result was to increase asset prices, most damagingly in the housing markets, and to make the richest, with their share and property portfolios, even richer. The QE created money tended to trickle up, not down. Though QE, by averting a general economic collapse after the Financial Crash, and allowing governments to generate the emergency funds they needed for their COVID response, was generally hugely beneficial, it is arguable that other mechanisms for money creation should have been found that would have produced those benefits without making the richest much richer and contributing to a housing price crisis.
Magic money trees are perfectly credible and enable effective collective resource management in emergencies. The QE funded responses to the Financial Crash and then the COVID crisis have, perhaps ironically given the eagerness of central bankers, and especially most politicians, to obfuscate the money creation nature of QE itself, proven the validity of this approach. It’s just the way of creating money through the QE mechanism itself that, in social justice terms, is highly questionable. Oddly, or perhaps not, the exact species of magic money tree “grown” by our societies, in Europe , the US and Japan, seems to favour the richest.
It is, though, the fear of inflation that primarily explains the bizarre contortions behind QE: in particular, the fact that created money was used to buy back debt, sometimes immediately, as the debt was issued specifically to be bought straight back. Central bankers are haunted by the spectre of periods of hyperinflation, such as in Germany in the 1920s, when the Weimar Republic attempted to pay Germany’s war reparations by printing money, meaning that the price of a loaf of bread increased by 12 500 000% from 1921 to 1923. The EU goes as far as to outlaw one form of money creation, where by a government’s central bank simply creates money and lends it directly to its government, in Article 123 of the Lisbon Treaty.
Furthermore, the initial intention of central bankers doing QE was not to increase government purchasing power as such, but to stimulate economies by countering deflation and lowering interest rates (by buying up debt QE reduces the opportunities for creditors like banks to make loans and so makes them more willing, especially once they have a surfeit of new QE cash, to loan at lower rates, in order to re-expand those loan books. QE turns credit into more of a borrowers’ market). The Bank of England’s own early stance on QE can be read here: “Quantitative Easing: Quarterly Bulletin 2009”. Back then, the amounts of QE undertaken were still relatively small, and few would have predicted either the slowness of the economic recovery or the pandemic crisis a decade later. Clearly, though, central bankers need to face the reality that, certainly by the time of the COVID crisis, with government bonds being issued and immediately bought back, QE had very much become a way to fund emergency government expenditure.
QE obscures the reality of money creation, evading pesky rules such as Article 123 of the Lisbon Treaty (by February 2021 the EU itself owned 25% of its own debt, as a result of €2.5 trillion worth of QE: “Cancel the public debt held by the ECB and take back control of our destiny”), and comes with an in-built potential for its own future unwinding, as the government debts that have been bought (generally called government “bonds”, as these are high-quality/low risk loans that are very likely to be paid back, but also called “gilts” in the specific UK case, just because UK government bonds were once printed on gilt-edged paper) can simply be sold back to the markets, and the money received then cancelled out of existence, destroying the money that was created by the QE in the first place. Alternatively, when the debts mature, and the amount borrowed in the first place, called the “principal”, has to be repaid, the proceeds from the debt being finally paid off can also simply be cancelled out of existence, rather than being reinvested into buying more government debt or refunded to the Treasury. Indeed, these processes, the reverse of QE, constitute the mechanism described as “Quantitative Tightening”, with selling debts back to the markets, but cancelling the money received, called “active” QT and simply allowing debts to mature, and destroying the proceeds, called “passive” QT.
A very brief history of QE and QT
It is also important to understand that QE itself, with governments creating money to buy back their own debt, even to the extent of raising debt specifically so it can be bought back, is a relatively modern invention, being initiated by the Bank of Japan in March 2001 (“Quantitative easing by the bank of Japan”). Back in 2009 QE was still regarded by the Bank of England as an “unconventional measure” (“Quantitative Easing: Quarterly Bulletin 2009”). We are still working out the full implications of large-scale QE programmes, meaning that the effects of any extensive QT are even less well understood, as QT itself is only just beginning (for example, the idea of selling debts back does appear in that initial Bank of England report, but not the phrase Quantitative Tightening or its corresponding acronym).
In the UK QT started in Feb 2022 with passive QT, that then turned into active QT, selling the gilts back to investors, in November 2022 with the sale of £750 million worth of gilts and a target of carrying out £80 billion worth of QT a year. The US Fed re-started passive QT in May 2022, after an abortive experiment in 2018-2019, and the European Central Bank plans to start passive QT in March 2023. The Bank of Japan has so far resisted QT. Notably, the Bank of England is the first central bank to initiate active QT, and would have started the process even earlier, had it not carried out a further little flutter of QE in late September and early October 2022 in order to support the price of UK government bonds and avert a crisis for UK pension funds, after the disastrous Truss/Kwarteng mini-budget. In the end that amounted to £19 billion of further bond buying.
There is not yet, and may never be, a consensus as to how much QE contributed to the current wave of global inflation. For the vast majority of the duration of the active QE programmes inflation rates in most of the affected countries were low, so, outside of some specific areas such as share and property prices, any more general inflation caused by all that extra money was counter-balanced, as was anticipated, by deflation, so resultant “net” inflation was fairly negligible. However, there could have been some lagging effects: for example higher property prices, even in a context of lower mortgage rates, may eventually feed into rents and thereby add costs to the general economy. It is also probable that the COVID crisis related QE, and low interest rates generally, were continued for too long. Nevertheless, it is fairly clear that inflation is caused by the ratio of active purchasing power (basically money in circulation) to the resources that can be bought, so inflation or deflation can be caused, not only by changes in the money supply, but also by changes in the resource supply. It is changes in the resource supply that better match the timing of the current inflation wave: starting with COVID related disruptions to supply chains, then the huge shock, especially to energy prices, caused by Russia’s invasion of the Ukraine, all amplified by climate change induced extreme weather events and, for the UK, Brexit. On balance, it seems reasonable to assume QE had an effect, but not the major effect.
Where QE reduced people’s purchasing power the damage is also now very probably already done, and in general terms irreversible, as a broad lowering of prices, meaning negative inflation, would potentially stop the economy and lead to a deflationary spiral. The best that can be hoped for now is to slow the rate at which prices are rising. QE itself has stopped increasing the money supply, so it should no longer be contributing to inflation. The downside effects of QE have already been felt, which is another reason why accepting any re-application of the pain through QT seems very unreasonable, like asking people to pay the same bill twice.
The real trillion pound nightmare
Irrespective of to what extent QE led to currently increased price levels, it is still valid to ask whether the inverse of QE, Quantitative Tightening, and destroying all that QE created money, could help save us from ongoing inflation. Taking hundred of billions of pounds out of circulation would almost certainly have a significant downward effect on inflation, but only by reducing purchasing power generally. After all, QT reduces inflation by suppressing spending. At this point it is therefore essential to ask if it is really inflation itself that is the concern, or the cost of living crisis, where most of the UK population is suffering from falling real term incomes, to the extent that many are unable to afford basics such as heating or food. Clearly, the cost of living crisis ought to be our main issue here, and, once that is accepted, it becomes apparent that QT would not help at all: any fall in price rises would be counter-acted by fewer pounds in people’s pockets, as it is through those fewer pounds in people’s pockets that QT has its deflationary effects in the first place. QT would therefore not help address the cost of living in the slightest. A far more effective way to remedy the cost of living crisis is to deal with the resource shortages and price gouging that are primarily causing it in the first place (as explored here: “The cost of living crisis: how to destroy lives, wreck your economy and lose the economic war with Putin” . Note that most of those measures require more headroom for public spending, not less).
Of course, there are also distributional effects to consider. Perhaps QT could reverse the increases in inequality caused by QE, and there-by make the general population better off. Unfortunately, this scenario is highly unlikely: in fact QT will almost certainly exacerbate inequality still further. Consider: QT involves the government selling debts back to the markets, increasing the demand for credit, and turning the “borrowers’ market” under QE into a “creditors market” where interest rates rise again. This is a situation that benefits those individuals and institutions with money to lend, i.e. the richest, at the expense of the less well off, such as those struggling to pay mortgages. There is a “heads they win, tails you lose” flavour to QE and QT: it seems more likely than not that both mechanisms favour the richest.
To explore this further it is useful to put some figures around the likely financial effects of QT.
As at November 2022 the Bank of England held £744.9 billion of UK government gilts, amounting to about a quarter of total public sector debt (ONS: Public sector finances, UK: November 2022, taking total debt as Public Sector Net Debt excluding the Bank of England, the currently officially preferred measure of underlying public sector debt in terms of UK government targets, which was £2170 billion, and adding back in the £744.9 billion redemption value of the gilts currently held by the Bank of England.). So that is the scale of the public sector debt the Bank of England is aiming to sell back to the markets via QT.
Then we also have to factor in significant potential losses arising from first buying and then later selling those gilts. Counter-intuitively, the original, or redemption value, of a government gilt is not usually equivalent to the amount for which the gilt can be sold on in the markets, and, importantly, that market value moves in the opposite direction to interest rates. That’s because the amount of interest payable on most government gilts is a fixed proportion of its redemption value, called the “coupon” in the jargon. That coupon doesn’t change as general interest rates go up or down, which causes the market price of gilts to change instead. For example, if interest rates go up buyers won’t purchase a gilt unless the “yield” they could earn on that gilt purchase is comparable to what they could earn by loaning out the same amount of money at the then prevailing interest rate instead, so if interest rates go up the market value of gilts falls, causing the fixed coupon to constitute a higher proportion of the gilt’s market value. As QE programmes bought gilts in deflationary periods when interest rates had already been lowered (in an attempt to stimulate the economy) but QT is being initiated during an inflationary period, when interest rates are higher, the market price of the QE purchased gilts was higher when the gilts were bought than when they are being sold. The government will therefore make a further loss on those gilt sales of about £100 – £200 billion (See: “Monetary policy and the value of Public Debt”).
Remember also, and this essential, that the government doesn’t get to keep any of the proceeds from selling those gilts, as the whole point of QT is to cancel out, destroy, the money created by QE in the first place. The money received from selling those gilts back to the markets will simply cease to exist, in an exact reversal of the money creation involved in QE, and with the precise intention of doing specifically that, of destroying money in order to reduce the money supply and the threat of inflation. Hence the title of this article: and though that title should have talked of “up to” a trillion being added to the public sector debt it is clearly in reality most likely up to but “close to” a trillion, which doesn’t make for a very snappy strapline. Another simplification in that title is that active QT, selling back those gilts to the market, adds to the public sector debt in the manner described, but passive QT, simply letting the gilts mature and then destroying the principal as it is paid back, instead runs down government reserves, though, of course, that could in itself lead to the need for more government borrowing. Either way the important thing to note is that up to and close to a trillion will be wiped off the public sector balance sheet.
As mentioned above, the current HMG and UK Office of Budget Responsibility (OBR) favoured measure of public sector debt is public sector debt excluding the Bank of England, in order to exclude all these QE related debt purchase effects and other fairly technical operations of the Bank of England as the UK’s central bank. That measure of public sector debt therefore excludes the gilts now owned by the Bank of England itself. As soon as those gilts are sold back into the markets, though, they become “real” debts again in the sense that those debts are then owed by the UK state to other entities, and so those debts get added back to public sector debt excluding the Bank of England.
Now, pause for a moment to consider what adding hundreds of billions to the government’s favoured total of public sector debt (remember, that was £2170 billion in November 2022) would mean to the government’s spending plans, especially those of a government controlled by a political party already predisposed to austerity for reasons of ideology and the self interest of its donors. Then we can forget austerity 2.0: think more, as the title of this piece suggests, “eternal austerity” instead. Think about the current state of our public services, especially the NHS, and the plight of many public sector workers, and the millions requiring help with the cost of living crisis. Bear in mind that austerity isn’t about people just being a little less “comfortable”. Austerity kills, with a recent study linking 330 000 British deaths between 2012 and 2019 to austerity (“Over 330000 excess deaths in Great Britain linked to austerity finds study”) and the current rise on excess deaths in the UK being associated with under-funding of the NHS (FT: “The NHS is being squeezed in a vice”). Then throw in the need to respond rapidly to the catastrophic climate emergency, or to better protect ourselves from future pandemics, and it is clear that QT is extremely ill-judged..
Then QT can come to seem not as a mere item of obscure financial engineering best left to the experts, but as a a clear and significant threat to the people of this country. Rather than correcting the inequalities caused by QE the rewinding of QE via QT is likely to do precisely the opposite. The QE created money will stay with the richest, while the money to compensate for that destroyed via QT will eventually be demanded from the poorest, through cuts to wages, benefits or to services such as free healthcare, or via broadly regressive tax rises, e.g. to council tax, VAT or national insurance. It is odd, or again perhaps not, that our society’s main weapon for fighting inflation is to expect its generally poorer members to get poorer, on the promise that eventually, in the jam tomorrow that never comes, at least certainly not since the Financial Crash, they will then paradoxically somehow get richer. That strategy seems even more peculiar when, as we have seen, the acknowledged main factors causing inflation are on the supply-side.
Then there is the question of interest. Currently the public sector, via the Bank of England, owns the QE purchased portion of its own debt, so no interest on that debt is payable to external parties. That interest becomes due again as the gilts are sold back into the markets. Ironically, though, interest payments are one reason why some economists argue in favour of QT, because they assert that QT will actually, counter-intuitively, save on overall public sector interest payments.
The role of Bank of England reserves, the argument in favour of QT and the controversy over Bank of England interest payments.
The reason it is possible to make this claim is because of the way central banks like the Bank of England work. Basically, a central bank is the commercial banks’ own bank. Whenever money has to be transferred from one commercial bank to another, this is done via accounts that those commercial banks hold at the Bank of England. If this wasn’t the case, each commercial bank would only be able to settle with any other commercial banks if every bank held accounts at every other bank, a much more complex and clumsy system.
The monies held by those commercial banks in accounts at the Bank of England are called “reserves”. Reserves are best thought of as an electronic equivalent of physical currency. In a way directly equivalent to the printing of notes or the minting of coins, reserves are only created by the Bank of England, and can only potentially be destroyed by the Bank of England when the reserves are returned and back under central bank control. Therefore, though each commercial bank can vary the amount of money it keeps on reserve at the Bank of England, the total amount of reserves can only be changed by the Bank of England.
Now this Bank of England “electronic money”, these reserves, do not define the total amount of money in circulation. Banks lend more money out than the reserves they hold, with this temporary money being destroyed when those loans are paid back, so the banks cannot retain this temporary money, but do profit from the interest they can charge on those loans. Most of the money in circulation at any time is actually this temporary money. Commercial banks are allowed to lend out more money than they hold provided they have sufficient reserves and capital to cover any reasonably conceivable claims on the bank at any time. Over the course of any day (when the banks are conducting business) customers at the commercial banks will transfer money, and those transfers will be between different banks, if those customers hold accounts at different banks. Overall, on average, most of those transfers should broadly cancel out, with the money transferred from each bank roughly equalling what is transferred into it, but still, at the end of each day of banking, the banks have to settle any remaining debts with other, and they do so by transferring those reserves between each other’s accounts at the Bank of England, in a process called “clearing”. Thus, movements of the reserves between commercial bank accounts at the Bank of England mirror the transfers of the main bulk of money in the actual economy (there is other money too, such as notes and coins, but what we have just described covers the workings of the main money supply).
Similarly, the Government itself holds reserves at the Bank of England. In the words of the Bank of England itself: “When the government increases its balance at the central bank, through collecting taxes or issuing debt, it does so at the expense of the balances of commercial banks: when it reduces its balance, through expenditure or paying salaries, it does so by increasing the reserves available to commercial banks.” (BoE: “Understanding the central bank balance sheet”). Therefore, the reserves also move backwards and forwards between the government accounts and the commercial bank accounts.
The relevance of all this to QE is that when the Bank of England bought back government debt with money it had just created, that just created money took the form of reserves in the accounts of commercial banks at the Bank of England. Irrespective of which institution really sold those gilts back to the Bank of England in the first place, and, regardless of how that money has flowed around since, the upshot is that those reserves, though they will have been transferred back and forth between the different reserve accounts at the Bank of England many times, are still held in those accounts at the Bank of England.
This creates a problem, as, since 2006, the Bank of England has paid interest on the reserves held in the commercial bank accounts (prior to 2006 interest wasn’t paid). This was done to give the Bank of England another way to influence interest rates, on the assumption that the commercial banks would be unwilling to themselves lend at rates lower than they could earn risk free on their reserves at the Bank of England, so this rate was intended as an interest rate floor. Back in 2006 the cost of doing this was low because interest rates were low, and they were even lower during the period of QE, so buying back gilts, say with fixed interest rates of 2.1%, by expanding the commercial bank reserves (with that QE created money), on which the interest rate was only often 0.1%, saved the public sector tens of billions in terms of the costs of servicing its debts.
Once inflation hit and interest rates started to rise again (basically to contract the money supply, i.e. to reduce the amount of all that commercial bank “temporary money” that is introduced into circulation through loans, by making borrowing more expensive) this situation reversed entirely.
It is here that the argument in favour of Quantitative Tightening comes in. With the interest rate on the reserves now higher than the interest rate on gilts, it reduces government debt servicing costs if it now sells the gilts, with the private sector buying those gilts using the commercial banks reserves. That reduces those commercial bank reserves. Effectively government debt is swapped for a form of debt (the reserves) that pay a higher interest rate back to one (the gilts) that pays a lower interest rate. This approach does, however, come with an immediate downside. With the general interest rate being significantly higher than the fixed interest rate (in terms of redemption value) of the gilt, the “coupon”, the gilts themselves have a market value lower than their redemption value, which in turn will usually be much lower than the market value at which the Bank of England originally purchased the gilts. Therefore this approach realises the potential losses we mentioned above.
However, this in itself begs an obvious question. At a time of increasing interest rates, should the Bank of England continue to pay interest on the bulk of those commercial bank reserves? By June 2022 the New Economics Foundation was estimating that, by stopping paying interest on most of the reserves, and only paying an interest rate on the top tier, so still allowing that rate to influence market rates, the Government could save £57 billion over the next 3 years (FT: “Sunak urged to save £57bn by withholding BoE interest on reserves”). The Institute of Financial Studies then repeated the same point in October 2022, when it was proposing very similar reforms: “Given the Bank currently holds around £800 billion of gilts, Britain’s debt-servicing costs are highly sensitive to even small changes in the path of Bank Rate (Section 7.3). Taking current (6 October) market expectations for a substantial rise in Bank Rate together with the Bank’s current published plans for unwinding QE, the implied savings would be between around £30 billion and £45 billion over each of the next two financial years. These are big numbers, and would of course be even bigger if the Bank does not actively unwind QE via asset sales but lets it roll off as bonds mature.” (IFS: “Quantitative easing, monetary policy implementation, and the public finances”) Basically the emerging consensus, amongst financial experts outside the Bank of England, is that the Bank should pay a tiered interest rate on the reserves, with each commercial bank being required to hold a certain amount of reserves at zero rate, but with reserves above a certain level still being paid interest at the Bank of England headline rate, so that the headline rate would still underpin interest rates generally. At the time of writing, though, the Bank of England was still refusing to act (Reuters: “BoE won’t accept interference over interest payments”).
To put this issue in perspective, the sums discussed would comfortably avoid any public sector workers taking real term pay cuts (“How much would a public sector pay rise really cost the UK government”).
With such reforms in place, the argument for QT on the basis of managing the costs of servicing public sector debt loses its justification.
What to do
Once the justification of savings on debt servicing is removed we are left with QT as a mechanism that won’t reverse any of the significant downsides of QE, such as the increases in inequality or any general price rises, which may have once been due to QE driven expansion of the money supply. As deflation is not permissible we are stuck with those general price levels now. QT could help dampen any further prices increases, but most likely by ultimately taking the money to be destroyed from the pockets of the vast majority of people, so doing nothing to address the cost of living crisis. Meanwhile QT is intended to increase interest rates, further impoverishing borrowers, such as those with mortgages, though, on the upside, there is a possibility that could stop house price rises, possibly even reduce them slightly, but, as the construction industry is a major driver of economic growth, if those falls were significant a deflationary spiral would again be likely.
Meanwhile the effect of QT on the public sector balance sheet will be negative to the tune of eventually nearly a trillion pounds: passive QT cancels out public sector reserves, while active QT recreates real underlying public sector debt. QT further constrains the government’s headroom for spending at the same time as it makes an austerity programme focussed on reducing public sector debt ever easier to justify. With widespread impoverishment, collapsing public services, the likelihood of further global health crises, from pandemics to antibiotic resistant infections, and, last but very, very much not least, the climate emergency, continuing and never-ending austerity will be disastrous for nearly all of us. On top of all this, we are also currently engaged in an economic war with Russia, with obvious impacts on prices, especially for energy.
In this context to continue to pursue QT, in fact, in the case of the UK, to be the global frontrunner in implementing QT, all just to dogmatically “prove” that there isn’t a “magic money tree”, when obviously the success of QE in mitigating the effects of the Financial Crash and the COVID crisis has very much already proven that there very much is a magic money tree, is insane.
So, first and foremost, QT must be stopped immediately.
What, then, should we do about QE?
Step one would be to address the issue of the extra interest now payable on all those QE created commercial bank reserves by implementing the tiered interest reforms outlined above.
The most obvious step two is to do nothing. The gilts at the Bank of England have maturities set at 5 – 20 years, so we could just allow them to mature and, when they mature, and the Treasury pays off the principal of the loan, refund that payment back to the Treasury, or simply not require the payment from the Treasury in the first place, rather than wiping that money out of existence (as that would be passive QT). This would be equivalent to a gradual cancellation of this gilts.
There is a problem with this plan though: in fact with any cancellation of those gilts. It comes back again to those commercial bank reserves at the Bank of England.
In terms of the internationally accepted conventions on how central banks do their accounting, those reserves are regarded as liabilities, while the gilts the Bank of England purchased, via QE, are assets (remember, in theory those gilts now represent money owed to the Bank of England from the Treasury). If we cancel those gilts we eliminate those Bank of England assets while leaving the corresponding liabilities, those commercial bank reserves, still in existence. The Bank of England balance sheet would become significantly negative, and no one is certain as to what the side-effects of allowing that to happen could be.
Now, the reserves are very strange liabilities. As argued here by a former head of the OECD’s General Economics Division (“Monetary policy and the value of Public Debt”): “Note that the central bank’s liability is a very odd liability indeed. Unlike the case of government bonds, settlement of the central bank’s liability can never be demanded, even in principle. Bank reserves are money, the stuff in which all transactions are settled. If banks were to demand repayment of the liability that demand would be meaningless. Ever since countries abandoned the gold standard bank, reserves have become the ultimate money. Moreover, the commercial banks are not rendering any service to the Bank of England in lodging their reserves with it. On the contrary, it is serving them by acting as a clearing house for inter-bank transactions and by acting as lender or borrower of last resort should their own lending operations leave them short or long of liquidity. Payment of interest on bank reserves is not the result of any obligation, legal or moral. It is simply a pragmatic policy choice, a device used to control the credit activities of commercial banks.”
It is arguable that if the Bank of England was a commercial outfit it would be charging a service or account fee rather than paying interest, but at the moment this is how the usual rules on banking stand: those reserves are treated as liabilities. We also need to remember that it isn’t sensible to simply cancel hundreds of billions of pounds worth of those reserves, as those reserves are broadly and ultimately “backing” everyone’s actual money.
This problem is solvable. Seemingly the issue of QT has generated the most public discussion in the EU, which is possibly why the European Central Bank has somewhat dithered on the issue. Despite the Bank of England currently leading the way on QT, the issue is barely mentioned in the UK at all. In the USA most controversy has arisen amongst financial pundits concerned that QT could suck sufficient liquidity out of the markets to cause another crash (FT: “Fed’s faster ‘quantitative tightening’ adds to strain on bond market”), where as in this article we have only covered the effects of QT on public finances . However, in the EU, more than a hundred economists from across Europe, including Thomas Piketty, signed an open letter to the ECB opposing Quantitative Tightening (“Cancel the public debt held by the ECB and take back control of our destiny”). Their suggestion regarding the ECB is this: “Let it cancel the debts that it holds (or transform them into perpetual debts with 0% interest rate) and let the European states commit the same amount to a widespread social and ecological recovery plan. “
It’s the perpetual debts with 0% interest that seems to be the most realistic plan. Then an “asset” item remains on the Bank of England balance sheet to offset those reserve liabilities, but there’s no need to do any financial engineering to cope with parts of the debt maturing or to deal with transfers of interest. Nor would this Bank of England asset really have to be perpetual. Eventually more sensible central bank accounting rules could be widely adopted, that don’t, by convention, treat those reserves as liabilities, for example by excluding them from the central bank balance sheet altogether. One day, there will also be further fundamental reforms to the banking system itself (for example, possibly on these lines: “Sovereign money: an introduction”). Failing all else, the real term value of that zero interest debt would eventually decline to the point that it’s cancellation would be uncontroversial.
Conclusions
There are two main but essential conclusions.
To avoid crippling the purchasing power of the public sector at a time of multiple, interlocking crises, and passing on a significant debt burden to future generations, Quantitative Tightening must be stopped immediately, both in its active and passive forms. Doing further Quantitative Easing right now, at a time of high inflation, is deeply undesirable, but we must accept the existence of the QE already done, all the more so as, for the immediate future, doing any further QE would be extremely difficult to justify. In terms of central bank accounts, that means converting those central bank assets to zero interest debts with no maturity date. It also requires the adoption of a tiered interest rate on the QE created reserves payable by the central bank, so that those reserves can continue to exist, even at a time of rising interest rates, without also imposing a serious strain on public finances.
Secondly, and more generally, the success of QE in both averting a global economic depression after the Financial Crash, and then rapidly making trillions of pounds/dollars/euros available to support governments’ COVID responses, without crippling public finances or the economy, means that we have proven that it is perfectly valid, sometimes, for governments to fund themselves through money creation. Of course, nothing is really magic, and so this doesn’t equate to governments being able to conjure resources out of thin air, but it does allow them to instantly redistribute purchasing power, in a way that can be perfectly appropriate to deal with public emergencies, provided said governments can be held democratically accountable for such actions.
As the Quantitative Easing way of creating new money, by buying back debt from financial institutions, has a strong tendency to make the richest even richer, as well as involving some contortions in terms of public accounting, other ways should be found to create new money in future, such as directly spending that money into the economy to meet critical needs. Nevertheless, creating new money should always be done with extreme caution, as issuing new money inevitably devalues that money generally, but will cause little or no measurable inflation in a context where the underlying pressure on prices is deflationary. Money creation should therefore be wrapped around with tight controls, and conducted with due regard to inflation targets, perhaps 2 %– 4% annual inflation most of the time,
The Weimar Republic became notorious for a policy of money creation so reckless it caused one of the most infamous intervals of hyperinflation in history. It is likely, however, that a policy of wiping out trillions of pounds/dollars/euros from public sector purchasing power, over the next decade or so, at a time of major global emergency, not least because of the existential threat of climate change to the survival of human civilisation, would in future, if there is one, be seen as even more insane. Quantitative Tightening must be stopped now.
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