The money go round – quantitative easing

The news yesterday that the French and German economies grew a little in the second quarter whilst the UK one was still plunging has led to reappraisal of the UK strategy. The UK kept interest rates too high for too long in 2007-8, as I pointed out at the time. Modest recovery will come in the UK, but lower interest rates always takes sometime to filter through. We should see some benefit from late 2008 cuts in rates before the end of this year.

The UK’s curent policy is for the government to pre-empt most of the cash for its own borrowing needs, and then to lecture the banks on how they ought to be lending it to someone else! Let’s just remind ourselves what quantitative easing entails.

The Bank of England buys let’s say £5 billion of government bonds from investors. Shortly afterwards the UK government issues another £5 billion of bonds to meet its immediate cash needs by borrowing.Very often the bonds the Bank buys are similar in interest and length of time to repayment as the new bonds the government is issuing.

Who benefits from these transactions? Dealers in bonds do, as there is more turnover and more commission. Investors in bonds may do, as often the terms offered on the new bonds they buy may be slightly better than the terms surrendered on the ones they sell back to the authorities. Foreigners benefit, as some of them just sell their government bonds for cash, and move out of sterling if they are nervous of the UK future. The biggest winner is the government, which finances its large deficit relatively easily.

Some of the UK sellers of bonds do not immediately buy new ones. They deposit the proceeds of their sales in banks. Banks money holdings go up. The Regulator tells the banks that they must keep more money liquid and must not lend this out to the private sector. So the banks use the new cash deposited to buy government bonds themselves, as these are regarded by the Regulator as safe and liquid assets.

Current policy is to push more cash into the system, but to demand more caution by the commercial banks. This policy will help the government borrow the money it needs without too much competition for funds. We should not expect it to release large sums for private ventures or to help companies. It is a policy to make financing the deficit easier before the election. It is interesting to note that the net deficit is forecast at £175 billion this year, and by coincidence the approved quantitative easing programme is now also £175 billion.

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30 Comments

  1. Brian Tomkinson
    Posted August 14, 2009 at 8:13 am | Permalink

    Clearly the Bank of England is not independent but a puppet of this disastrous government being complicit in this scheme. I keep saying it but with every day it seems more certain that the strategy is to print money to finance government profligacy and stoke up inflation, encourage the devaluation of the pound adding further to inflation and hope that they can eventually succeed in inflating away the colossal government debt.

    • Adrian Peirson
      Posted August 16, 2009 at 2:04 am | Permalink

      Almost correct, the Govt are Puppets of the Bank of England, which is Not the Bank of England.

      I give you 7 out of ten for at least having Puppets, Govt and Bank of England in the same sentance.

      • Atlas shrugged
        Posted August 18, 2009 at 1:23 am | Permalink

        Quite so, give that man a gold star. The question is. Why does John Redwood seem not to know, what is so obviously and historically the case?

        Is John Redwood telling porkies, or is he just genuinely ignorant.

  2. A.Sedgwick
    Posted August 14, 2009 at 8:47 am | Permalink

    Your last sentence states the point of qe – this government is printing money to help finance its deficit. Do as I say not do is the way with dishonourable governments. No doubt many over exposed companies, families and individuals would like to do the same.

  3. Donna W
    Posted August 14, 2009 at 9:11 am | Permalink

    Printing money in the quantities already carried out and now planned will only end one way – in a few years’ time we will have the dragon of inflation to slay all over again.

    But that is probably what Gordon wants. Labour will blame the Tories for allowing inflation to run wild, knowing that most of the population is so financially illiterate they won’t link it to his quantitative easing.

    Someone needs to start explaining this to the electorate in words and examples they understand, John.

    Gordon’s policy is probably the most cynical of all his cynical policies. Whilst pretending to care about the elderly and people on limited or fixed incomes generated by savings, he is actively pursuing a policy which will destroy their savings and will impoverish them. He is a (unflattering term).

  4. Robert K, Oxford
    Posted August 14, 2009 at 9:46 am | Permalink

    A very neat anlaysis. I would be interested on your thoughts about the impact of QE on the money supply once the velocity of money starts to increase. With this amount of liquidity being pumped into the system surely there is a significant inflation risk

    • Mike Stallard
      Posted August 15, 2009 at 5:52 am | Permalink

      But is there? For the moment, the government is, in effect, printing then taking the money out of the system for itself. It is then pouring money into the bureaucracy who spend it as they did before.
      So, in effect, no new money is pouring into the system: it is the same as it was in 1997.
      This means that prices within the country are not gong to be affected.
      The danger, of course, is when international bankers and Standard and Poor’s pull the plug. At the moment, the plug seems to be holding.

      • Robert K. Oxford
        Posted August 17, 2009 at 11:12 am | Permalink

        Well, in fact the government is not taking money out of the system. Instead, as you rightly say, it is pouring money into the bureaucracy from where it flushes into the wider economy. This illustrates how inflation is one of the three types of taxation – the other two being borrowing and direct/indirect

  5. APL
    Posted August 14, 2009 at 10:30 am | Permalink

    JR: “The news yesterday that the French and German economies grew a little in the second quarter ..”

    Imports to the French and German economic zones plunged like many other countries, making their figures look better. It does suggest though that the internals of these economic zones are suffering like many other countries. Like many other economic zones discretionary spending is dramitically down.

    Our government is modling the cash incentives for purchasing new vehicles on the German model. It is s stupid idea because it is a self defeating initiative.

    Presumably for export led economies if other countries are reducing their inports then that must in due course hit those countries that export. It’s too early to call summer for these to countries.

  6. Acorn
    Posted August 14, 2009 at 10:30 am | Permalink

    This “money go round” thing ain’t arf complicated. As an amateur trying to increase my knowledge of macroeconomics I am getting more confused by the day.

    For instance the “reserve balances” at the BoE, dropped by £30,000,000,000 this week. I am assuming that this is QE that is parked at the BoE by commercial banks and the like, balancing out all sorts of crap that remains on said bank’s balance sheets that has yet to be marked to market ???. There was a flurry of rule changes by the DMO and the BoE last week, are the two connected; don’t know.

    I am also unclear on the difference between what the BoE is doing on QE and what the DMO is doing; they seem to be one and the same, don’t know.

    Some light is cast on my dilemma by the Annual Report and Accounts 08/09 from the DMO. For those Redwoodians as sad as I am, it is well worth reading the whole thing. It does go some way to explaining the role of the National Loans Fund; the DMO and it’s DMA (Debt Management Account); plus the BoE; CRND; PWLB etc. It is nearly understandable for the amateur, (except for the accounts of the Debt Management Account)

    http://www.dmo.gov.uk/documentview.aspx?docname=publications/annualreports/dmodmarep2009.pdf

    The BoE balance sheet is at:-

    http://www.bankofengland.co.uk/publications/bankreturn/2009/index.htm

    The DMO rule changes are meaningless to the non-bond trader but are here, (06-Aug 2009 publication date entries):-

    http://www.dmo.gov.uk/reportView.aspx?rptCode=D8D&rptName=50661152&reportpage=Press_New

    Perhaps I should stop reading this stuff and wait for the movie that explains it all. Ahhhh, that sounds like a job for Mr Redwood.

    • james harries
      Posted August 15, 2009 at 11:38 pm | Permalink

      I’m baffled too.
      Perhaps the origin is in the contradictory demands made of banks:
      1. Lend more money
      2. Hold more reserves
      I can’t see how this can be done unless we admit the bail-outs are a gift, not a loan.
      That is politically impossible?

  7. david
    Posted August 14, 2009 at 10:35 am | Permalink

    I see Mr Cameron has referred to Mr Hannan as an ‘eccentric’.

    http://twitter.com/paulwaugh/statuses/3305111320

    I’m sure you’d agree.?

  8. alan jutson
    Posted August 14, 2009 at 11:47 am | Permalink

    John

    What is the chance of you giving your views on the UK Financial System/Banks and Government Department spending at the Conservative Party Conference in a few weeks time.

    Reason for asking:
    I know of no one else in any other Political Party who seems to have such a grasp of either subject, with regard to what exactly the problems are, and some positive solutions to resolve those problems.

    When you are calm and are given time to explain things clearly, your comments seem like the sort of basic commonsense we all apply to our own situation and lives.

    It isn’t rocket science, but others seem to try and make out it is.

    The electorate need to be made aware of exactly what is going on at the moment and the consequences of the action which is being taken.
    Our Government needs to be exposed with actual facts and statistics, in order to epose the media campaign which they are pushing out.

    Its a world wide recession.
    Its a world wide Banking crisis.
    We are investing in the future.
    No cuts in Government spending

    DC if you are reading this, think about it, and think long and hard, I do not think you will find a better candidate for this task.

    Reply: I will do so – I have a couple of fringe meetings pencilled in.

    • alan jutson
      Posted August 14, 2009 at 2:41 pm | Permalink

      That is good news, but you deserve a larger stage me thinks.

      • Mike Stallard
        Posted August 15, 2009 at 5:58 am | Permalink

        Absolutely: this stuff is simply not out there. I check this with my wife; she doesn’t know what QE actually is!

    • APL
      Posted August 14, 2009 at 9:43 pm | Permalink

      Alan Jutson: “Its a world wide recession.”

      It is.

      “Its a world wide Banking crisis.”

      It is.

      “We are investing in the future.”

      No of course the Labour government doesn’t know what investment means.

      “No cuts in Government spending”

      There will be no cuts in government spending before the next general election, if Gordon Brown has to knaw his own leg off to make sure. That way when the new government comes in, and the true state of the economy is manifest, the labour party can squeal ‘ look, we told you, Tory cuts’.

      Of course, because of the behavior of this Labour government, the cuts implemented by the next will have to be deeper and more savage than otherwise might have been the case.

  9. oldrightie
    Posted August 14, 2009 at 11:53 am | Permalink

    The downstream consequences of this will be horrific. Since it will be a Conservative Government that will carry the can it’s good politics for Brown, disgraceful immorality. Labour to a tee.

  10. Steve Cox
    Posted August 14, 2009 at 12:05 pm | Permalink

    It’s currently a monetary fantasy land, where billions of pounds are magicked up as if by Harry Potter. As you say, some people are making a lot of money out of it, but as always the bill will be left with the taxpaying and saving public.

    The elephant in the room is how and when to reverse QE in such a way as not to cause ruinous inflation. The government doesn’t know and couldn’t care, as it knows that it is on Death Row. More worryingly, Mervyn King and his so-called experts on the MPC (adverse comments left out) appear to have no idea either.

    The banks now have more money on deposit at the BoE than there is cash in circulation in the UK. What happens when they decide to start lending that? Or the BoE/FSA forces them to?

    Weimar Republic/Zimbabwe, here we come.

  11. Josh
    Posted August 14, 2009 at 12:08 pm | Permalink

    I have no problem with the policy of Quantitative Easing. The output gap is far too large for inflationary pressures to build up, and capacity utilisation is at an all time low. However, what I am furious with is that most of the asset purchases have been of government bonds. We should be buyings lots of corporate bonds and charging an interest rate on any hoarded capital. The FSA should lower its reserve requirements now until the economy starts to go again, and then the Bank can sell back all of these bonds, reduce the money supply and get back to a more sustainable footing.

    Milton Friedman’s greatest lesson to us all was that monetary policy is far more powerful than the Keynesians gave it credit for. Between 1929-1933, the Fed let the money supply fall by 1/3, with absolutely disastrous circumstances, turning what should have been a normal cyclical downturn into the worst depression in history.

  12. Mark
    Posted August 14, 2009 at 12:36 pm | Permalink

    Your analysis is spot on: we can expect QE to increase still further as the forecast deficit turns into a nastier reality.

    The elephant in the room you don’t mention is the other big consumer of borrowed funds – the mortgage market. It would appear that banks are being encouraged to pump what little cash they are prepared to lend into housing in a bid to reflate the bubble and create more illusory “wealth”. It is clear that Northern Rock has been specifically mandated to do this, and it seems the other state banks are expected to follow suit. At the end of 2000, mortgages outstanding amounted to £533bn according to the Bank of England. The latest statistics show mortgages outstanding are now £1,226bn – almost £700bn more: an amount greater than the officially acknowledged government debt. The amount is very similar to the customer funding gap, which rose from zero to over £700bn by the end of 2008: somewhat over £300bn of this was met by direct borrowing abroad by UK financial institutions (and presumably much of the remainder by selling (mortgage backed) securities abroad via hedge funds and other intermediaries). See the chart on page 2 here:

    http://www.bankofengland.co.uk/publications/fsr/2008/fsrsum0810.pdf

    As usual, Alice Cook has some pertinent observations:

    http://ukhousebubble.blogspot.com/

    Another way to look at this is to say that if we regard house prices as being roughly sane in 2000, we could adjust the expected mortgage outstanding for general inflation and net investment in housing (new builds plus improvements less depreciation and demolition) to get an expected level of mortgage lending. The difference is the extent of the money pumped in to inflate the house price bubble.

    Of course, so far as the election and the aftermath are concerned, Brown believes that so long as voters can be fooled into believing that house prices will not resume their fall, they’re all right, Jack: moreover, when inevitably they do fall (or we get very high inflation if QE leaks into the wider economy, with sharp falls in real house prices), he will snipe and blame it on the new government. It is likely that he will time his election calling mainly on this factor, and how long he can get away with printing under QE.

  13. Demetrius
    Posted August 14, 2009 at 2:13 pm | Permalink

    In one Jeeves and Wooster episode, Bertie having hatched a plot to help a friend is miffed when Jeeves looks down his nose at what is proposed. Jeeves concern is that a plot that requires several place to be in the same place at the same time, and all to act in the manner expected is fraught with danger. Jeeves, inevitably, is right, and Bertie lands himself in a dire situation. So we have 175 bn in the red, and propose to meet it by printing 175 bn in funny money, with the help of a lot of foreigners in different places. Government by Drones Club?

  14. Lola
    Posted August 14, 2009 at 7:10 pm | Permalink

    Sort of on topic – more evidence has come across my desk today as to how far the banks are out of control. RBS has charged a low paid acquaintance of mine another £35 plus the end of month charge of £30 for going over her limit by about £1.30. This is a bank that is bust. Every RBS employee has a job courtesy of my – and your generosity. Without about £20k from each of us, which of course includes my acquaintance.

    Something has to be done about this. The only reson the banks charge this way is because they can. They are a cartelised supplier of a monopoly product. Their concept of ‘service’ – well there is nothing I can write that is printable.

    Please God that when and if you get into power you’ll get hold of the Boy Osborne by the throat and get him to sort this as a priority.

  15. John Finningham
    Posted August 14, 2009 at 7:16 pm | Permalink

    When it comes to UK debt few of us underestimate the serious problems we are facing over the next couple of decades. When I say decades you Mr Redwood if honest will admit that whoever is the next governing body of this land faces huge debt and many think surpasses the debt of WW2. That took several decades to pay back.
    I have offered a few examples of how to save money by several £billion per year and if adopted could be a temporary measure until our country is in a better financial position. The proposals are very simple and would win huge public support even if they are only temporary. Suspend all EU subsidy from the UK, tell the EU that our country cant enter into it until our economy is in a better shape. Suspend Nuclear armament, despite nuclear warheads being old does not mean they are useless therefore Trident can be temporarily scrapped also saving several £billion. The national population database and not just id cards to be scrapped saving £billions. An immediate stop on immigration to the UK. Low category offenders released from prison and tagged.
    I have blogged on many ideas and base much of my opinions on common sense and what the public want. By making any of these measures on a temporary basis would not harm any party’s standing. Common sense is not left right or centre of politics it is just right.
    So Mr Redwood what is your opinion on these ideas and I mean your opinion and not your party.

  16. Sally C.
    Posted August 14, 2009 at 7:42 pm | Permalink

    It is important to remember that keeping interest rates too low for too long is what got us into this crisis in the first place. We know that Alan Greenspan was shocked into cutting interest rates sharply after flying over the devastated World Trade Centre towers in 2001. For the three years from 2001–2004, the Federal Reserve created as much new and additional money in the form of additional bank reserves as was necessary to drive down and then keep the Federal-funds rate below 2 percent. And from July of 2003 to June of 2004, it drove the Federal-funds rate even lower, down to approximately 1 percent. The fall in interest rates made home ownership appear substantially less expensive and consequently, a lot more attractive. As a result, a great surge in the demand for mortgage loans and in the purchase of homes took place. The funds created by credit expansion poured into the real estate market and drove up the prices of homes and commercial real estate. However, some of the credit expansion also ended up in the stock market. This is obvious from a cursory glance at a graph of the Dow and the FTSE. Although the Fed and the B of E did gradually raise interest rates thereafter, the increases were so small that they did not register with people or companies. Both thought the boom was going to go on forever and kept on borrowing to buy houses, in the case of individuals, and other companies, in the case of companies, at what now look like vastly inflated prices, leaving both the private and commercial sectors of the economy with huge debts. The banks, in particular Northern Rock and HBOS, made hay while the sun shone. The sun set when Northern Rock’s money market counterparties decided that they were no longer comfortable lending them money due to the excessive leverage they had taken on. The banking system was effectively NR mulitplied many times over. Suddenly no bank was creditworthy. The Fed had to step in in America and the Bof E had to step in here.
    While it is right that the central banks should ensure that banks have liquidity, it should not be the job of the central bank to prop up an over inflated housing market or companies that have taken on too much debt, by making debt even cheaper than before. By cutting interest rates to the lowest level ever the Fed and the B of E are encouraging individuals and companies to borrow even more money – something that I find criminally irresponsible. The question is – how can they ever raise interest rates without causing even greater problems for all those companies and individuals that have taken on debt over the last year? Is it their intention never to raise interest rates again?
    By the way, on the subject of QE, according to a speech given by Spencer Dale, chief economist at the B of E, the original £125 billion undertaken by the Bank, was equivalent to 9% of annual UK GDP so we can assume that £175 billion is well over 10% of GDP. This is effectively monetary base and can be leant on a mulitiplier by the banks. Assume a multiple of 10 and you can see that the B of E has pulled out all the stops – all in an effort to keep CPI at 2%! The CPI target is part of the problem. In a period of deleveraging, it is not appropriate to have the B of E chasing a CPI target of 2%.

  17. sealo0
    Posted August 14, 2009 at 7:44 pm | Permalink

    John

    Burnham on the C4 news interview tonight

    When asked for names of senior ‘Hannanites’, he did give two: Liam Fox and John Redwood.

    any comments?

    Reply: Just shows how desperate Burnham and Labour are. They keep on telling lies.

  18. no one
    Posted August 14, 2009 at 8:52 pm | Permalink

    the problem with current government policy is that lots of the money thown into the system is not being spent on UK produced goods or services, its flooding abroad

    does anyone have any idea what businesses the UK can lead with in the new world order and make money? at the moment we seem to be handing over our biggest skills to others

    we are not going to be able to compete, and if we are not able to compete we will not be able to pay all this money back

    we cannot in any case compete with countries with no health and safety practises, or decent treatment of employees, we need to seriously address the issue of free trade in an environment where we are one of the few places trying to play by decent rules

    if it were me id be throwing money at educating the kids of the UK better, and training the working population, i wouldnt be throwing it around such that its immediatley spent on projects outsourced in india or on cars imported from outside europe and so on

    i think the only long term way the UK can stay afloat and earn the money to sort much of this is to lead the world with the education and innovation of our workforce, sadly we are going in the opposite direction

    its fairly obvious the UK banks need smashing into smaller organisations, we need smaller banks which can fail without taking down the whole system

    we need to get the unemployed wastelands contributing to the economy quickly as well, it is possible, it just needs some real incentives to all involved

    etc

  19. anoneumouse
    Posted August 14, 2009 at 9:51 pm | Permalink

    Doomed I tell you, were all doomed.

    In 6 months time the £ will go the same way as ‘Assignats’ and rest assured the euro will follow closely on its heels.

    invest in $, Yen, or the rupee

  20. Mike Stallard
    Posted August 15, 2009 at 6:10 am | Permalink

    I awoke this morning to a revelation.
    I thought, on going to sleep, that government was a wise gathering of decisive people taking relevant decisions which ran the country. The Ministers, in Cabinet, ordered and the Civil Service obeyed. Changes could be made.
    This meant that you only had to change the government to get good decisions and everything would be back to 1997.
    I had hoped that the Conservatives would be that government.

    My revelation was this: the position is not that of people sitting wisely in Cabinet at all.
    Rather it is of desperate young men sitting in a rubber boat being swept downstream past lethal rocks and on towards the rapids which are fast approaching.
    This means that, unless the Conservatives, if they are elected, are really good, we are all going over the rapids. People are again mentioning Zimbabwe and Weimar on the blog; Argentina went over the rapids too. So did Turkey quite recently.
    It really isn’t difficult!

  21. Cityunslicker
    Posted August 17, 2009 at 10:00 pm | Permalink

    QE will not cause inflation for sure. Demand is too low, just like in Japan, where there is still deflation 10 years on. This is the more likely scenario following an asset bubble and banking crisis.

    Nonetheless, QE achieves nothing but to burdern our future children with debt. QE is a short-term measure, the long-term is to reduce wasteful spending and cut taxes to produce growth.

    I am not sure Osborne gets this either nor Cameron. The game has changed substantially and requires new solutions. Many think a jump start of the old order will work. It won’t, its 1979 again.

    The point about Government funding is central, this is the real purpose of QE, to support the Labour Government for a few more months. It is sickeningly cynical.

  22. Ralph Musgrave
    Posted September 25, 2009 at 4:20 pm | Permalink

    Brian Tompkinson, Donna W, Robert K Oxford above and thousands of others around the country are worried about the inflationary effect of Q.E. It won’t be inflationary until the additional money results in a significant rise in spending. Moreoever, if (and it’s a big if) government spots the rise in spending in time, it can take deflationary measures and forstal the inflation.

    Stephen Cox rightly asks how easily Q.E. can be reversed. There’s a Reuters article here which suggests this “reversal” might not be as easy is some assume: http://uk.reuters.com/article/idUKLF58745020090415?pageNumber=2
    I also give reasons for thinking it will be less easy than many are assuming: http://qereverse.blogspot.com/

    Cityunslicker repeats the popular idea that national debt is a “burden on our children”. Samual Brittan rebuts this idea here: http://www.samuelbrittan.co.uk/text321_p.html Plus there is a prof of economics at Warwick who attacks the “burden” idea on his blog (I’ve lost the URL). I agree with both these authors.

    Anoneumouse (10/10 for the name) suggests sell pounds and Euros and buy amongst other things US dollars. If the “Q.E. will cause inflation lot” are right, I wouldn’t: the US has engaged in Q.E. to the same extent as we have, while Euro countries have not, as far as I know. For a graph showing the effect of Q.E. in the U.S. (i.e. the rise in their monetary base) see: http://research.stlouisfed.org/fred2/series/BASE

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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