Forget LIBOR, QE is the real scandal

About ten days ago most people wouldn’t have known the LIBOR from an ice sculpture of Vin Diesel. Now the London Interbank Overnight Rate (the rate at which banks lend to each other overnight – not everything in economics is as obtuse as it sounds) is at the centre of a furious political storm and will soon be at the centre of a Parliamentary inquiry.

A flavour of the passion roused by Barclays’ actions came when the normally measured Mervyn King spoke of “the deceitful manipulation of a key interest rate.” This was especially striking coming from him as his job, Governor of the Bank of England, is all about manipulating interest rates.

And it was even more striking as he said this just as he was about to administer another dose of Quantitative Easing, £50 billion, taking the total so far to £375 billion since the scheme started in March 2009. That’s about a quarter of GDP.

QE’s stated purpose is to put money into banks and lower long term interest rates, spurring borrowing, investment, and economic growth. There hasn’t been much sign of this but QE’s defenders tell us that we have to compare what weak growth we do have with the cataclysm which would have befallen us without QE. We’ll never know.

But QE has had a number of definite effects. By handing over £325 billion to banks in return for long term assets QE has boosted the bank’s profitability and, of course, those bonus pots for executives. And it is not just any old long term security that the Bank of England has been buying but British government debt. This has had the handy effect of helping George Osborne keep gilt yields down.

While banks and the Treasury have done rather nicely out of QE, savers, particularly retirees, haven’t. The driving down of long term interest rates by QE has driven down annuity rates, which are linked to long term interest rates, by 27 percent since 2008.

As Simon Rose, from pressure group Save Our Savers says, “QE is government-sanctioned theft from those who are trying to make provision for themselves. It is wreaking havoc on pension funds with the National Association of Pension Funds reckoning QE has cost pension funds a massive £270 billion.”

That’s not to say that all pensioners are suffering. The fall in gilt yields has been accompanied by a rise in gilt prices (the two move in opposite directions) which is great news for anyone whose pension pot is invested in gilts. Like Charlie Bean and Paul Tucker, deputy governors of the Bank of England, who, thanks to the rise in gilt prices they engineered, saw the value of their pension pots rise by £1.04 million and £1.35 million pounds each last year to a total value of £3.56 million and £5 million respectively.

One effect QE hasn’t yet had is inflation. Yes, CPI has been above the Bank of England’s target range for two and a half years, but the inflation figures we have seen are way below what you might expect from an expansion of narrow measures of the money supply by an amount equal to a quarter of GDP.

Quite simply, the money pumped into banks via QE has stayed there. Banks have not lent it out, as Vince Cable keeps complaining, but if they ever did, if QE worked as the prospectus says it should, we would see inflation.

The diagrams below illustrate how this would work. Money is a tricky thing to define so there are several measures. We count the stock of notes and coins in circulation and call it M0. But there are bank current accounts which can be converted into cash quickly, so we add these to M0 and get the M1 measure. Add some deposit or interest-bearing accounts and we have M2, add some other deposits and we get M3, and add building society deposits and we have M4.

Figure 1 is a simple, stylised illustration of how these various measures of the money supply relate to each other, with the black box in the bottom left representing M0, red M1, orange M2, yellow M3, and white M4.

Figure 1

Figure 2 shows a situation where QE has doubled the narrow money measures of M0 and M1, but, either because banks are hoarding or individuals and enterprises aren’t borrowing, this has not filtered through into the broader monetary aggregates and appeared in inflation figures.

Figure 2

Figure 3 shows what would happen if the increase in narrow money shown in Figure 2 found its way out of the banks and into the wider money supply.

Figure 3

Assuming a proportional increase in broader monetary aggregates in response to an increase in narrow money to maintain existing ratios, a doubling of narrow money will lead to a doubling of broader money. Anyone who doubts the possibility of such a scenario in Britain ought to consider the effects of QE on the monetary base; it has nearly tripled since 2008.

NB: This graph shows the move from the situation in Figure 1 to that in Figure 2

This is the curious thing about QE; even if it works, it doesn’t. If banks do “use these increased deposits as the basis for increased lending to businesses and households” we will see inflation. If they don’t then there’s no point doing it.

Reflecting on Japan’s experience with QE in his book, The Holy Grail of Macroeconomics, Richard Koo argued that “As long as there are no borrowers, no amount of quantitative easing will harm the economy. But if the policy is continued after borrowers return to the market, it can lead to dangerously high money-supply growth and inflation”. The same applies with hoarding banks.

Koo called Japan’s QE a “non-event”. We ought to hope that ours is as benign, if it isn’t we’ll all feel the same pinch our savers already are. That, not LIBOR, is the real scandal.

This article originally appeared at The Commentator

The euthanasia of the rentier: Why the assault on savers must end


Take that thrift!

With the British economy flat lining, America’s stumbling, and Europe’s in a nosedive, the clamour is growing for policymakers to ‘do something’. The Bank of England is, once again, being urged to deploy the weapon of Quantitative Easing – the spending of newly created money on long term assets.

Would this do any good? It hasn’t so far. The truth is that money is not wealth, goods and services are, and a central bank simply producing more money does not make us wealthier. But if central banks can’t create more wealth by creating more money they can redistribute the wealth there is.

This has been happening in Britain for nearly four years. Between October 2008 and March 2009 the Bank of England slashed interest rates from 5 percent to the historic low of 0.5 percent. When this failed to reignite economic growth the Bank resorted to £325 billion worth of QE. Whereas the Bank usually works on the short term end of the Yield Curve when setting the base rate, with QE it set out to pull down the long term end.

The stated aim was to put money into banks to get them lending again. I’ll leave it to you to judge how far the programme has succeeded in that aim, but one predictable side effect has been to lower returns all along the curve.

And this matters. With policymakers pulling every trick to keep interest rates everywhere as low as possible, Britain’s savers are being ravaged. On one estimate they are being robbed of £18 billion per year. Simon Rose, of pressure group Save Our Savers, puts the figure savers have been stripped of at £100 billion since the start of the crisis, “a staggering amount of money” he says “given that it would pay for the Olympics ten times over.”

The Bank’s monetary shenanigans haven’t boosted growth (cheerleaders have fallen back on the old argument that they have, at least, staved off catastrophe – again, I’ll let you be the judge). They have caused a vast transfer of wealth away from Britain’s savers and towards debtors and zombie banks and this is bad economic policy for reasons of growth and stability.

An entrepreneur with an idea must spend money on premises, wages, and all kinds of other possible outlays before seeing a single penny in revenue. The only way the entrepreneur can fund this outlay is from savings, either their own or other people’s channeled through a financial institution.

An increase in saving allows this period between embarking on production and sale of the product to lengthen (or fund other production periods for other goods). The lengthening of the production period, in turn, permits more stages of production,increasing ‘roundaboutness’ as the Austrian economist Eugen von Böhm-Bawerk put it.

Take shelter, a basic human need. Without the savings to sustain us over a prolonged production period, the period between embarking on production and using the shelter must be short, perhaps as long as it takes us to find a cardboard box. But with savings we can extend the production period and introduce many more intermediate stages. We can purchase land, draw up plans, purchase materials, hire labour etc.

The story of human material progress can be characterized as the lengthening of production processes enabling ever more intermediate steps. In short, savers are the difference between a three bed terrace and a cardboard box.

This much is not controversial; almost all economists agree that saving is an indispensable ingredient of increasing wealth. But the attack on savings risks shorter term instability too.

Lowering the base rate and QE works the same way, just on different ends of the Yield Curve; assets are purchased from banks with money newly created by the Bank of England.  From the point of view of a bank there is no difference between money deposited with it by savers and money it receives from the Bank of England in return for financial assets; it can lend out and earn profits on both.

But from the point of view of the wider economy there is a huge difference between the two types of ‘savings’. When savers deposit their funds with a bank they are doing so because they wish to withdraw this money in the future to fund consumption then. The resultant fall in interest rates, which makes it possible for firms to borrow to invest in the means to supply this future consumption, represents the actual time preferences of economic agents.

The ‘fake savings’ of Bank of England deposits, however, represent no such thing. While they can be lent and borrowed to fund investment projects with longer production periods there has been no change in the time preference of economic agents. There will be no real savings to purchase the output of these enterprises in the future.

When this is revealed these unprofitable enterprises will be liquidated causing recession. It is, thus, only the deposits of savers which can provide the capital which allows for longer production processes and increasing wealth on a stable and sustainable basis.

In his ‘General Theory’ in 1936, John Maynard Keynes looked forward to “the euthanasia of the rentier” when interest rates would be driven to zero and capital would be free and abundant. This nonsense, as much as anything else he said, represents a threat to our economic growth and stability. The assault on savers must end.

This article originally appeared at The Commentator