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29 April 2015

QE, Debt Monetisation by Stealth



Quantitative easing, in central banking terminology, is the creation of currency by the repurchase of existing debt from the balance sheets of commercial banks, thus helping to re-introduce liquidity in order to reduce an institution’s leverage position. This operation supposedly increases the solvency of the bank in the event of a shock, and it is also supposed to encourage banks to lend more freely to the “real economy”, in other words to small and medium sized businesses, to encourage growth; and it is used to devalue the currency in order to boost the export sector. It also helps to keep a lid on interest rates but I will come on to that a bit later. Principally, it is government debt that is being purchased; however, central banks have purchased mortgage debt and even equities.

Money Printing

The actions of central banks are seen in many quarters as printing money, or blatant counterfeiting. However, providing the debt is actually resold at a later date, effectively reversing QE, the liquidity added disappears. The problem currently is that the debt can only be resold if there is a buyer for it and that depends upon future real economic growth. Conditions for that are overwhelmingly bad at present as more debt is currently being added to boost growth, which is fine when the debt is productive; the bigger problem is when there is bad investment, based on speculation, and moral hazard presides. Therefore, if we assume for the moment that central banks hold the QE debt indefinitely, they can effectively retire the debt, repurchase it themselves when it matures, continue to pay interest on it (which incidentally happens currently with the proceeds being paid to the treasury - this really is the magic money tree) and effectively hide it. I think in the Enron days they used to call this type of action creative accounting. It is of course legal fraud when instituted by a central bank. QE devalues the purchasing power of currency by directly increasing the money supply. Currently the Bank of England has indirectly monetised about 25% of UK government debt (£375 billion). 

Interest Rates

QE has had another important function to perform. It has stopped interest rates from rising and in fact has helped depress interest rates to unnaturally low levels. Without this, the interest payments on global government debt would have meant that the entire global financial market would have been bankrupt. Of course, one could suggest that technically western central banks and governments are already bankrupt, but while they control interest rates and money supply they still have a grip on their own reality. Getting back to the UK, based on a continuing  government overspend/deficit it may not be too long before the central bank will need to add more liquidity to the commercial banks so they can help to buy new government debt by selling the central bank more of the old debt they have accrued for collateral purposes. A vicious cycle emerges. Could it be that the Bank of England will before long be jumping back on the QE train? Who knows, they may eventually monetise the entire UK national debt of £1.5 trillion. 

History

Historically, money printing has caused high levels of inflation, even in some cases hyper- inflation. Based on the current levels of QE many have presumed that inflation was an inevitable consequence of money printing. We do have inflation in some areas but deflation in others. To understand the difference between inflation and deflation all we have to recognise is that inflation is caused by rising levels of money supply and deflation by contracting money supply. Thus, asset prices such as stocks, bonds, fine art and housing in major centres have all been rising, inflated by the very money given to commercial banks by central banks and ultimately held in the most part by those commercial banks as (illiquid) collateral. Deflation, on the other hand, is generally being seen in everyday products. This is a consequence of falling global demand due to the massive levels of private debt that still exist and will take decades to repay. It is also caused by a globalised world forcing down a major cost of production -  workers’ wages. As wages fall, debt repayment takes even longer. If central banks start eventually to normalise interest rates and thus tighten money supply, they risk a contraction in asset values and another contagious banking crisis; if they continue to create and monetise debt they risk a loss of confidence in currency values particularly where currency is being held as reserves by surplus nations. 

Consequences for the UK

We as a nation have been importing deflation from the cheaper producing nations but this will not continue if we devalue the pound further. Imports will ultimately cost us more, but in order to control interest rates we will have to continue to expand the money supply which under current circumstances will be left at the door of the central bank. It is only through economic growth (UK PLC making money), balancing the budget and ultimately debt repayment that we as a nation will avoid bankruptcy. Sadly, the political culture of deficit spending to offer up unsustainable policies in order to get elected is clearly to be seen in the current crop of politicians. Most on the left seem to be offering an end to austerity, while others just regurgitate the same old polices that have got them elected in the past. Low tax takes due to a reduction in real incomes in a vain attempt to become competitive and unsustainable social polices probably mean we will continue to bump along the bottom.

Conclusion

How long can central banks and governments hide from the real direction of the global economy? Surely they can only print so much money and turn interest rates negative for so long before the public realise that the game is up and the emperor is wearing no clothes. Thus, interest rates can’t be controlled indefinitely which will eventually put us into a debt deflationary spiral in the event of a global shock (another Lehman moment).  Bankruptcy, are you ready?   


This article was written by Richard Horswill. All opinions expressed are strictly his own.


         



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