QE or not QE, that is the question

The Chris Cook Economics 3.0 column

I recently posted here on the possibility of consolidating existing dated UK gilt-edged debt into two new pools of undated debt. This perceived attack on the system really brought out the heavy guns in furious defence of our Twin Peaks (debt and equity) of financial capital, and the Alice in Wonderland concept of the National Debt, which is one of the six impossible economic things we, like the Queen of Hearts, believe in before breakfast.

I won’t rehearse all the arguments here, but one of the points that emerged was the realisation that the issue of undated debt I am suggesting is in fact already happening in the form of the Quantitative Easing, upon which the Bank of England and Treasury appear to have pinned their hopes to re-float the economy.

Money for Nothing
The first thing to point out is that there is nothing new about undated debt. Apart from the Consols and other undated interest-bearing gilts I referred to, the notes and coins we are accustomed to using as cash are in fact undated IOU’s issued by the Bank of England, which bear no interest. The notes and coin required by the banks’ customers are acquired as necessary by the clearing banks from the Bank of England, and their sterling value therefore constitutes an interest-free loan from the clearing banks to the Bank of England.

As recently as the 1960’s, over 20% of money in existence was notes and coin, but the pervasive spread of electronic banking and payments has reduced that proportion below 3%. All of the rest of the money in existence in fact consists of interest-bearing credit created as loans by credit institutions such as banks and building societies: or rather, it used to.

Quantitative Easing for Dummies
Credit costs nothing to create, whether it is created by a trade seller, who gives a buyer “time to pay”; by a private bank based upon an amount of regulatory capital specified by the Bank of International Settlements in Basel; or by the Bank of England, based upon the faith of the public in the government and its tax base.

In order to kick-start the economy, the Bank of England has been “pumping in” money by creating credit – as an accounting entry with a click of a mouse – and it has used this money to buy dated (repayable) interest-bearing Treasury loans known as gilts.

The idea of QE is that the sellers of gilts will either spend or lend the proceeds into circulation. Unfortunately the banks appear to be hoarding the resulting balances as reserves far in excess of the level required by banking regulations. The reason for this unwillingness to lend is that there is a shortage of creditworthy individuals, businesses and projects.

The result for banks is that instead of holding relatively illiquid dated government debt, they now hold extremely liquid undated cash balances, and they receive in respect of these reserves the current Bank of England base rate of 0.5%.

The Bank of England on the other hand is now sitting on a pile of up to £175 billion worth of Treasury gilts, and receiving maybe around 4.5% in respect of it. Against this income, they are paying 0.5% on reserve balances. The difference of maybe £7bn pa is a profit to the Bank, and hence to the long-suffering tax-payer via the Treasury.

Financial Pornography
Now one would have thought that the Treasury and their political masters would have been shouting this financial brilliance to the rooftops, but you would be wrong. The magic of “Seigniorage” – which is the technical name for such income derived by the issuer from the issue of money – is far too grubby to be described in any decent newspaper. As the German chancellor Bismarck famously said, it is not necessary to see how the sausage is made.

The de facto monopoly of private banks over money creation has meant that the benefits of such monetary legerdemain have not been for the public purse, as some have long argued it rightly should be, but have accrued to bank shareholders instead.

Fortunately, the age of private bank credit creation is pretty much over, finished off by a combination of securitisation – which allowed banks to outsource credit creation to a shadow banking system of investors – and Alan Greenspan’s tenure at the US Federal Reserve Bank.

Banks now have a systemic shortage of the capital necessary to support new credit creation, and are hoarding cash as they observe further approaching waves of defaults as the Credit Crash continues. They can see an approaching wave of residential loan defaults, from once-prime borrowers now unemployed; another wave of loan defaults in respect of commercial property loans; there will be others too, such as the over-extended industry of private equity.

Since investors are unlikely to start buying securitised debt any time soon, then the only place credit can come from is the government. This is the ultimate sacrilege to conventional economists, it being an article of faith that public credit creation is inflationary. Whereas the creation of credit by the private banks – whose credit bears the additional cost of unnecessary payments to unproductive rentier investors – is not inflationary. Strange, that.

While Treasury credit creation may be unconventional, and to many it is literally unthinkable, it does in fact constitute a simple but radical solution to our current problems.

Treasury Credit
Decentralised local treasury branches could create undated credits as necessary for the circulation of goods and services and subject to a treasury guarantee for which a provision or charge is made. Secondly, credit may also be created not only for “co-ownership” investment in the properties of any borrowers – distressed or just “underwater” – who wish to participate, but also anyone who wishes to release equity in a non-toxic way (NB: £1 trillion of UK property is owned free of mortgage by over-65s).

The process of Treasury credit creation could be handled by banks as service providers for a fee, at least in part performance-based. So the only capital banks would need to risk in this direct credit model would be the working capital necessary to cover their costs.

So in summary, QE could be massively extended as part of a reconfiguration of the financial system which recognises that the era of banks as credit intermediaries is over, and the era of banking as credit service provision may just be beginning.