Finance question

Posted by William M. Connolley on May 17, 2009
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One thing that has puzzled me for a bit about the current mess is the intereaction between the Government and the Central Bank (Bank of England or BoE, in our case). So the government is raising money by selling Gilts, in quantities that I forget but of the order of £200b when I last looked. Meanwhile, the BoE is indulging in Quantiative easing, a process whereby it pumps money into the economy by buying various bonds, but mostly Gilts, of the order of £20b.

This appears, at least at first sight, to be pointlessly self-cancelling. The government is selling gilts to itself (unless we pretend that the BoE isn’ t an organ of the government – are we supposed to pretend that?).

On the other hand, perhaps the point is that only the BoE is capable of creating money out of nothing – maybe the government strictly defined has no mechanism to do this. So it is obliged to go through the slightly strange dance.

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  1. #1 Phillip IV
    2009/05/17

    On the other hand, perhaps the point is that only the BoE is capable of creating money out of nothing – maybe the government strictly defined has no mechanism to do this. So it is obliged to go through the slightly strange dance.

    That’s exactly the point – the BoE has operational independence, as far as monetary policy is concerned. The government cannot force the BoE to buy its gilts, it has to place them with investors in the bond market, thus creating market control over the maximum amount they can raise. If the BoE subsequently feels too much of the market’s capital is locked up in gilts, it can then decide independently to buy some of them back. It might seem like a strange dance, but the alternative would mean allowing the government to create and spend practically unlimited amounts of money – a pretty sure road to hyperinflation.

  2. #2 David B. Benson
    2009/05/17

    William — You aren’t supposed to be able to understand it. Only central bankers do.

  3. #3 Aidan
    2009/05/17

    This has nothing to do with finance .. but I think I have found a Wiki traveller with a similar world view to your own:

    http://blog.plover.com/aliens/known-to-man-2.html

  4. #4 Nicolas Nierenberg
    2009/05/18

    The idea in the US is that the President and Congress are responsible for fiscal policy, which is how money is spent. And the Federal Reserve is responsible for monetary policy, which is how much money should be available to the economy.

    Fiscal policy, of course, doesn’t have to be balanced as the President and Congress can spend more (or less) than the amount of taxes and other income that they receive. This is financed by the Treasury Department (works for the President) issuing government debt. Of course in a country that borrows in its own currency they can always repay the debt by issuing new debt. Theoretically over use of this policy should down the price of the debt, and drive up the interest rates borrowers demand. My observation is that at least within the ranges of the last 30 years there is little evidence for this. (Probably because the government percentage of total debt is very small.)

    Monetary policy doesn’t need to balance, as the Federal Reserve can expand or contract its balance sheet at will. The can lend money, or they can buy back debt as required to achieve specific results, or to simply change the amount of money available.

    So yes, in theory the Treasury could issue debt to cover a deficit, and then the Federal Reserve could buy it right back. This would result in an immediate increase in the money supply equal to the deficit.

    [This appears to be the same as the UK. Govt issues debt; National bank creates (or destroys) money. You don't explicitly address my point, but I guess it becomes clear: the Govt can't create money; the Bank does that -W]

  5. #5 Alastair B. McDonald
    2009/05/18

    I don’t think that Nicolas has got it quite right.

    The President and the Congress do set the fiscal policy which includes TAXES and how they are spent. As he says the two sums do not have to balance with any deficit being made up by borrowing.

    The Federal Reserve’s job is to control the money supply, which originally they could do by printing more banks notes. Cheques and credit cards have now meant that bank notes are almost irrelevant to the money suppply although some countries with raging inflation do try to control it by restricting the amount of currency in circulation.

    One method of controlling the money supply is by altering the base interest rate, which is the rate the banks have to pay to the central bank for their borrowings. The other method used in the past by the Bank of England was insisting that the banks held a percentage of their funds in reserve. When that percentage was increased it would reduce the money supply. Now because of inter bank lending the central banks can no longer use that method, and the money supply spiraled out of control until the big credit crunch bust.

    But the reason these systems have not worked is because national economies are no longer isolated. Just as the US had to create a Federal Reserve bank to prevent repeats of the Wall Street Crash, so we will have to create an global reserve bank if we want to prevent another global Credit Crunch.

    But why have interest rates not risen? Because the Chinese have been lending us – the US and the rest of the Western World – vast sums of money at low interest rates so that we can buy their goods. We have been getting rich on Chinese credit. The question is what will they do when they realise that they are not going to get their money back! What will happen when they realise that we are going to pay them for all those goods they supplied us with using devalued currencies. But they have got to keep lending us money, otherwise the global economy will crash and they will get nothing back.

    So as long as the Chinese are prepared to lend our governments the cash by buying government bonds we can have low interest rates.

    Anyway enough rambling for one post.

    [Well the Chinese are a bit stuffed - they have all those US treasuries, so they can't afford for the dollar to collapse as it should, so they have to buy more -W]

  6. #6 Nicolas Nierenberg
    2009/05/19

    Yes I did leave out the bit about taxes in the first line.

    It has been quite a while since any one economy was isolated. But that reinforces my point which is that the global debt market is much larger than just the US Treasury market so the amount of Treasuries can’t really change interest rates. In fact in a panic US Treasuries went ridiculously low because of a flight to quality.

    Anyway the Chinese aren’t actually stupid. They purchase US Treasuries and other government debt because it is the safest possible investment, just the same reason others buy it. So far they have, on paper, made quite a bit due to the appreciation of the dollar and treasuries. I am fairly certain there is no grand Chinese plan to buy US debt so they can export products, it actually works the other way around. They get dollars, and they need a place to put them.

    The exact same thing was said about Japan in the 80′s and 90′s BTW. Nothing came of it.

  7. #7 Alastair B. McDonald
    2009/05/20

    I am fairly certain there is no grand Chinese plan to buy US debt so they can export products, it actually works the other way around. They get dollars, and they need a place to put them.

    The Chinese have kept the currency low against the dollar in order to undercut US manufacturers, but with their sales they have to put the money somewhere and as you say US Treasuries are as a good place as any. But that allows the US government to run up a deficit which is inflationary. In other words the US government gives the money they got from the Chinese back to the US citizens though government jobs and projects. So there is a lot of money sloshing around the US and then UK bankers borrow it from the US banks and pass it on to we UK citizens taking a huge cut and six figure bonuses claiming that they are wealth creators. They are not. They are just money lenders.

    This isn’t meant as an attack on the US. It was the British bankers that screwed us. (Although the US bankers did flog our bankers a lot of toxic assets.) But basically it all originates from Chinese money that they can’t spend.