QE inside out

Twitter can often be something of an intellectual cesspool in which people continue to shout across the cultural divide without ever hearing the views of the other side. It can, however, be a source of great enlightenment and I was very taken by a post (here) by Alfonso Peccatiello explaining why QE can never be inflationary. Having thought about it, there are many elements of this Twitter thread which are wrong. Nonetheless, it served a very useful purpose in forcing me to assess the nature of money and for that it is to be commended.

Inside versus outside money

At issue is the nature of “inside” versus “outside” money. Peccatiello argues that “inside money never reaches the real economy. Outside money does” and to the extent that he characterises QE as inside money, it cannot therefore impact on inflation. I suspect there is some confusion about definitions here and in order to get a better handle on this, we need to understand the concepts under discussion. The notion of inside versus outside money was introduced into economics by the seminal work of John Gurley and Edward Shaw, Money in a Theory of Finance, published in 1960. It was a very innovative work for its time and looked at the interaction between the real economy and monetary growth. As they put it, “real or “goods” aspects of development have been the center of attention in economic literature to the comparative neglect of financial aspects.”

Gurley and Shaw (G&S) define inside money as originating from within the private sector. Since one private agent’s liability is simultaneously another agent’s asset, inside money is in zero net supply within the private sector. Thus, funds held in bank accounts would be classed as inside money because they are an asset of private firms or households but a liability of private sector banks. Conversely, outside money derives from outside the private sector and is either fiat (unbacked) or backed by some asset that is not in zero net supply within the private sector. An increase in the stock of currency by the central bank would be classified as outside money, because although it is an asset of the private sector it is a liability of the public central bank.

The vexed question of money neutrality

Since outside and inside money represent different types of liquidity, they have differing effects on the wider economy. One implication of this is that the money stock is not homogenous – money is not just money as it is comprised of these two differing types. This calls into question the notion that money is neutral (i.e. it does not impact on real quantities in the long run and serves only to impact on prices). In light of the debate regarding the impact of liquidity creation by central banks and the recent surge in inflation, this may help us to shed some light on the monetary transmission process and the role of QE within it.

Without boring the reader with the details of the process, G&S demonstrate that in their general equilibrium framework inside money is neutral but outside money is not (the interested reader is referred here). How do we categorise QE?  In the sense that the central bank creates reserves to buy assets from the private sector (in this case, the non-bank private sector) but uses them to buy government bonds, they are merely swapping one type of outside money for another (cash for bonds). Consequently, the inside-outside composition of private sector assets remains unchanged. I thus agree with Peccatiello that QE can be categorised as inside money. If we accept the proposition of money neutrality, this implies that QE is unlikely to have any long-term impact on real activity. But this does not mean that it has no impact on prices. Indeed, classical monetary theory argues that if it does anything, QE will impact on price inflation.

Moreover, monetary neutrality relies on the absence of frictions but, as the work of Karl Brunner and Allan Meltzer has demonstrated, such frictions do exist and thereby allow monetary policy to have an impact on the real economy – perhaps only for a limited period of time. QE may not have had the impact on the economy that central banks hoped but there is in theory scope for it to boost activity. Analysis conducted by the BoE in 2011 suggested that the initial round of asset purchases boosted UK GDP by 1.5% to 2% compared to what would have happened in its absence.

Should central banks continue with asset purchases?

If we therefore accept that asset purchases do impact on inflation and prices, does it make sense for central banks to continue the programme, particularly in view of the surge in US inflation to 5.4% last month – the fastest rate since 2008? The short answer would appear to be no. Whilst it is true that the prices of used cars contributed a third of the monthly rise in the CPI in June, which is likely to be a temporary phenomenon, there is evidence that prices are rising rapidly across the board. Accordingly the Fed is widely expected to taper its asset purchases before too long with suggestions that the Fed will broach the subject at next month’s Jackson Hole symposium. Investors will recall the 2013 experience when the prospect of a slowdown in Fed asset purchases prompted the infamous taper tantrum which resulted in a spike in bond yields. However, with financial asset prices at red hot levels, taking some air out of the market may actually not be such a bad thing.

Last word

Whilst there is general agreement that QE has been the primary driver of asset prices in recent years, there remains much debate about its impact on the wider economy. Whilst I have never been persuaded of some of the claims made for it by policymakers, I have never accepted that it has zero impact. Even if the effects are small, such has been the magnitude of asset purchases that even small spillovers will show up in GDP and inflation data. This 2016 paper by Martin Weale and Tomasz Wieladek offers evidence that in contrast to the claim made by Peccatiello, “US (UK) QE had a similar (much larger) effect on inflation and (than) GDP.” If asset purchases have helped the economy to avoid a slow post-pandemic recovery, they have done their job. But having done their job, it may now be time to think about scaling back.

Soddy's Law

The name Frederick Soddy may not mean much to many people. Historians of science might recall that he collaborated with Ernest Rutherford on radioactivity and that he won the Nobel Prize for chemistry in 1921 for his research on radioactive decay. In the world of economics he occupies at best a place on the fringes despite having written four major works on the subject between 1921 and 1936. I recently dipped into his 1934 book The Role of Money (available online here) and although the prose is a little dated and some of the ideas are very much of their time (not to mention flawed), it is nonetheless fascinating to sift through his work to discover that he uncovered a number of macroeconomic ideas long before the celebrated economists of recent years. It is also worthwhile looking again at his work to determine whether it offers any insights on today's policy issues.

A man of astounding economic prescience

Although Soddy was largely dismissed as a crank during his lifetime, many of his policy prescriptions were later adopted into the mainstream. He was, for example, a great critic of the gold standard and argued strongly that exchange rates be allowed to float; he also argued in favour of using the government budget balance as a tool of macroeconomic policy and called for the establishment of independent statistical agencies to compile economic data (particularly to measure the price level). In the event, the idea of using fiscal policy as a policy tool was one of the cornerstones of the post-1945 Keynesian revolution whilst the suspension of dollar convertibility into gold in the early 1970s ushered in the era of floating exchange rates which has prevailed ever since. Moreover the UK established a Central Statistical Office seven years after Soddy first mooted the idea in 1934.

Economics as science

Soddy’s approach was rooted in physics, viewing the economy as a machine which requires inputs to derive outputs. Whilst there is a lot wrong with this way of thinking it was not out of tune with the mainstream views adopted in the post-1945 era, the echoes of which still persist today. But it is appropriate in one sense: A system which relies on such inputs will soon grind to a halt unless there is an infinite supply of them. Accordingly, Soddy’s ideas have been adopted by the modern-day ecological school of economics which views the economy less as a machine and more as a biological system.

The original motivation for his thinking was the recognition that a fractional banking system requires perpetual growth in order that the debt acquired in the process of generating today’s consumption can be repaid. As a scientist, Soddy understood that an economy based on the consumption of finite resources cannot continue to grow indefinitely since this would violate the laws of thermodynamics which prevent machines creating energy out of nothing or recycling it forever – an idea he set out in his 1926 book Wealth, Virtual Wealth, and Debt. 

Soddy recognised the fact that private sector banks create money simply by creating deposits thus inherently increasing the leverage in the system – in his memorable phrase: “Money now is the NOTHING you get for SOMETHING before you can get ANYTHING”. He further recognised that this exacerbated the swings in the credit cycle since banks were prone to call in loans when borrowers were least able to repay whilst they were most willing to grant credit when times were good and therefore when credit was least needed. Accordingly, one of Soddy’s main proposals was that the creation of money be taken out of private hands and should instead be fully backed by government created money.

Father of the Chicago Plan

Although Soddy’s ideas were generally ignored in the UK they did find support in the US. In a review of Soddy’s 1926 work, the great American economist Frank Knight noted that “it is absurd and monstrous for society to pay the commercial banking system “interest” for multiplying several fold the quantity of medium of exchange when a public agency could do it at negligible cost” particularly where there are huge costs associated with the booms and busts of the credit cycle. Influential US economists led by Henry Simons and Irving Fisher went on to formulate the Chicago Plan which advocated wholesale reform of the banking sector, notably the separation of the monetary and credit functions of the banking system, “by requiring 100% backing of deposits by government-issued money, and by ensuring that the financing of new bank credit only took place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks.”

Needless to say the Chicago Plan did not find favour in the 1930s. However in the wake of the 2008 financial crisis the idea of full-reserve (or narrow) banking did come back onto the agenda. Institutions such as the IMF have recently given serious thought to the idea, with an influential working paper in 2012 conducting quantitative analysis which concluded that “the Chicago Plan could significantly reduce business cycle volatility caused by rapid changes in banks’ attitudes towards credit risk, it would eliminate bank runs, and it would lead to an instantaneous and large reduction in the levels of both government and private debt.” The FT’s chief economics commentator, Martin Wolf, who sat on the UK’s Independent Commission on Banking, came to a similar conclusion (although he did not credit Soddy with the original insight).

Rethinking narrow banking

In recent years the debate has taken a step further with the advent of digital currencies. In theory the likes of Bitcoin represent a form of narrow banking given that its supply is fixed. However, to the extent that each Bitcoin unit is divisible into sub-units of 100,000,000 it is possible to imagine a world in which value can be destroyed by division, in which case we are no better off. But the concept of a central bank digital currency (CBDC) may be a different story. The Bank of England’s illustrative model for a Sterling CBDC utilises a two-tier intermediation model, whereby Payment Interface Providers (PIPs) would keep all CBDC reserves at the central bank. These PIPs may be pure payment intermediaries or may be commercial banks processing transactions but the key point is that these CBDC deposits would not be used for lending. Such a policy is not without risks (as I discussed in this post a year ago) and I retain some scepticism that a CBDC does many of the things that are claimed for it. Nonetheless, their introduction may take us a long way closer towards realising Soddy’s idea.

One of the reasons why economists remain sceptical of narrow banking is the conventional view that it will reduce banks’ lending activity which will in turn act as a brake on economic growth[1]. But a lot of modern macro theory increasingly calls this view into question. This paper published in September 2020 by Hugo Rodríguez Mendizábal makes the case that a “fully reserve-backed monetary system does not necessarily have to reduce the amount of liquidity produced by depository institutions.” Space considerations mean that we cannot do justice to the full implications of the case for narrow banking and it is clearly a topic for another time. Suffice to say that it is a very active research area these days.

Last word

For a man who was regarded as a crank operating at the margins of respectable economics, many of Frederick Soddy’s “crazy” ideas have subsequently found a surprising degree of mainstream acceptance. Almost a century after he sowed the seeds, the idea of a full reserve-backed banking system refuses to die and has now become a respectable topic of research. It is perhaps not surprising that many of his ideas have such modern day resonance since many of today’s global economic problems echo those of the 1920s and 1930s. Indeed, as he wrote in 1934: “There is a growing exasperation that an age so splendid and full of the noblest promise of generous life should be in such ill-informed and incompetent hands.”

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[1] Diamond, D. W., and P. H. Dybvig. 1983. ‘Bank Runs, Deposit Insurance, and Liquidity.’ Journal of Political Economy 91(3) pp401-19

Should we continue spending a penny?

One of the policy ideas that was floated in the wake of last week’s UK Spring Statement was the possibility of scrapping the lowest denomination coins (the 1p and 2p piece). According to research cited by the Treasury last week, “surveys suggest that six in ten 1p and 2p coins are used in a transaction once before they leave the cash cycle. They are either saved, or in 8% of cases are thrown away” (see chart). Since the Royal Mint has to produce and issue additional coins to replace those falling out of circulation, and because “the cost of industry processing and distributing low denomination coins is the same as for high denomination coins” this not unreasonably raises the question of whether we need the lowest denomination coins.

I have to confess that I have long wondered the same thing given that over the years I have collected large quantities of pennies in jars, which weigh a lot but have little monetary value. Moreover, the amounts in coin which vendors are legally obliged to accept in the UK are very low. For example, the legally acceptable maximum payment in 1p and 2p coins is a mere 20p (it can be more, depending on the discretion of the payee). For 5p and 10p coins, that limit rises to £5. That is a very arbitrary amount: I can legally only use 20 x 1p coins in one transaction whereas I can use 100 x 5p coins (which are also  irritatingly small). I also recall that the one time many years ago when I wanted to cash in my pile of bronze and took it down to the automatic machine at my local supermarket, the nominal value of the coins was something like £42 but I paid a £2 commission fee, corresponding to almost 5% (and yes, I know I should have taken it to a bank).

So it should be clear that I am not a fan of coinage that clutters up space for little return. And the UK has form when it comes to taking small denomination coins out of circulation. Way back in 1960 the farthing was removed from circulation. For those unfamiliar with UK coinage, the farthing was equivalent to a quarter of a pre-decimal penny – around one-tenth of a modern penny. In 1983, the halfpenny was taken out of circulation and I do not recall any great wailing and gnashing of teeth at the time. Moreover, since 1984 the price level as measured by the CPI has increased by a factor of 2.5, and one penny today is worth less than 0.4p in 1984 prices. In other words, the real value of the penny today is less than the halfpenny in 1984.

One of the arguments which is increasingly used in favour of demonetising the smallest unit is that its face value is often less than the cost of production. In the US, for example, it cost 1.5 cents to mint each penny in 2016, and although the US continues to issue the penny, the Bank of Jamaica recently announced it would phase out the one cent coin on the grounds that it is too expensive to make. The Royal Mint in the UK has not revealed how much it costs to strike a penny in the UK, but so far as we know it is less than its face value.

But the penny has a strong hold on the UK public imagination and last week’s suggestion was met with such a howl of outrage that the government was forced to back down. It has been around for a thousand years in various guises although it was not until 1714 that it began its transformation from a little-used small silver coin to the bronze item that has become such a staple part of the UK coinage system. Some people are concerned that abolishing the penny would encourage retailers to round up prices – and there may be some truth to that – but a better argument against abolition is that low income households are bigger users of cash and they would likely be hit disproportionately hard by its abolition. Indeed, it is notable that the Treasury’s call for evidence was based on the notion that we are increasingly moving towards electronic cash – but whilst that may be true for most, it is not so for all. The charity sector was also quick to argue that the collection bucket is a useful place to get rid of low denomination coins.

But as much as I value tradition and have no desire to impoverish the less well-off, the arguments in favour of keeping the penny are not strong enough to save it in my view. Inflation has eroded its usefulness – as anyone who has tried to spend a penny in recent years can testify. It ought to go the way of the threepenny bit, the sixpence and the half crown – not to mention the pound note. In any case, there is still the 2p – why keep the penny when you can have two of them in one coin?

Keep the hands off the stash

They say that we live in a cashless society. The same cannot be said for India. On 8 November, the prime minister gave just four hours’ notice that 500 and 1,000 rupee notes would no longer be legal tender. People were told they could deposit or exchange their old notes at banks until 30 December, and new 500 and 2,000 rupee notes would be issued. This dramatic move was designed to flush shadow economy transactions out into the open in a bid to curb tax evasion. Given that these notes made up 86% of all cash in circulation, this has clearly led to more short-term disruption than necessary.

Official figures from the Reserve Bank of India suggest that as of January, currency in circulation with the public was almost 43% below year-ago levels. This does not bode well for overall economic growth: The IMF has lopped one percentage point off its 2017 growth projection, with the October forecast of 7.6% having been recently downgraded to 6.6%. According to the IMF, the disruptions which forced people to queue outside banks to exchange their notes and the simple shortage of cash resulting from the switchover, will curb consumption in the early part of 2017. It is fairly certain that activity will subsequently recover and before too long India will be able to regain its crown as the “fastest growing major economy” (it might still hold onto this position, depending on what happens in China in 2017). Nonetheless, the episode highlights how an apparently capricious decision of this nature can have far reaching consequences.

One of the prerequisites of money in a modern economy is that it acts as a stable source of value and medium of exchange. At a stroke the Indian government wiped out the cash holdings of those citizens who had not deposited their money in the bank, and in the process has done nothing to win the trust of those who have been disadvantaged. A bigger issue is that if we erode trust in money, we potentially erode wider trust in institutions.

In Europe, for example, the ECB has faced a battle to establish its credibility, particularly in Germany where it replaced the much-revered Bundesbank. As former European Commission president Jacques Delors pithily remarked in 1992: “Not all Germans believe in God, but they all believe in the Bundesbank.” Many people in Germany today have a problem with the monetary policy which the ECB is conducting because they see a huge explosion in the stock of money created by the central bank which they fear will ultimately lead to higher inflation. Whether they are right or wrong, only time will tell. But it is important for the ECB to win the credibility battle today or it may not survive long enough to say ‘we told you so’.

As it happens, there is a strong case for suggesting that if governments are serious about reducing the scope of the shadow economy, maybe they should withdraw all high value notes from circulation. To the extent that it is pretty easy to transport large quantities of cash in 1,000 Swiss franc notes or the 500 euro note without carrying a huge volume, the authorities are concerned about their use in illegal transactions. As a neat little paper by Peter Sands points out (here), the equivalent of one million dollars  in cash weighs just 2.2 kg in the highest denomination euro note whereas it weighs 10kg in the highest denomination  US dollar bills. Precisely for this reason, the ECB is to stop issuing the 500 euro note next year.

But in contrast to the ECB, which has given plenty of warning, the Indian authorities gave virtually none. As a way to crack down on the shadow economy and other avoiders of tax, it may well be highly effective. But if it leads to a sharp decline in economic activity with consequences for tax revenue, it may turn out to be counterproductive. Moreover, the government rather strangely decided to phase out the 1,000 rupee note and replace it with a 2,000 rupee note. It is not exactly what the authorities elsewhere would advocate in the fight against shadow activity. But given recent experience, those who might be tempted to hold any of their untaxed income in rupees in future may think again. It will thus be interesting to see whether it ultimately boosts demand for gold – the ultimate safe haven during times of uncertainty.