Pay attention ‘cause this is a tricky one. Former Chairman of the US Federal Reserve Alan Greenspan said something very interesting in a recent interview on MSNBC. When asked were US treasuries (US debt) still safe to invest in [coming after the US downgrade by Standard & Poors to AA+], Greenspan replied “ Very much so. This is not an issue of credit rating. The United States can pay any debt it has because it can always print money to do that so there is zero probability of default.”
Printing money (aka Quantitative Easing or QE1, QE2 etc in the US) conjures up images of ropey old monetary dinosaurs, eyes bulging as giant money presses spit out endless dollars, euros, yen , yuan or what have you. In the electronic age, luckily you don’t actually have to physically roll out legal tender paper and print away to your hearts content (at least, not in a civilised economy). Instead, you can use a trick of accounting to simply write in €10bn, €20bn, €100bn…onto the ‘asset’ side of the Central Bank balance sheet (or in the ECB case, the balance sheet for the eurozone-17).
The hope is that printing money will spark economic growth or inflation or both. Why? Well think of this. Every economy consists of goods and services – that’s what we produce. If that’s what we produce, then surely measuring money – what we spend on that stuff – is measuring how the economy is doing. Which it does.
Economic growth then (the change in output year on year) must = the amount of money in the economy (supply) X the speed its sloshing around (velocity).
Today, the speed (velocity) has dropped to a standstill. But, each Central Bank can increase the supply! How?
- Lower interest rates (make existing money ‘cheaper’)
- Print money (make more money)
Lower Interest Rates
As interest rates drop to zero, its use as a tool stir up some economic activity collapses. Think about it. Interest rate falls encourage people to spend more and save less.Mortgages are cheaper, more to spend by homeowers on anything other than interest, your savings earn less in the bank so you withdraw them and buy a new car etc.
As people spend, the economy grows, demand grows, more is produced, more people are working and eventually prices rise (inflation). To stop inflation? Raise interest rates, people save more and spend less and you stabilise your economy. In a recession, things are far more rocky. Reducing the interest rate may not have an effect because:
- Consumers/businesses face uncertain futures and mounting bills so they choose to save for a rainy day (which is every day in a bad recession like the current one).
- The banks (the ‘pipes of the financial system’ that deliver credit around) are in such a mess (full of toxic/bad debts and facing a market blighted by uncertainty) that reducing the rate may not be passed on to consumers by retail banks in totality – as banks try to keep as much money in their vaults and spend it on doing more profitable things – which, thanks to (a) is probably not loaning it to consumers/businesses. This means banks prefer to buy shares, buy non-bank companies, buy government bonds (treasuries) – because even though they are, on paper, potentially on paper less profitable then lending to consumers/businesses – the bank thinks the gamble is worth it.
In other words, you can’t just force people or businesses to spend. Right so, as a Central Bank you’ve tried to make money ‘cheaper’ and more widely available – and it didn’t work. What now?
The alternative is to just make more money yourself. As printing money is seen as a direct and efficient way to transfer cash to the household/consumer sector i.e. you, me, the guy who works in the local Spar etc. The way the Central Banks do this is via the banking sector. Because you, me and your man in Spar all have bank accounts or deal with banks in some form or another.
Lets say the European Central Bank conjures up €100bn in its balance sheet. It then lends it to the Irish Central Bank, the Greek Central Bank, the Portuguese Central Bank and so on. These Central Banks (being the nerve centre for all banking in each country) holds this money, allowing the country’s banks to write loan cheques with the ECB money safely tucked away in the Central Bank vault. As banks only need to have a ratio of around 10:1 of loans: reserves – it can lend out 10 times the amount it keeps in the vault. Remember that the ECB created this itself. Its artificial. Imaginary. But can be cheap and effective. And it sloshes around the system/the economy, doing lots of good along the way – until interest rates rise again and take it back out of the system.
Sounds great! Why not do it?
Theres a few reasons…
- Inflation Injecting money artificially into the system can be like throwing another shovel of coal on the fire. Too much coal and the fire will roar, possibility out of control. If you rapidly increase the amount of cash in the system, leaving demand the same – inflation in evitable. Why? Imagine you personalised it. Every man and woman received €100 from the government (who got it from the ECB, say). They pop into the local Apple store. The number of iPhones (supply) on the shelves they can buy has not changed. Only demand for the iPhones has. For supply of iPhones to meet demand for iPhones, prices would inevitably rise (think of the prized ‘very hard to get’ Christmas toy every Christmas). So, supply of money increases à demand for iPhones increases à supply of iPhones remains the same à demand for money falls (why need money if I cant buy what I want). With demand booming for iPhones, Apple will try to produce more or open their stores longer to deal with demand needing to pay higher wages. Imagine this same things happening across the world in different cities for different products. With prices rising and wages rising, that €100 you got way in the past is not worth nearly as much to you. For the country, your exports have become less competitive, and imports boom to feed the demand. As a country, deficits mount and you’re in deep trouble. Of course inflation does always happen. When tried in Japan in the 1990s, inflation didn’t happen. Then again, the effort itself didn’t have much effect either.
- Reputation Printing money = an admission of a basketcase economy to investors. The US is slightly different because the value of the dollar is never really in dispute. However the same cannot be said about the current fragility of the euro. It won’t break up or collapse but that doesn’t stop people betting or thinking that it will. Happily, the architecture of the euro (ECB control of monetary policy) means that the eurozone-17 cannot print money, an action that without the euro, political pressure would force a very different resolution. Plus its never been proven to work. Where it was used (In Japan) it had some success but was judged to be mute.
- Germany Germans and by extension the ECB (modelled on the German Bundesbank and funded predominately by Germany) are fixated on price stability. To them, printing money = inflation and instability, a big no-no.
- History Printing money has a chequered history in Europe. 1920s Germany saw hyperinflation thanks to printing money recklessly turn tens of marks into millions and billions of marks for the same item nearly overnight. In response, the near worthless currency was used to paper walls, light fires and…well you guess what else…
- Optimal Size? The optimal amount required to make a difference is inexact. Its always great to look like the government (or ECB) is ‘doing something’ to convince investors but it smacks of throwing money into a black hole. If the CB creates too much, the country/countries it administers will suffer inflation and be priced out of export markets. In other words, action now might bring an upswing in the short term but leave you pretty shagged in the long term. Economists will say ‘if exactly the right amount is printed, the effect will bring employment levels back to normal with little inflation.’ That’s true, depending on what you do with the money.
- Value of your currency following on from the last point –what if you overprint? You’re in deep trouble. The value of your currency will fall, those in the know will not buy it and buy more ‘stable’ currencies which are holding their value. If the BoE did this, then theoretically where £1=$1, suddenly £0.50= $1. Lots of Americans might buy British goods, sparking a boom in exports but with a silver lining of possible rampant inflation (see inflation).
- Commodities You cant be sure that money will go into the economy. Banks could just end up buying commodities (gold, copper, silver, nickel, tin) bringing their price up. The price of gold for one is skyrocketing recently hitting a record high of $1,800 an ounce, similar to levels seen during the economic uncertainty of the 1970s and 1980s. Why? Gold holds its value well and no ones making any more of it. It’s as near a sure thing ‘safe haven’ investment as you can expect in this day and age. Therefore a good measure of uncertainty in the economy is the rising place of humdrum commodities. Of course, what goes up…
The bottom line: Markets like stability. Markets hate instability. Fiddling around with ‘printing money’ generally means injecting instability unless you do it in a targeted way. (unless you have a Delorean and have gone to the future to analyse how much money you should create). The political pressure to ‘do something’ might tip Central Banks into sacrificing long run stability for short run gains.