The Old Lady (of Threadneedle Street) fails to get an ‘A’

In two recently released videos, the Bank of England (BoE) explains what fiat money is and what monetary policy means.

This is good progress in the understanding of monetary operations, especially in the light of conventional wisdom having inspired a number of erroneous interpretations during the banking and financial crisis.

However, more progress is desirable, notably with respect to the following statements written in boldface.  I will explain why, at the end of this post.

Both in videos and publications, the BoE describes the use of money as a convenient alternative to individuals issuing their own IOUs, when confidence would be an issue. Similarly, banknotes issued by the BoE are IOUs from the central bank to the individual holding the banknote. The difference, however, is that BoE banknotes are supplied by a single (monopolist) supplier, not by a variety of individuals.

A twenty-pound note is no longer convertible into gold. However, it is “worth twenty pounds precisely because everybody believes it will be accepted as a means of payment both today and in the future… And for everyone to believe that, it is important that money maintains its value over time and is difficult to counterfeit. It’s the central bank’s job to ensure that that is the case.”

The BoE also makes it clear that the amount of central bank money is fixed by the demand of its users and not by the central bank “as it is sometimes described in some economics textbooks.” They also explain: “Loans create deposits, not the other way around”; “QE is not free money”; and bank reserves do not provide incentives for banks to lend “as the money multiplier mechanism would suggest”.

They further explain that the central bank controls interest rates, and they claim that this is a powerful means to provide the ultimate limit to bank lending. Monetary policy, they claim, directly affects the amount of lending and “broad money”, such as M2, or M3.

The Great Faults in monetary management committed during the Great Recession hide in the innocent statements above (in boldface) and this is why:

  • The basis for acceptance of fiat money is not simply people’s confidence. As has long been known by money historians dealing with “token money” and by economists who are aware of the political foundation of money, any national currency that is ‘fiat’ can be redeemed in the form of ‘tax credit’. In other words, the national currency is the only means that people can use to pay their liabilities to their government, notably taxes. The BoE is silent on this point.
  • The effectiveness of the “transmission mechanism” whereby interest rates affect lending and the overall economy is known to be ambiguous. The fundamental reason is that banks are pro-cyclical, as a famous quote attributed to Mark Twain explains effectively: A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain. The level of interest rates affects the economy mildly and in an ambiguous way. To state that monetary policy is powerful is an unsubstantiated claim.

Negative rates: Should we take Alan Blinder seriously? Or José Viñals?

I recently argued that negative rates are just another tax on the private sector, and are no incentive for bank lending to households and firms. In my view, with interest rates below zero the economy will freeze up. Alan Blinder has argued exactly the opposite. For Blinder,

If the Fed turned the IOER [interest on excess reserves] negative, banks would hold fewer excess reserves, maybe a lot fewer. 

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ECB: What do negative interest rates do?

Responding to press conference questions, ECB President Mario Draghi has said the ECB is ‘technically ready’ to bring interest rates below zero.

Yesterday, Bloomberg reported rumors that the ECB is ready to act. Today, Draghi denied that there is anything new happening on this front, and ECB Board member Asmussen said he’d be cautious about using negative rates.

While traders keep trying to guess Draghi’s next move, one may want to consider, one more time, the effects of negative interest rates.
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Big news from Frankfurt…or not?

“ECB Cuts Rates Unexpectedly as Low Inflation Threatens Recovery”

“The ECB cut the main interest rate at which it lends to banks to 0.25%”

“The ECB showed the need to act”

Wait a minute.

The interest rate that matters for monetary policy (this is the rate on loans between banks) is already below 0.1%, so today’s move is not going to get this any lower!

Today’s move does nothing except sending another signal that the Euro economy is in full deflation, and the ECB is likely to keep the current rates that low for a longer time.

No actual change of interest rates.

And no impact on the real economy, anyway.

Just more evidence that the overall European deficit is too low!

George Soros’s (incomplete) proposal to save Europe

George Soros has formulated one more call for Eurobonds here.

I’m in agreement with most of it.  Yet, not all.

  • Divergence in the Eurozone was largely caused by Germany not complying with the 2% inflation rule. Deflation, ever since 1999, gave Germany a means to lower the real exchange rate and steal demand from its partners (beggar-thy-neighbor).
  • There is nothing good with Greece running a surplus: A surplus means that financial assets owned by the private sector are reduced by the same amount (as a matter of accounting).
  • Eurobonds would compare well with U.S. Treasuries if and only if the ECB agreed to be the lender of last resort of the Eurozone
  • Remedying the euro’s main design flaw requires more than Eurobonds: There must be, at a minimum, a means to let automatic fiscal stabilizer work. Today, fiscal stabilizers cannot work and fiscal policy is pro-cyclical, as described in the chart here.
  • Hitler was the outcome of harsh reparations plus the 1931 crisis that was caused by austerity and the Reichsbank not willing to fund German Treasuries for fear of inflation.

The problem with Quantitative Easing…

… was illustrated today by Raghuram Rajan, the Reserve Bank of India governor, along these lines:


Rajan also questioned the existing monetary policy stance of industrial countries. Specifically, he asked whether pushing real interest rates lower through forward guidance, asset purchases or nominal rate cuts was “part of the solution, or part of the problem”.

The slow pace of growth, he said, casts doubts over whether the low interest rate environment was really encouraging people to spend and invest more.

He observed that the main spenders before the crisis were typically the people who were hit the hardest, and made the point that people who had borrowed against their houses were now struck with negative equity.

The people who saved before the crisis, he said, were largely saving for their retirements. After the crisis they find themselves needing to save more, a problem that is compounded if the central bank pushes down real interest rates and reduces their income further.

In other words, low interest rates have a contractionary effect.

The austerity chart that’s worth 1000 Words

This is an update of my favorite chart these days, following the release of this year’s first semester figures of Eurozone unemployment (19 million 246 thousands).

The overall government deficit (all 17 countries included, dotted red line) peaked in 2010 when austerity began. It has declined since then. And notice: Last time it declined  (2005-07), it dropped a bit with a bit of growth and job creation. Not because of austerity.

With austerity, the falling deficit correlates with job destruction: First time in the one-and-a-half decade of the euro.


And the reason is simple: Governments’ provision to raise taxes and cut spending has, unsurprisingly, acted pro-cyclically.

European leaders must have strong, powerful reasons to implement policies that harm the physical and emotional health of their citizens. Do they?

More on this on Social Europe.