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.