The Big Mystique

William Davies

  • The Courage to Act: A Memoir of a Crisis and Its Aftermath by Ben Bernanke
    Norton, 624 pp, £27.99, October 2015, ISBN 978 0 393 24721 3
  • The End of Alchemy: Money, Banking, and the Future of the Global Economy by Mervyn King
    Little Brown, 448 pp, £25.00, March 2017, ISBN 978 0 349 14067 4

Early in 2014, the Bank of England put out a quarterly bulletin entitled ‘Money Creation in the Modern Economy’ which put to bed one of the most persistent – and false – claims in the history of economics. According to orthodox economists as far back as Adam Smith, money originates in the need to exchange one good for another. I have produced more bread than I need, you have produced more clothing than you need, and we need some simple instrument by means of which to swap one for the other. Products and services different in kind can all be rendered comparable and tradable, once they are assigned a monetary price. Money is on this view first and foremost a means of exchange, and banks are like warehouses, storing and distributing it. If anything goes wrong with money, it’s almost certainly the fault of the state for borrowing and printing too much of it, which causes inflation. All this is what Mervyn King, governor of the Bank of England between 2003 and 2013, refers to as the ‘traditional’ theory of money. But ‘Money Creation in the Modern Economy’ explained that money can be created out of thin air, which is exactly what happens every time a bank makes a loan. Banks don’t wait for a customer to drop £100 into their savings account before lending it to someone else. When they lend £100 they add the figure to the borrower’s account while simultaneously recording it as an asset on their own balance sheet. Banks aren’t warehouses; they are more like alchemists.

The implications of this are profound and politically far-reaching. Since the late 19th century, economics has focused principally on the mechanisms of market exchange – consumer preference and price – while trying to ignore the inconvenient realities of how credit and debt are created. Money viewed in terms of exchange exists purely in the present tense, as the possibilities it offers me right now. It behaves as instructed. Understood as credit, however, it knits together past, present and future, with all the hopes, disruptions and uncertainties that go along with that. It’s here that money becomes caught up with ideas of progress and risk. It is also where money starts to misbehave.

Free marketeers have always tried wherever possible to neutralise money, to reduce it to something inert and predictable, and free from political meddling. The idea of the gold standard retains its hold on libertarians and economic conservatives alike because it seems to anchor money in something outside politics altogether, whose supply is determined by nature. For less dogmatic free market liberals, rigidly governed independent central banks are the more palatable alternative: the illusion can be maintained that they are apolitical, even while they control the levers of monetary policy. Displays of anti-democratic bravado, such as those made by the European Central Bank during the Eurozone crisis, both depend on the premise and deepen the sense that the rules of money are set in stone. The intended message is that money is under control, but not under political control.

In as much as they are unelected experts who exist at arm’s length from any parliament, independent central bankers might be described as ‘technocrats’. But to compare them to other technocrats (energy regulators, say) would be a gross mistake. Part of the task of running a central bank, at least until recently, has been to sustain the image of money and banking as tedious, technical matters, not political at all. Most technocrats can just get on with technocracy; central bankers have had to give a convincing performance of it for the public and the markets. When all goes to plan, money is something we all take for granted, and that owes something to central bankers’ carefully choreographed displays and neurotically crafted statements that there’s nothing to see here, please move on.

Why would the Bank of England publish a paper like ‘Money Creation in the Modern Economy’? The most immediate explanation is that the Bank itself has been engaged in the strategic invention of new money on a vast scale – more than £400 billion and counting – since Quantitative Easing (QE) was introduced in 2009. Just as commercial banks create money when they lend (which magically appears as an asset on their balance sheet), central banks can create money by buying government gilts from pension funds and insurance companies, and adding the cost to the liabilities on their own balance sheets. The expectation is that the pension funds and insurance companies, having sold their gilts to the central bank, will then use some of the money they receive to buy additional assets (such as equities) so as to rebalance their portfolios. Payment for the gilts is made into the sellers’ bank accounts, so that commercial banks’ reserves are increased at the same time, which in turn increases the amount those banks are able and (ideally) willing to lend. The idea is that flooding the financial sector with new money in this way will increase bank lending and capital investment. But the whole process begins with a technocratic diktat: the central bank decides to increase the quantity of reserves that commercial banks are deemed to hold with it, and does so merely by altering a figure on a screen.

If you’re open to the charge that you’re performing conjuring tricks in the public’s name, maybe it’s safest to fess up and explain how such tricks are managed. The Bank of England’s revelation of where money comes from was in keeping with an effort that central banks have been making for some time to demystify what they’re up to. This effort has been a guiding principle of the careers of both Mervyn King and Ben Bernanke, who was chair of the Federal Reserve between 2006 and 2014. The watchword of central banking since the early 2000s has been ‘transparency’, with ‘inflation-targeting’ the mechanism chosen to achieve it. Once a central bank has made known its target for inflation (meaning inflation can fall too low as well as rise too high), outsiders can form a pretty good idea of what it’s going to do next. The aim is to minimise the sense of surprise that accompanies announcements of monetary policy, so that the markets can ‘price in’ interest rate changes before they actually happen.

The policy was first introduced in New Zealand in 1989 and instituted by the Bank of England in 1997 when the incoming Labour government made the Bank independent. Combining central bank independence with inflation-targeting was the means chosen to kick politics out of monetary policy. The thinking was that while politicians, policy fads and whole governments may come and go, investors and currency traders can rest assured that over the long term interest rates will be set according to unbending institutional rules. Bernanke argued the case for inflation-targeting by the Federal Reserve for many years, and eventually got his wish in 2012. Most central banks set their inflation target at 2 per cent, the figure that is seen as offering adequate price stability to investors without throttling growth and employment. This figure is used to justify QE: inflation has been too low in many economies since the financial crisis, warranting ‘unconventional’ monetary policies in an effort to stimulate bank lending. In addition to an inflation target, publishing the minutes of monetary policy committee meetings further exposes the mechanics of how money is made and regulated.

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