Cooking The Books 2: Financial Alchemy
When the Bank of England introduced “quantitative easing” last year is was popularly described as the government having recourse to the printing press. This was not meant to be taken literally – the Bank of England did not arrange for more notes to be printed – as it was done electronically. Nor, as Charles Bean, a deputy governor of the Bank of England explained in a speech to the London Society of Chartered Accountants on 13 October (www.bankofengland.co.uk/publications/speeches/2009/speech405.pdf), was it the same process that leads to more currency (notes and coins) getting into circulation (through banks being put in a position to have to convert some of their reserves with the Bank of England into cash).
Bean described it as “a programme of large scale asset purchases financed by the issuance of extra reserves”. A new fund called the Asset Purchase Facility was set up to which the Bank of England has so far lent £200 billion. This did not come out of the Bank’s existing assets but was literally created out of nothing:
“Technically what happens is the following. The Asset Purchase Facility buys assets funded by a loan from the Bank. In turn, the Bank funds that loan through additional reserve creation. If that sounds like financial alchemy, consider how the money flows through the system. When the Asset Purchase Facility buys a gilt from a pension fund, say, it can be thought of as paying with a cheque drawn on the Bank of England. The pension fund will then bank the cheque with its own commercial bank, so the latter now has a claim on the Bank of England – that is what reserves are. In reality, these payments are not made by cheque, but rather are carried out electronically. But the principle is the same, though one key difference is that we pay the Bank Rate to the commercial bank on its claim on us, as well as charging the Bank Rate on the loan we make to the Asset Purchase Facility.”
So, what is involved is a circulating IOU from the Bank which can be used to buy financial assets and which, from an accounting point of view, takes the form of a notional increase in the reserves which the commercial banks keep with the Bank of England, except that it is the Bank not the commercial banks that has increased these reserves.
Will this cause inflation? After all, what the Asset Purchase Facility spends does represent an increase in purchasing power. However, the immediate aim is not to cause a rise in the general price level but a rise only in the price of government bonds and stocks and shares:
“If the Asset Purchase Facility buys gilts from pension funds or asset managers, they will then have to look for another home for their money. As it is not very rewarding just to hold it on deposit, they are likely to look to put their money into other assets, including equities and corporate bonds. Thus not only does the price of gilts rise as a consequence of the Asset Purchase Facility’s initial purchases, but also the prices of a whole spectrum of other assets”.
This limited aim seems to have been achieved as prices of bonds and shares on the stock exchange have risen, helping to repair some black holes on financial company balance sheets. But there is supposed to be a wider aim: to “boost spending and activity” as Bean put it. Which hasn’t been achieved. Bean, in fact, honestly admitted that if and when economic activity revives there will be no way of telling whether or not this was due to quantitative easing “for the simple reason that we can never know with precision what would have happened in its absence”.
The intention is that, as the real economy recovers, the process will be reversed. The Asset Purchase Facility will sell the bonds it purchased and repay its loan from the Bank of England. The Bank will then liquidate the corresponding commercial banks’ reserves with it. If this happens there will be no general inflationary effect as the extra purchasing power pumped into financial markets will be taken out again. But this could be years away. In the meantime the extra purchasing power will continue to go towards financing a stock exchange revival, even perhaps a speculative bubble – while the real economy goes its own way, recovering in due course for real economic reasons not through financial alchemy.