Friday, 9 January 2015

Who creates the money that funds QE?

I say central banks do. Frances Coppola says COMMERCIAL banks do. In particular she says “The only institutions that can create the money used for economic transactions in the real economy are commercial banks…”. She is overstating her case there.

But this is a complicated and partially semantic argument. This is my attempt to unravel the complexity.

According to a work called “Quantitative Easing” and published by the House of Commons Economic Policy and Statistics Section, paragraph 3.1:

“Central banks have the ability to ‘create’ money. This happens electronically rather than through the physical printing of extra bank notes. The banks will then use this money to fund purchases of assets. The Bank has mainly purchased government bonds. Purchases of government bonds will increase commercial banks’ deposits at the Bank of England.” (Incidentally I’m almost certain that “The Bank” refers to the Bank of England.)

So that seems simple enough: it’s the central bank that creates the money.

However, in the US, the central bank, the Fed, only deals with so called “primary dealers” when it wants to purchase government debt. And primary deals are all banks.

Now that’s slightly different to the UK where the Bank of England purchases debt direct from both commercial banks and other financial institutions like insurance companies and pension funds.

According to Standard Life:

“QE is a way for the world’s central banks to boost the economy and avoid deflation. They ‘create’ money — not actually printing it but electronically — and use it to buy assets from financial businesses. Typically they buy government bonds. The banks, insurance companies and pension funds selling such bonds…”.

So…where the central bank buys from commercial banks, the procedure is (far as I can see) that the CB announces it’s in the market for government debt, so commercial banks create some money and run out into the market and purchase government debt which they will sell to the CB a short time later.

In that case, it can indeed be argued that the money for QE is created by commercial banks. On the other hand those commercial banks wouldn’t create that money unless they knew that a short time later they were going to be reimbursed with CB created money. So who “creates the money that funds QE?” It’s a bit of a chicken and egg question. It’s semantic.

On the other hand where the CB purchases debt DIRECTLY off non-bank institutions like insurance companies and pension funds, then CB money is presumably created first. (Though it wouldn’t be impossible for commercial banks to have some agreement with insurance companies etc under which the latter don’t get paid till commercial banks have pocketed money obtained from the CB.)

 Give everyone an account at the central bank?

A further point which reduces the relevance of commercial bank created money is that there is nothing in theory to stop everyone having an account at the CB. That is, the only reason that CBs limit the number of entities that can open accounts a CBs is to keep things simple for CBs.

An if everyone DID HAVE an account at the CB, then commercial banks would become irrelevant to the QE process: that is, to effect QE, CBs would just create money out of thin air, and give it to government bond holders in exchange for their bonds. The latter individuals / entities might at some later date transfer that money to an account at a commercial bank, but that’s by the by.

And letting everyone have an account at the CB is not an outlandish idea. William Hummel advocates that idea. And the Fed has recently been activity considering the idea. Plus in the UK, anyone can open an account at “National Savings and Investments” which is a government run savings bank. NSI does not give customers cheque books or plastic cards and it does not offer loans. But money can be withdrawn and transferred to a commercial bank within 24 hours. So that’s getting very close to letting everyone have an account with the government / CB machine.

Commercial bank created money.
In contrast to the above rather semantic question as to whether it’s commercial banks or CBs that create the money that funds QE, there are cases where money is DEFINITELY created by commercial banks and not by CBs: that’s where such a bank lends out money created out of thin air to mortgagors and businesses. And commercial banks do that a thousand times a day.

So with a view to maintaining a clear distinction between the latter form of money creation and money creation that funds QE, I’m claiming that when it comes to mortgage and business loans, the relevant money is DEFINITELY created by commercial banks. In contrast, when it comes to the money that funds QE, I’d call that “CB created” money. But like I say, that’s a bit semantic.


  1. Could money creation be less complicated than this?

    I am looking at a green American Dollar ($1). I is a convenient size, shape, and weight. It has the signature of the Treasurer and Secretary of Treasury of the United States. It is a fairly new bill with the signature Timothy Geithner.

    Across the top of the face of the bill are the words "Federal Reserve Note". Apparently it is a NOTE.

    I am aware that the Treasury of the United States also issues BONDS.

    With this background, I can imagine that the Federal Reserve issues NOTES and the Treasury of the United States issues BONDS. Representatives of each organization can meet and exchange products, so that each representative can walk away with the others work.

    Then the Federal Reserve can happily hold bonds and Treasury can pay the debts of the United States.

    And of course this can all be done electronically!

    This process is unbelievably simple. Maybe too easy to believe.

    Thanks for the post.

    1. If you're suggesting that only central banks should create money (i.e. that commercial banks should be banned from creating money), then I agree. That's full reserve banking and it's certainly simpler (and more stable) then the existing system.

  2. As far as I know both the Treasury and the central bank only accept reserve balances in exchange for treasuries.
    Commercial bank created money is not accepted for this purpose. Banks either already have enough reserves to buy the treasuries or they must borrow them.

    1. Agreed. In the above article I was just trying to work out how much truth there is in Frances Coppola's claim that it's COMMERCIAL bank money that purchases bonds under QE. Far as I can see (to repeat) her claim is only true where commercial banks purchase government bonds PRIOR to selling them to the central bank, at which point (as you rightly say) the central bank issues reserves in exchange for the bonds.


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