Quantitative Easing: What happened to the money?

Quantitative Easing (QE) created reserves to pay for bonds (eventually entirely government bonds) bought by the Bank of England from the private sector. The expectation was that those who sold the bonds would use the money to buy new bonds issued by private corporations to replace bank lending which had dried up.
The first chart shows how the levels of securities outstanding have changed relative to their levels in March 2009, the start of QE.







In the run-up to the crisis, private non-financial corporations (PNFCs) were not raising any new money by issuing bonds or shares, whilst banks and other financial corporations (OFCs) were each issuing new securities at a similar rate to the government. These rates accelerated sharply after Lehmans’ collapse in September 2008, but slowed markedly at the onset of QE (although the gilt issue settled at around £15bn a month – by September 2013, the par value of gilts in issue had increased by £825bn since the onset of QE). PNFCs however, did start to issue bonds to take advantage of the QE money.
The second chart stacks the bond issues together to compare the amounts raised with the money made available by QE.







This shows that for the first round of QE, around 75% of the money was taken up through bond issues by the private sector, although the finance sector took the lions’ share. With the onset of the second round, however, the banks began to pay off their bonds, and with the third round, so did the other financial corporations. The PNFCs, however, continue to raise money through this route.
The third chart shows that the banks were able to retire their debt funding because of the accumulation of retained earnings, which stabilised their levels of capital, although these slipped back during the second half of last year.







The other financial corporations were presumably also able to redeem their bonds by accumulating retained earnings.
It can be surmised from this, that the balance of the money from the first round of QE, and substantially all of that from subsequent rounds was used to purchase gilts, and the fourth chart shows that there were plenty to choose from, with falling yields providing attractive opportunities for capital gains.






In conclusion, quantitative easing has had three effects:

1. by creating an artificial demand for gilts it increased their market price, thereby reducing yields and increasing the attractiveness of higher-yielding corporate bonds;
2. in a time of uncertain asset valuations it enabled the financial sector to raise temporary loss-absorbing loan capital by issuing bonds, which gave them the breathing space to build up their equity; and
3. it provided for those corporations who were able to manage the issue of bonds a source of debt funding to replace the bank lending which had dried up due to that uncertainty.

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Where Does Money Come From?

Key findings

• Physical cash accounts for less than 3% of total money in the economy.
• Commercial banks create the other 97% and play a key role in deciding where it should be allocated.

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December 12, 2012 // Written by:

Andrew Jackson,Richard Werner,Tony Greenham,Josh Ryan-Collins

Second edition available to buy now, including new sections on Quantitative Easing, LIBOR and the Eurozone sovereign debt crisis.
There is widespread misunderstanding of how new money is created. Where Does Money Come From? examines the workings of the UK monetary system and concludes that the most useful description is that new money is created by commercial banks when they extend or create credit, either through making loans or buying existing assets. In creating credit, banks simultaneously create deposits in our bank accounts, which, to all intents and purposes, is money.
Many people would be surprised to learn that even among bankers, economists, and policymakers, there is no common understanding of how new money is created. This is a problem for two main reasons. First, in the absence of this understanding, attempts at banking reform are more likely to fail. Second, the creation of new money and the allocation of purchasing power are a vital economic function and highly profitable. This is therefore a matter of significant public interest and not an obscure technocratic debate. Greater clarity and transparency about this could improve both the democratic legitimacy of the banking system and our economic prospects.
Defining money is surprisingly difficult. We cut through the tangled historical and theoretical debate to identify that anything widely accepted as payment, particularly by the government as payment of tax, is, to all intents and purpose, money. This includes bank credit because although an IOU from a friend is not acceptable at the tax office or in the local shop, an IOU from a bank most definitely is.
We identify that the UK’s national currency exists in three main forms, the second two of which exist in electronic form:

1. Cash – banknotes and coins.
2. Central bank reserves – reserves held by commercial banks at the Bank of England.
3. Commercial bank money – bank deposits created either when commercial banks lend money, thereby crediting credit borrowers’ deposit accounts, make payments on behalf of customers using their overdraft facilities, or when they purchase assets from the private sector and make payments on their own account (such as salary or bonus payments).  

Only the Bank of England or the government can create the first two forms of money, which is referred to in this book as ‘central bank money’. Since central bank reserves do not actually circulate in the economy, we can further narrow down the money supply that is actually circulating as consisting of cash and commercial bank money.
Physical cash accounts for less than 3 per cent of the total stock of money in the economy. Commercial bank money – credit and coexistent deposits – makes up the remaining 97 per cent of the money supply.
There are several conflicting ways of describing what banks do. The simplest version is that banks take in money from savers, and lend this money out to borrowers. This is not at all how the process works. Banks do not need to wait for a customer to deposit money before they can make a new loan to someone else. In fact, it is exactly the opposite; the making of a loan creates a new deposit in the customer’s account.
More sophisticated versions bring in the concept of ‘fractional reserve banking’. This description recognises that banks can lend out many times more than the amount of cash and reserves they hold at the Bank of England. This is a more accurate picture, but is still incomplete and misleading. It implies a strong link between the amount of money that banks create and the amount that they hold at the central bank. It is also commonly assumed by this approach that the central bank has significant control over the amount of reserves banks hold with it.
We find that the most accurate description is that banks create new money whenever they extend credit, buy existing assets or make payments on their own account, which mostly involves expanding their assets, and that their ability to do this is only very weakly linked to the amount of reserves they hold at the central bank. At the time of the financial crisis, for example, banks held just £1.25 in reserves for every £100 issued as credit. Banks operate within an electronic clearing system that nets out multilateral payments at the end of each day, requiring them to hold only a tiny proportion of central bank money to meet their payment requirements.
The power of commercial banks to create new money has many important implications for economic prosperity and financial stability. We highlight four that are relevant to the reforms of the banking system under discussion at the time of writing:

1. Although useful in other ways, capital adequacy requirements have not and do not constrain money creation, and therefore do not necessarily serve to restrict the expansion of banks’ balance sheets in aggregate. In other words, they are mainly ineffective in preventing credit booms and their associated asset price bubbles.
2. Credit is rationed by banks, and the primary determinant of how much they lend is not interest rates, but confidence that the loan will be repaid and confidence in the liquidity and solvency of other banks and the system as a whole.
3. Banks decide where to allocate credit in the economy. The incentives that they face often lead them to favour lending against collateral, or assets, rather than lending for investment in production. As a result, new money is often more likely to be channelled into property and financial speculation than to small businesses and manufacturing, with profound economic consequences for society.
4. Fiscal policy does not in itself result in an expansion of the money supply. Indeed, the government has in practice no direct involvement in the money creation and allocation process. This is little known, but has an important impact on the effectiveness of fiscal policy and the role of the government in the economy.

The basic analysis of Where Does Money Come From? is neither radical nor new. In fact, central banks around the world support the same description of where new money comes from. And yet many naturally resist the notion that private banks can really create money by simply making an entry in a ledger. Economist J. K. Galbraith suggested why this might be:

The process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent.

This book aims to firmly establish a common understanding that commercial banks create new money. There is no deeper mystery, and we must not allow our mind to be repelled. Only then can we properly address the much more significant question: Of all the possible alternative ways in which we could create new money and allocate purchasing power, is this really the best?


Ref  New Economics Foundation.


Blogger Reference Link  http://www.p2pfoundation.net/Transfinancial_Economics