[I wrote this yesterday but held off--as I often do for "spacing" reasons. In the interim Nick Rowe did a post on the same paper. I recommend you read his reaction if you only have time for one. It's much better.]
The Bank of England was kind enough to send me a new report explaining monetary policy. Unfortunately I think the report is way off target. On the other hand if they knew anything about my blog they would have known that would be my reaction. Let’s start here:
This article has discussed how money is created in the modern economy. Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And in contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of either base or broad money. The Bank of England is nevertheless still able to influence the amount of money in the economy. It does so in normal times by setting monetary policy — through the interest rate that it pays on reserves held by commercial banks with the Bank of England. More recently, though, with Bank Rate constrained by the effective lower bound, the Bank of England’s asset purchase programme has sought to raise the quantity of broad money in circulation.
I hate the term ‘modern.’ The money directly produced or “printed” by the central bank is called base money. I don’t know about Britain, but in America the share of total money that is base money is actually higher than 100 years ago. So there is nothing “modern” about our current system. And the BoE does directly control the amount of base money, at least in the sense of “directly control” that the BoE uses when they describe direct control of short term interest rates. Yes, if you set an interest rate target then the base becomes endogenous. But it’s equally true that if you set an inflation target then interest rates become endogenous. However changes in the supply and demand for base money remain the lever of monetary policy. And notice the BoE implies that once they stopped targeting interest rates they were no longer even doing monetary policy (or perhaps it’s just misleading language.) The BoE controls the base in such a way as to target interest rates in such a way as target total spending in such as way as to produce 2% inflation. And yet in that long chain interest rates are singled out as “monetary policy.”
Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts.
Lots of people use the term ‘reserves’ when they would be better off using the term ‘monetary base.’ Back in 2007 the part of the US monetary base that was “coins” was larger than “bank reserves.” So it would have been more accurate to talk about central banks injecting coins into the system. And prior to 2008 new base money mostly flowed out into currency in circulation within a few days, even if the first stop was the banking system. Banks were not important for monetary policy, although of course they were a key part of the financial system.
I recall that Paul Krugman was once criticized for saying banks can “lend out” reserves. I generally don’t say things like that because I ignore banks. But there was nothing wrong with Krugman’s claim. Yes, it’s true that when money is lent out and the borrower withdraws the loan as cash, the borrower does not literally “hold reserves.” So the BoE is technically correct. But that’s a meaningless distinction, as it’s all base money, and reserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.
One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.
In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.
I recall that once when Krugman was faced with this sort of argument he said something to the effect of “it’s a simultaneous system.” Banking is an industry that provides intermediation services. Banks have balance sheets with assets and liabilities. It makes no sense to say that one side of the balance sheet causes the other. If people want to borrow more, then bank interest rates on loans and deposits adjust in such a way as to provide a new equilibrium, probably with a larger balance sheet. But that’s equally true of the situation where people want to hold larger amounts of bank deposits. It’s completely symmetrical. Consider the real estate broker industry. Does more people buying houses cause more people selling houses, or vice versa?
Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.
In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England.
I’m not a fan of the money multiplier model, but it’s sometimes unfairly maligned. Textbooks don’t treat it as a constant, any more than they treat velocity or the fiscal multiplier as constants. They may do an example where it is constant, but then they discuss reasons why it changes.
The real problem here is “binding constraint.” In economics there are almost never binding constraints on anything. If you at a binding constraint position then odds are you are not optimizing. A reduction in the supply of apples will generally raise apple prices even if not at the binding constraint where one less apple would cause starvation. By (permanently) adjusting the supply of “reserves” (again base money is what they actually mean) the central bank can affect the value of the medium of account (base money), and hence all nominal variables in the economy. That includes the nominal size of the toilet paper industry, the nominal size of the steel industry, and the nominal size of bank balance sheets. Most importantly NGDP. If wages and prices are sticky they can also affect real GDP in the short to medium run.
Not sure why the Bank of England is so interested in the nominal size of the bank balance sheets, and not other industries. Surely there are other nominal industry outputs that better correlate with the goals of monetary policy (NGDP) than the banking industry! Why not focus on those industries?
The deeper problem here is the BoE mixes up microeconomics (the relative size of the banking industry) with macroeconomics (the determination of nominal aggregates), in a very confusing way. You need to model the medium of account to have any sort of coherent explanation of monetary policy. The interest rate approach combined with a banking sector and a “slack/overheating” model of inflation just won’t cut it. Certainly the BoE report is not as bad as some of the things you see from MMTers, it nods to the old-style monetarists in its discussion the problems that might arise from of excessive growth of the aggregates. But it nonetheless fails to come up with a model of the price level or NGDP. It can’t tell us why Britain has 20% inflation one year, and 2% another. You need to explicitly model the supply and demand for base money to do macroeconomics.
PS. And why doesn’t the BoE subsidize and run a NGDP prediction market?
PPS. Perhaps my report was too negative. I suppose it’s a fine explanation of monetary policy if you go for the interest rate approach to monetary economics, it’s just that I hate that approach.