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Too soon to stop QE

Created:

1 December 2009

Written by:

Chris Dillow

There was some good news in yesterday's M4 figures. They showed that the bank deposits of the non-financial sector have grown by 2.9 per cent in the past 12 months. Although this is still below the 6 to 9 per cent growth that the Bank of England considers consistent with normal economic growth, it's an increase on the 2 per cent growth we saw in July. Which raises the question: with this important measure of the money stock accelerating, is it time for the Bank to stop printing money? I don't think so.

First, foreigners can buy more goods, services or assets from us than we buy from them. Insofar as their buying is converted into sterling, so our sterling bank deposits rise at their expense.

Second, the government can affect our bank deposits. If it employs us, or buys goods from us, our bank deposits rise. But when it taxes us or sells us gilts, our bank deposits fall.

Third, banks create money simply by doing new business. If you get a mortgage from a bank to buy my house, bank lending rises, but so do bank deposits, because your mortgage becomes my bank deposit when I sell you the house. There is, though, a caveat here. If the bank must issue shares in order to make the extra loan - that is, must increase its capital base - overall bank deposits don't increase as much as the loan. This is because people who buy shares from the bank reduce their bank deposits in doing so.

My chart shows how these last two factors have contributed to overall M4 growth in recent years. You can see that, normally, the public sector has almost no effect on M4. This is because issues of gilts offset the excess of government spending over taxes. So, normally, it is fluctuations in bank lending that drive changes in M4*.

However, in the last few months, things have changed. Banks' contribution to M4 growth has plummeted. This is partly because they are making fewer loans than they used to, but also because those loans have been accompanied by an increase in their capital base, which is negative for the money stock in arithmetic terms. In the past 12 months, banks have added a mere £32bn to M4 - close to their smallest contribution since 1995.

What's more, most of the lending that banks have done is not to the real economy - households and non-financial companies - but to the financial sector, among them their own subsidiaries. Of the £47.8bn of M4 lending in the last three months, £43bn has been to non-bank financial institutions.

However, banks' declining contribution to the money stock has been offset by a huge public-sector contribution. This is the result of quantitative easing: in buying gilts, the Bank of England ensures that government borrowing actually adds to the money stock.

Indeed, in simple arithmetic terms, all of the growth in M4 in the past 12 months has come solely from the public sector. This is because the external contribution (our net buying of foreign stuff) has been sufficiently negative to offset the paltry contribution from banks.

In other words, the private sector is not creating money at all - a fact that is unprecedented in current records (which began in 1988), and I suspect a long time before then.

M4 is growing solely because of quantitative easing. Which suggests that it might be too soon for the Bank to stop this policy.

*My chart shows M4 lending net of changes in banks' net non-deposit liabilities, which are very largely changes in banks' capital base. The figures come from table A3.2 of Bankstats.