Monetary economists, led by Nobel Prize winner Milton Friedman of the University of Chicago, not only espoused free market ideas but truly believed that to curb inflation one had to control growth in the monetary base. He was also adviser to President Reagan and Margaret Thatcher, both of whom were grappling with the highest price rises in decades. I remember anxiously waiting for Thursday's weekly US M1 money supply data. The ideas have since been largely abandoned, and Paul Krugman has gone so far as to label the Bank for International Settlements as 'sadomonetarists' for espousing austerity against a background of lacklustre economic growth.
Once 2008-09's Great Financial Crash (as it's now being called) hit, the Bank of England slashed its key interest rate to a record low half a per cent, strong-armed banks into merging with each other, and later copied the US Fed in buying up government securities in a process now known as quantitative easing. Yet inflation, while not exactly hitting the annualised 2 per cent target, remained tame, and for the past year CPI has been running at an embarrassingly low (for central banks) 0.20 per cent. In fact, over the past 20 years, when borrowing ballooned, it held around a median of around 2 per cent.
What gives? Let's think about what money really is and who creates it. Cash and notes in circulation make up a tiny, and costly to maintain, portion called M1 (other measures are imaginatively called M2, M3, M4 and maybe more in other countries). The central bank, tasked with ensuring the smooth and efficient functioning of basic financial transactions, can if needed phone up Thomas de la Rue and ask them to print more notes. When small change is in short supply it is often an early warning sign of impending high inflation. Five pound notes often run short, possibly because they are popped in piggy banks.
M4 Money Supply
Which brings us on to the velocity of circulation - how many times cash turns a trick. The five pound note moves from the drug dealer (his preferred denomination) to the off-licence, from there to the bureau de change and then on to the second-hand car dealer; round and round we go. Unlike cash stuck down behind the sofa, it generates wealth at every stage - and possibly inflation too - so it's not just how much money there is, but how quickly and often it moves that matters.
Central banks can also shrink money, either by tightening reserve requirements for private sector banks (hanging on to an increasing amount of their money), buying up securities or simply squandering it. Last year, courtesy of its extreme monetary policy, the Swiss National Bank managed to lose 23bn Swiss francs.
The Treasury, another 'outside' money creator (public sector), also magics money out of nowhere. It nearly always runs budget deficits, spending more than it raises in taxes, which is normal so long as the gap isn't too huge. To plug the hole, it issues government IOUs, more often than not snapped up by the lenders who hold these assets on their books and are the preferred collateral for reserve requirements.
But far the greatest amount of money lies in commercial bank accounts, created by 'inside' money (the private sector), where M2 measures sight deposits and M3/M4 both sight and term deposits. Note that the Bank of England at this point does not distinguish between commercial and retail borrowers and depositors; there is no stigma around investment banks' money versus the so-called 'safe' retail. Money is merely a unit of account which does not necessarily measure wealth.
BBA Bank Lending
Then we have quasi-money, things that can be turned almost instantly into cash if push comes to shove. Sovereign and commercial bills, notes and bonds, top-quality equities, invoices of major companies, personal guarantees and jewellery. These can be redeemed as and when or repurchased on an agreed date in advance. It is via this last method that central banks keep control of money sloshing through the system, draining and adding liquidity in order to fulfil their mandate of assisting day-to-day financial operations, keeping a balance between cash and goods/services available.
Although money derives its value from its scarcity relative to usefulness, commercial banks are at liberty to grant new loans at will. If a suitable potential customer comes knocking at their door wanting to borrow, the branch manager becomes a fairy godmother-type figure granting the punter's wishes. Ta-raa! Just like that we have more money and then it gets even better because that loan then becomes a deposit somewhere. Central banks keep an eye on this sort of thing, imposing limits as to how much must be kept with them in case of a rainy day (reserve requirements). This is the basis of fiat money and the fractional reserve banking system.
10-year gilt yield
Secured lending is preferable to unsecured as underlying assets can be sold to mitigate losses on loans gone sour (usually considered as being 90 days in arrears). Hence bankers' interest in mortgage lending, commercial real estate, auto financing and to a lesser extent white goods financing (still popular in emerging markets). Towards the bottom of the heap (in terms of quality) lie credit card debt - and its frequently usurious rates of interest - and small business lending as these have little to fall back on and are more likely to renege on loans. If you want 'safer' banking the last thing you should encourage are loans to small and medium-sized enterprises.
Traditionally, banks used to lend roughly 10 times as much as they had on deposit. Bad debts might alter the ratio and greed might tempt them into risky loans. Rules and prudent lending were usually enough to rein things in, but at the height of laissez faire banking in the mid-2000s some large banks were shovelling out up to 40 times as much as their capital base, the sort of leverage only available on some derivatives. Obviously, you can see how quickly and easily things might come unstuck. A small change in deposits would force a rethink as working with the wrong ratios sends around the central bankers to shut up shop with cease and desist orders. This is precisely what happened with Bear Stearns and Lehman Brothers because other banks got wind of potential problems and refused them money market loans. Note that some are suggesting that deposit guarantee schemes available to retail customers are in themselves subsidising commercial banks, who then work with tighter margins, making their business models less safe.
BBA mortgage approvals
After the crash, a process of shrinking to fit began. Too big to fail meant calling in loans, not renewing revolving credit, selling what they could and hiving things off into rotten corners - all of which shrank available money. It also meant that the deposits associated with these loans slipped into a black hole; gone, vanished in a blink as the eponymous stain remover claims. So banks give with one hand and take away with the other. After an initial surge in 2009, courtesy of the central bank trying to stave off swaths of bankruptcies, UK M4 has been trundling along at about zero despite QE; same thing in the eurozone.
Failing in their duty to target inflation and/or unemployment, central bankers are still surprised their text books aren't helping. Earlier this month, chief economist of the European Central Bank, German Peter Praet, told Belgian magazine Knack: "If you print enough money, you will always get inflation. Always." He's obviously forgotten that on the other side of the equation you have loads of eurozone banks labouring under bad debts, balance sheet trimming (not slashing yet), increasing capital and reserves, with few creditworthy customers wanting new loans, and citizens who do not have the confidence to expand their businesses.
Some might say that negligible inflation is a good thing. Yes, ironically it does marginally benefit savers and employees despite the derisory rates on savings - but only so long as real interest rates are positive. Borrowers have a problem, though, because their loans will not shrink but grow in real terms, will be a yoke around their necks for a lifetime (35-year mortgages anyone? In Japan, they experimented with 100-year ones - which you could inherit!), Such hard, long-drawn-out work with opportunity costs along the way.
UK CPI
Finally, apart from top executives at the biggest stock exchange-listed firms, real wages in the developed world have actually fallen for many people. The ratio has moved in favour of return on capital and against return on labour, in part caused by the fall in the power of the unions. It is also to do with globalisation, so that manufacturers must compete with other far-flung producers which may have very different political, economic and legal structures. Workers, knowing they're unlikely to get a pay rise don't even bother asking for one lest they be labelled troublemakers learning to tighten their belts; cost-push inflation is negligible.
Average earnings
To conclude, retail and investment banking, not central bankers and politicians, create and destroy money - and some would say businesses and wealth, too. The system is based on the confidence, not necessarily a confidence trick, of those entrusting their deposits weighing up the expected returns from business borrowing.
