Where has all the money gone?

This is so simple that I thank god the people that run the economy don't try to become brain surgeons or rocket scientists.

Some basics (apparently little understood)

Today over 97% of all the money used in the UK economy is created by banks, in the form of electronic bank deposits, with just 3% being created by the state in the form of notes and coins.

Banks are able to create money through the accounting process they use when they make loans.

When banks extend loans to their customers, they create money by crediting their customers’ accounts.

Conversely, when a loan is repaid to a bank, the bank deposits that were used to repay the loan disappear from the economy, as a result of the accounting process used.

The fact that the vast majority (97%) of the UK’s money supply is created by private commercial banks, when they make loans, means that there are certain simple rules that determine the amount of money in the economy:

1. If banks are making new loans faster than old loans are paid off, the money supply will increase.

2. If the public pay down old loans faster than they take out new loans, the money supply will shrink.

In short, as debt increases, money supply increases, and as debt is reduced, the money supply shrinks.

For most of the last 40 years case 1, above, has applied, and the money supply (and level of debt) increased consistently from 1970 until late 2008.

Following the onset of the financial crisis, banks panicked and severely restricted the amount of new loans they made. However, existing loans had to continue to be repaid.

Banks were not creating money by making new loans to compensate for the money that was disappearing from the economy as it was used to pay down old loans. This lead to a shrinking of the money supply, a fall in spending in the economy, and a more severe recession.

From September 2008 (the start of the financial crisis) and November 2012, £89 billion of money was withdrawn from the economy as businesses paid off debts and were unable to refinance existing loans. In addition, £35 billion of money was destroyed as consumers paid down existing personal loans (mortgages not included).

Quantitative Easing was a means of injecting new money into the economy to replace the money that was disappearing as old loans were repaid.

The flaws in this approach to QE

There was a critical flaw in the implementation of QE. The money created via QE was intended to replace the money that was disappearing from the real economy, as individuals and businesses paid down their existing debts.

Instead the Bank of England injected the money into the financial part of the economy, by buying bonds from pension funds and insurance companies. The Bank of England increase the quantity of money (bank deposits) in the hands of these financial sector firms and investment companies, and therefore increase the amount of money circulating in the financial markets.

In order for the money creation to lead to an increase in spending (growth) in the real economy, the deposits created through QE would need to move from the financial markets to the real economy. But Pension funds could not simply pay all this newly created money to their beneficiaries (pensioners), as to do so would have run down the value of the fund and left insufficient assets for future beneficiaries.

QE has pumped new money into the financial markets, where it has stayed circulating and inflating prices of financial assets (stocks, bonds etc.).

It was not realistic to think that this newly created money would ever reach the real economy or have an effect on employment, economic growth or inflation. The lack of any significant improvement in economic growth, despite the creation of such huge sums of money, shows that the money created has not reached the real economy.

But the value of stocks and bonds has increased to new heights?

Injecting QE into the real economy

If the money that was created via QE (a total of £375 billion) had been spent directly into the real economy, then GDP would have been boosted by up to 6% a year.

Would this injection of newly created money into the real economy have been inflationary? Initially, no, because it would have first created new demand that would have ‘soaked up’ the spare capacity in the economy (the 2.5 million unemployed workers, under-worked staff, part-time workers who want to be full-time, half-empty restaurants, factories working four days per week instead of five, etc.). The impact of this extra spending would have been, quite simply, a recovery from the economic recession.

Eventually the creation of money in this way would have become inflationary. However, the very point of QE is to create inflation. A rise of inflation in the real economy would have shown that QE was successful, but also that it was time to halt further QE.

How could QE have been injected into the real economy?

Four of many potential options are laid out below:

1. Through funding new government spending: for example, large planned infrastructure projects could have been brought forwards, schools could have been rebuilt, flood defences could have been built. All of these would lead to additional employment, further spending in the real economy and economic growth, as construction workers spend their salaries into the real economy and this money circulates.

2. By using money from QE to cover existing government spending and reducing taxes. For example, VAT raises approximately £100bn a year. By suspending VAT for 3 years, at a cost of £300bn, an extra £300bn would have been left in the hands of consumers and businesses. Assuming this was split evenly between consumers and businesses (a 10% fall in prices, and an additional 10% margin to the business), this would have increased disposable income, made businesses less dependent on bank financing to expand, and potentially led to job creation.

3. By distributing the money directly to citizens, as a form of ‘citizens’ dividend’. This money would have been used for spending (growth) and also for debt-repayments (helping bank solvency, reduced household debt so higher disposable income due to lower debt repayments).

4. By employing the unemployed. The £375bn created by the Bank of England was sufficient to employ 2.5 million people full time on the national average salary for approximately 5 years. Logistical issues aside, it should be clear that there were more effective ways of stimulating the economy through the creation of money than injecting new money into the financial markets and hoping this money would reach the real economy.