Going cold turkey would finish off a dysfunctional global financial system that’s now hopelessly addicted to emergency infusions. The only solution is surgery on the system itself.
This article first appeared in Prospect magazine on 16 July 2021.
The world economy is a mess. The system, notionally governed by the invisible hand of the market, is no longer governed in any meaningful way: private excess puffs up bubbles that government indulgence ensures can never burst. We seem condemned to volatile commodity prices, wild capital flows, worsening imbalances in trade, taxation and income, and—before long—the next sovereign debt crisis. And then there’s inequality. During lockdown, the total wealth of billionaires rose by $5 trillion to $13 trillion in 12 months, the most dramatic surge ever registered on the annual Forbes billionaire list.
Where do such riches come from? Compared to before the pandemic, there’s less real economic activity: we are collectively poorer. And yet within a year of the great panic of March 2020, many asset prices were surging. Wall Street and the City of London are again awash with liquidity—and in a speculative mood. One vogue is for something called SPACs, or “special purpose acquisition companies.” That sounds so vague as to bring to mind the South Sea Bubble companies of 1720, whose pitch is remembered as “carrying on an undertaking of great advantage but nobody to know what it is.”
How is this mismatch between financial markets and underlying reality possible? Because just like in the aftermath of the Great Recession, the civil servants in our central banks spotted the dreadful potential of unchecked panic, and rode to the rescue of private speculators by flushing the system with made-up money through a process we’ve come to know as quantitative easing.
Commentators on both the right and the left are increasingly fixated on the role of QE. In a way, that’s understandable. The policy—deployed on and off ever since the financial crash—has been pursued to an extraordinary degree in the face of Covid-19. By this June, the US Federal Reserve’s balance sheet had doubled in size since the pandemic began, and has now swelled by 800 per cent since 2007.
Orthodox voices, such as American broker Peter Schiff and US economist Larry Summers, fret about inflation and debauching the currency. Meanwhile, radical thinkers such as Guy Standing rail at QE-induced asset-price rises enriching the “have-yachts” over the many have-nots on precarious, stagnant wages. Central banks stand charged with morphing from guarantors of stability to underwriters of inequality.
All sides worry about the danger of getting hooked, including some of the central bankers themselves. At his swansong Monetary Policy Committee in June, the Bank of England’s outgoing chief economist, Andy Haldane, pleaded for the Bank to start rolling back the QE programme, but was outvoted by colleagues who feared the consequences. After successive QE bailouts—for the 2008 banking meltdown, the Eurozone crisis, the Brexit vote and now Covid—we have learned that QE is easier to start than stop. After the US Federal Reserve tried to “taper” its way out of dependency in 2013, it soon decided that the market “tantrum” provoked was more dangerous than yielding to the addiction.
It is delusional thinking for anyone—left or right—to imagine that there is a safe way to kick the QE habit under a chaotic global financial system which has such a thirst for it. In the end, there is no way out other than to do what Roosevelt did in the aftermath of the Great Depression and the Second World War, and transform the international financial system itself.
What’s new, what’s not
Central banks—backed by royal charters and the state—have always had the power to create credit and expand the money supply. They have, since at least the founding of the Bank of England in 1694, provided credit to their clients in government and in commercial banks, accepting collateral in exchange for the money they create—a routine process known in the jargon as Open Market Operations (OMOs). They can run OMOs in reverse, too, selling the securities on their balance sheets in exchange for cash, taking money out of circulation, contracting the supply and raising its “price”—the rate of interest.
Through such means, central banks have long used their power of credit creation to help fund the government, keep commercial banks afloat and then, from the 20th century, to keep the economy in balance too.
At one level, QE is just another name for OMOs—newly “minted” electronic money is paid into the accounts of the central bank’s clients, who in exchange offer up collateral in the form of bonds. By buying them up, central bankers contract the supply of bonds in the market, which raises their price or, equivalently, lowers their yield—the interest that’s paid on them. In that way, the process puts downward pressure on the borrowing costs of governments and other debtors.
So what’s really new here? The difference between OMOs and QE is in the scale and the wider array of assets involved. Whereas OMOs typically purchase short-term government debt, QE programmes snap up government debt of all maturities, including long-term bonds. In the US, the EU and UK, central banks also extended the definition of eligible collateral to include riskier corporate bonds, and began buying them up too.
As to the scale, already by 2009 the Bank of England had purchased bonds to the value of £200bn. By August 2016, after the Brexit vote, purchases rose to £445bn. During the market’s grave March 2020 wobble, purchases rose to £645bn. By November 2020, the bank had acquired assets of £895bn. This stock of purchases is now equivalent to about half the annual flow of UK national income.
Moreover, with QE, the old two-way traffic of OMOs seems to have become a one-way street. While central bankers are acquiring bonds, they are not, as yet, selling them back into the market. The fear is that doing so would flood it, slashing bond prices and forcing up their yields—making it harder for borrowers, not least governments, to service their debts.
Even hints of bond disposals can provoke market tantrums. In Japan, the establishment is so reluctant (or impotent) to change the system that QE appears to have morphed from a temporary programme into a permanent feature of the economy. There’s no reason to assume this couldn’t happen here. Perhaps it already has.
Back to basics
So why, fundamentally, does the 21st-century economy seem to need so much QE? The first step in finding answers is to go back to basics regarding the nature of money.
This is tricky terrain for economists, because—remarkably enough—they are not routinely trained in the theory of money and banking. You can get through an economics degree, even an economics career, without pausing to think seriously about either. As Claudio Borio of the Bank for International Settlements explained in 2019: “bar a few who have sailed into these waters, money has been allowed to sink by the macroeconomics profession. And with little or no regrets.”
To understand how grave an intellectual vacuum this leaves, imagine the chaos if physicists working on space projects had not been trained in the theory of gravity—a concept that is fundamental to physics in the way that money is fundamental to the economy.
To the extent that mainstream economists think about money at all, they are divided on it. Some, like Bank of England economists, do understand that money originates as a social construct; that credit—or, in the words still written on every banknote, a “promise to pay”—is based on trust, and ultimately underpinned by regulation and the institutions of the state.
Importantly, commercial bank money rests upon the same social foundations. When banks make loans, they have always acted as “magic money trees,” creating new deposits in the accounts of those who borrow from them—in effect new money. But the stability of this commercial system of money creation depends on trust in the promise to pay, or repay—without that faith, banks wouldn’t have the confidence to lend, savers wouldn’t dare entrust their funds with the bank, and right across the economy, activity would dry up because nobody could be sure they would be paid for anything.
This all-important trust is achieved, first, through the legal enforceability of “promise to pay” contracts, and then, more specifically in the banking context, through licensing, regulation and, ultimately, the backing of a central bank. The health of the economy is also crucial—in a depression many debtors will go bust, defaulting on loans and shaking faith in the banking system. Again, it falls on the public authorities to manage this, whether by running a stable economy or through strictures regarding the amount of money a bank needs to set aside as protection against non-repayment.
The Bank of England understands all this, but in doing so stands out from the economics crowd. Most orthodox economists rely instead, whether consciously or unconsciously, on the antiquated commodity-exchange theory of money. Traditionally based on gold, this way of thinking treats money not as credit but as a system of exchange based on an underlying commodity: one that is scarce, and so—supposedly—stable in price.
This is why, from the conservative point of view, QE—the creation of more fiat money—is so alarming. The great difficulty for this camp, however, is that it is precisely their worldview that has created the system that cannot any longer get by without central bank infusions.
The commodity economy
Cryptocurrencies such as Bitcoin are the supreme example of where the commodity-exchange theory leads. They are creatures of the “dark web,” which is designed to avoid regulation. This is a form of money based not on trust, but on distrust of public authority. Bitcoin “miners” hope to replicate gold, the scarce asset that for so long underpinned the world’s money, with their digitally-created, but apparently finite, commodity. Scarcity is the attraction, a supposed defence against state meddling. What’s forgotten is that if the world’s economic activity actually had to be calibrated to fit an arbitrarily fixed volume of circulating cryptocurrency, then—exactly as under the gold standard—the world would experience prolonged and painful depressions.
This threat hasn’t stopped cryptocurrencies becoming big business: the Wall Street Journal reported their combined valuation as being $2 trillion this spring—approximately equivalent to all the US dollars circulating in the world as cash. Advocates hope that digital currencies can one day replace the current system of money—taking any vestige of political accountability for economic governance and financial stability along with it.
Despite the worrying direction of travel, cryptocurrencies do not—yet—represent a systemic threat. The vast “shadow banking” system, which has grown out of the same flawed monetary thinking, is another matter. Comprising pension funds, hedge funds, insurance companies and other investment vehicles, it now manages a $200 trillion stock of assets, dwarfing that $2 trillion cryptocurrency valuation, and also vastly exceeding the annual income (or GDP) of the world as a whole, estimated at $86 trillion. Being in the shadows, then, no longer means being on the margins.
Central bankers have permitted and sometimes encouraged this sector to expand beyond the regulatory frameworks of governments. But the real roots are deeper, lying in the great structural shift of pension privatisation. Between 1981 and 2014, 30 countries fully or partially privatised their public mandatory pensions. Coupled with cross-border capital mobility, the move to private retirement savings steadily generated vast cash pools for institutional investors.
Today one asset management firm, BlackRock, manages in excess of $8 trillion of the world’s savings. Such companies have outgrown the capacity of “main street” banks to provide services. No traditional commercial bank could absorb these sums; few governments are willing to guarantee individual accounts of more than $100,000. The new form of “banking” answered the need to accommodate the enormous sums of globalised capital.
Like pawnbrokers, who practised an earlier form of unregulated credit, shadow banks exchange the savings they hold for collateral. But instead of watches and wedding rings, they lend out on the strength of government bonds and other securities.
Replete with cash, they can provide “liquidity” on a vast scale to businesses or investors who need it. In return, the borrowers offer up a security—and write an IOU offering to repurchase it later, at a higher price. This markup is, in effect, the interest on the loan. These repurchase deals are struck in the “repo” markets which form the heart of the shadow banking system.
Note that this whole system avoids reliance on the social construct of credit, upheld by trust and enforced by law, which traditional banks had to work within. Instead, the system is one of deregulated exchange in which cash is simply one more commodity—no more regulated than any other.
Securities are swapped for cash over alarmingly short periods: through economic history, such churning trades have often been a sign of speculative frenzy overpowering sober judgment. Moreover, operators in the system have the legal right to re-use a security to leverage additional borrowing. This is akin to raising money by re-mortgaging the same property several times over. Like the banks, they are effectively creating money (or shadow money, if you like), but they are doing so without any obligation to comply with the old rules and regulations that commercial banks have to follow.
So we have power without responsibility, but—worse—we have parasitical power. Because, as Daniela Gabor of the University of the West of England has explained, even this “shadow money relies on sovereign structures of authority and credit worthiness.” Why? Because private financiers rely heavily on government bonds as the safest collateral for their repo trades. It is estimated that two out of three euros borrowed through shadow banks are underpinned by the collateral of sovereign bonds issued within the Eurozone. Any decline in the value of government bonds as a consequence of shadow banking activity will influence the government’s cost of borrowing, and—ultimately—fiscal decisions.
Worst of all, the shadow money that comes out of these institutions is now so systemically important to the economy that when it threatens to dry up, as it does from time to time, it cannot safely be ignored. Which brings us back to quantitative easing—the remedy that central bankers reach for in the face of this recurrent threat.
The reason why emergency injections of money are increasingly needed is that the shadow banking system is structurally prone to volatility and debt crises. The borrower’s promise to repurchase an asset at a higher price is relatively easy to uphold when the value of that asset remains stable. But the value of assets can rise or fall suddenly, which in this system can set in train self-amplifying feedback loops—with catastrophic consequences.
Back in August 2007, the great financial crisis was triggered when a French bank, BNP Paribas, issued a press release explaining that “the complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly—regardless of their quality or credit rating.” (Emphasis mine.) This announcement caused inter-bank lending worldwide to freeze, and required immediate central bank intervention.
The sudden loss of confidence in the value of assets severely destabilised not only shadow banking—where the exchange of cash for assets relies heavily on the fair valuation of assets—but also the supposedly “main street” banks that had become heavily embroiled in it.
The images of savers queuing to withdraw their deposits from Northern Rock in 2007 was merely a symptom of a crisis that had already taken hold. Savers had got wind that the institution was in trouble because of its exposure to exotic money market activities that went way beyond traditional commercial banking. The front door looked like a bank, but the back office was deep in the shadows.
Instead of the familiar financial panic triggered by a bank run—savers withdrawing their deposits at once—the underlying problem was something akin to a “run” on the repo market. Shadow bankers were surprised to find the mortgage-backed securities they accepted as collateral had plummeted in value. As the value of sub-prime mortgages fell, contagion spread to credit securities unrelated to sub-prime markets. The entire model threatened to collapse, spelling ruin for the global economy. Central banks were forced to intervene, reaching for QE as their preferred weapon.
But in doing so, central bankers, supposed “guardians of the nation’s finances,” accepted as given this sprawling, chaotic private system. After the crisis, capital adequacy rules for commercial banks were tightened in many countries, but little has been done since then to stabilise and regulate the shadow banking system.
As a result, another moment of grave crisis arose last March, when the tiny, invisible coronavirus triggered another potentially catastrophic shadow bank run. As one of the institutions charged with holding the ring, the New York Federal Reserve, nervously explained: “the global economy experienced an extraordinary shock… and asset prices adjusted sharply.” (Emphasis mine.) Once again, central bankers were forced to ride to the rescue.
Our collective vulnerability to this monster has been plain for more than a dozen years, and yet we’ve failed to tame the beast. Indeed, it has continued to grow, rising from an estimated 42 per cent of the global financial system in 2008 to nearly half in 2019.
The global Financial Stability Board that monitors (but does not regulate) the system dislikes the moniker “shadow banking” and hopes to re-brand the system as “non-bank financial intermediation,” which scarcely sounds any less, well, shadowy. Besides, it is not what we call the system, but what we have allowed it to do that has produced today’s volatile and obscenely unequal globalised economy. Whenever the vast shadow banks wobble, there is the threat of a disastrous contraction of the credit for the real economy, which could bring everything crashing down. As long as the system is allowed to stand, there is no alternative to taxpayer-backed central banks rescuing private markets.
The only way to call time on QE, if that is what we truly want, is to deconstruct and then reconstruct, regulate and stabilise the whole financial system, so that the extraordinary privilege of credit creation is always balanced by a responsibility not to take undue risks. And if footloose capital responds by skipping across borders and away from oversight, then we may also need to look at controls on that front too. Only then will the world stand any chance of kicking the QE habit, address those dangerous imbalances and finally escape this grim shadowland of money.