Printing Money, Sovereign Debt and Money Supply. All is well, Indeed!

Central Banks - Back in the day

The Bank of Venice, established as early as 1171, was the first institution resembling a bank. It extracted forced loans (yes, you read it correct!), allowed interest payment and enabled usage of funds by Government for crusades and assistance to expeditions. It set the notion of a public deposit taking bank using institutional framework. 

In contrast, the Bank of England, established 1694, is one of deposit, discount and circulation bank. It’s the model on which most of today’s central banks are based on. The bank was setup to enable William III government to borrower ￡1,200,000 at 8% per annum - funds needed for building navy capability. Government even allowed the entity to issue bank notes which were handwritten initially. The bank notes were linked to Gold Standard that eventually got replaced in 1931 (Great Depression) due to imminent need to increase the money supply in the economy. Gold standard restricted the money supply as it was dependent on actual gold production and supply amongst other reasons. 

It paved the way for Government to borrow by issuing securities and Central Bank subscribing to them. Quite a unique way but it’s been working for many years. Government thus are not required to raise taxes or reducing the planned expenditure, but they can borrow at a flat yield curve. US, Japan and many governments around the globe have their debt sitting on Central Bank’s balance sheet. 

Fast forward to last decade

Global Financial Crisis (‘GFC’) did not happen in some remote distant memory for most of us. However, GFC was a massive economic event, that led to acceleration of various sovereign Quantitative Easing (‘QE’) programs - an asset purchase program that equates to ‘printing money’ as Central Bank purchases longer-term securities from the open market leading to increase in money supply. 

Given COVID and so many governments going back to so called ‘printing money’ phase. Another money printing exercise. Wait a minute. Many notable Economists already stated that we are skating on thin ice with regards to economic health, debt levels and growth. To figure this out, I had to revisit my macro economy notes and re-live the incredible discussion we had on central bank’s role on creating money.

Monetary Base 

Before you think of a gigantic printing press swooshing to action amidst the lockdown, and printing stacks of hard currency; we may need to understand how the money that you and I understand gets created in the first place. It may also help to understand how much money one thinks is with his bank and how much money is actually there?

Central banks have an amazing superpower to create money by press of few strokes on a computer. Seriously! Most of the ‘so called money’ is digitally credited and debited, it boils down to numbers reflected on a computer screen. US Fed balance sheet that was sub $1trillion before GFC today is hovering around ~$6.7trillion today (with chances of increasing ahead). It means that Federal Reserve has been trying to increase the money by purchasing assets viz US Treasury, Mortgage Backed Securities; with the expectation that it eventually impacts the money supply in the economy. 

Let’s understand the relationship between Central bank, Commercial bank, Borrower and Depositors to understand the flow of money. This is what happened between 2007-2009 that demonstrates the Central Bank’s magical power to create money. Central Banks purchase Government securities, Mortgage bank securities that lead to increase in the ‘Excess Reserve’ of Commercial Banks to pay for securities. 

Source : Professor Antonio Fatas course on Macroeconomies in the Global Economy [Refer : https://antoniofatas.blogspot.com]

In nutshell, the above actions definitely increases the monetary base (Currency + Excess Reserve), however it may not always translate into equal increase in money supply. For sake of simplicity, till this step, Central Bank with their magic wand has led to increase in the monetary base and now its time to figure out how the Commercial Bank can use the newly bestowed money and increase the money supply. 

Money Multiplier (‘m’)

Commercial Banks are based on fractional reserve model i.e. in simple terms the actual money supply > monetary base. Commercial Banks are the key institutions that multiply the funds. How? If the Reserve to be placed with Central Bank is less than Deposit’s (actual money placed by depositors), the money multiplier (m) factor is > 1 as Commercial Banks can use the money to make incremental loans to borrowers. 

m = 1 / Reserve Ratio [e.g. if Reserve Ratio is 5%, m = 20]

Theoretically, every US$1Bn introduced by central bank would have US$20Bn impact on money supply (m = 20). The actual money supply increases when Central Bank’s reserve requirement decreases and that’s a tool that central banks regularly uses to increase money supply in the economy. 

Commercial Banks - actual creators of money, deposits and multiplier effect: 

The actual impact of money multiplier has been steadily decreasing over last 10-12 years. The fact is that Commercial Banks don’t start rapidly lending to borrowers when Central Banks reserve requirement decreases. Many times the banks are quite happy to subscribe to government debt at low yielding returns instead of lending to riskier corporates. The magical money created by Central Bank thus may not be having the desired impact on the real money supply in the economy. 

Commercial Banks actually create deposits in reality by lending. When they extend debt to public / private entity they create loan asset on their balance sheet and a matching corresponding deposit liability. The borrower uses the loan funds and eventually it lands in a supplier’s, worker’s, contractor’s account as deposit within the Commercial Banking ambit.

In fact Commercial Banks create loans and deposits and they are not constrained by Central Bank’s reserve ratio requirement to make the decision. The quantum of funding each trade / transaction is subjected to their own capital. That’s the only notable constraint they have. The factors that a Commercial Banks need to consider when extending loans is a) Risk-return paradigm as the loans need to make risk-adjusted returns for bank b) Compliance with capital adequacy requirements - Risk Weighted assets need to meet the present capital thresholds for Commercial Banks and be within Single Borrower limit 

Sovereign Debt & Inflation 

Overall, the reduced money supply and current crisis would leave public and private balance sheets heavily indebted and that may have far reaching impact on various economies especially indebted ones. Let’s take a closer look. 

Comparing FY08 to FY18, Advanced economies Debt-to-GBP jumped from 78.5% to 122%. While Emerging and Middle-Income economies went up from 33.7% to 62% in the similar period. US holds 31% of world’s debt (~$21.5 trillion) followed by Japan at 17%. In two decades, the world’s debt jumped $20 trillion to $69.3 trillion. This debt comes really cheap. Interest rate are at generational low and for some governments have moved it into -ve territory. 

However, Japan has ~240% of Debt-to-GDP but they have demonstrated that it is manageable at sovereign level. For years there has been no inflation even though the long term interest rates are closer to zero. US presently is still at 105% of Debt-to-GDP and this ratio had peaked to 121% during WW. The early notion and fear was that it would burden the future generations. However, post WW, this money supply led to golden age of US capitalism. Further, US debt is issued in their own currency and hence fundamentally they can never default as long as inflation remains in control. 

In nutshell, the only risk with increased debt and money supply is inflation. The inflation that causes problem is due to too much aggregate spending leading to demand pull inflation. Nobel prize winner Milton Friedman had proposed a similar concept to printing money i.e. helicopter money - an unconventional monetary tool to combat deflationary depression (interest rates low, economy remains in recession) where the government could theoretically drop money from sky. The concept has found support from Ben Bernanke, Former Fed Chairman as the helicopter money would eventually be used to spend and trigger economic activity. 

Summary 

Commercial Banks may be reluctant to make loans due to capital constraint or inherent risk to a sector especially during times like COVID. This stifles growth and halts the economic activity in the economy. In the last few months unprecedented move by Fed, they extended their purchases into Corporate Investment Grade and High Yield bonds, thereby making them actual lender of last resort. This has propelled a record issuance of Investment Grade Bonds followed by High Yield bond issuance. This is helping the companies with necessary liquidity to managed COVID and it has turned Fed as the buyer of all such paper issuances. 

Further, governments are stimulating the economy by making deficit spending even at the cost of increase in national debt. However, the public deficit is infact a surplus in private sector and can have the desired impact of placing my cash in the hand of corporates and individuals to trigger the economy.

In nutshell, Printing money, money multiplier, generating liquidity and deficit spending thereby ensuring smooth functioning of financial markets are all valid responses to the present situation. It may however remind of Merton H. Miller's, famously known for Modigliani-Miller theorem (MM theorem), quote

If You Take Money Out of Your Left Pocket and Put it in Your Right Pocket, You're No Richer

In the end, it may seem like everyone is a winner.

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This article first appeared on https://medium.com/@gauravsanan/printing-money-sovereign-debt-and-money-supply-all-is-well-indeed-36f02ac2b94