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Inflation and Quantitative Easing

Dear EditorsI have read many of your economics publications and note that your explanation of inflation may be summarised as - the excess issue of an inconvertible paper currency. Now, I thought that this is exactlywhat is being done (21st century style) with quantitative easing. However, in the Socialist StandardJanuary 2010 in the article ‘Financial Alchemy’ you appear to be saying that this is not happening and that quantitative easing will not result in inflation. Please could you clarify this point for me and for other readers.


Reply: We do indeed argue that the cause of inflation is the excess issue of an inconvertible paper currency,  that is, currency that is freely printed and not convertible into an underlying commodity like gold. Currency can be said to be issued in excess when it is above and beyond the amount needed to carry out production and trade, injecting purchasing power into the economy that is not related to real wealth  generation. This effectively means a bloating of monetary demand in the economy not sufficiently matched by increased production, which then serves to pull up prices as a whole. Wherever currency has been issued in excess this way, prices have risen and this has been far and away the main reason why the price level now is well over thirty times what it was before the start of the Second World War. The amount of currency in issue has risen far faster than has been warranted by increases in  production and trade, with the amount of currency in circulation being £450m in 1938 whereas it is now around £54,000m and still rising.

Quantitative easing (QE) is an interesting phenomenon in that when it was first mooted no-one seemed to be clear on what, precisely, would be involved. Our view has been that if it exacerbates the ongoing excess note issue then it would be inflationary. The way QE has worked in practice, with the Bank of England setting up a separate Asset Purchase Facility (APF), means this does not seem to have happened. Notes and coins are still increasing at the same sort of annual rate they have been the lastfew years, and there has been no noticeable change to this. What has happened instead is more unusual.

In practice, a massive loan has been granted by the central bank. This has been loaned by the Bankof England to the Asset Purchase Facility and it has been used to buy financial assets. The vast majorityof the APF’s purchases appear to have been government gilts with a smaller amount of corporate bonds being bought – in buying these up, their prices have risen, their interest payments (yields) have fallen for investors and so in turn equities have become a more attractive investment (which is what has largely fuelled the recent stock-market recovery).

The effect of all this on the overall price level has been minimal at most though, as it has been a process concentrated specifically on these types of financial assets. In some ways it is a massive,  debt-fuelled version of what used to be called ‘open-market operations’ by the central bank.

As Charles Bean, the Deputy Governor for Monetary Policy at the Bank of England has stated with regard to QE and its effect on financial assets: ‘not only does the price of gilts rise as a consequence ofthe Asset Purchase Facility’s initial purchases, but also the prices of a whole spectrum of other assets... Also the rise in asset prices increases wealth and improves balance sheets. In this way, Quantitative Easing helps to work around the blockage created by a banking system that is still undergoing a process of balance sheet repair.’ It can be added that when the prices of gilts rise and  their yields fall, this helps to keep interest rates low too as there is a close connection between  government gilt yields and the interest rates charged by the commercial banks.

To make all this happen the initial loan to the APF has been generated by a metaphoric flick of an electronic switch in the only way this can ever occur – through the actions of the central bank itself,the lender of last resort. As we have explained previously private banks are completely unable to expandtheir balance sheets with a stroke of the pen or flick of a switch, only the central bank can initially do this,just as it can inflate the currency it issues.

The key point is that this loan by the Bank of England to the APF, effectively a massive IOU or seriesof IOUs, has to be paid back. When the APF sells these assets back into the markets it will have precisely the opposite effect to when it was buying them up, draining away the temporary additional purchasing power that had been created and pumped into the financial system.

So, all in all, this is a central bank financial stimulus aimed at lowering interest rates, increasing economic activity and pushing up the price of financial assets. But it has to be temporary because if the Treasury is not to create another big financial black hole for itself it will at some point have to sell back the assets it has bought through the APF (ideally at the prices it bought them at, or higher), as otherwise it will just have lumbered itself with tens of billions of pounds worth of gilts it had issued earlier to finance its own government debt! So while it is a transitory financial alchemy of a sort, with any profits that accrue from this buying and selling process going to HM Treasury, so the Treasury also has toindemnify any losses incurred.

QE is not inflationary in the traditional sense in that while it can fuel asset price bubbles in certain sectors of the economy it does not cause general price rises and is only temporary. Currency inflationcauses more general price rises across the economy as the excess currency circulates throughoutit, and of course can – and indeed will – continue for decades if not deliberately halted.– Editors.