Currency Dynamics

It has been suggested that inflation occurs as a direct result of the currency supply increasing, which then invariably leads to an increase in prices. While the mechanism is more complex than this simple statement suggests, it is still true that increasing the currency in circulation, by whatever means, will invariably cause an inflationary effect on prices. In this context, the model below is only intended to be generally illustrative of how currency in circulation can be increased by the issuing of bond IOU’s and quantitative easing, although the relationship between the government, treasury and central bank can differ in each nation-state. For while the treasury is typically a department of government, the central bank may be privately owned, partially autonomous or just another branch of government, although most central banks, irrespective of type are normally tied to government policy. By way of example, the UK central bank, i.e. the Bank of England, might be described as partially autonomous as it is expected to prioritise economic policy rather than any specific political agenda, although it is still answerable to parliament, i.e. a political institution. In contrast, the US central bank, i.e. the Federal Reserve, is often said to be privately-owned in the sense that it has share-holders who earn a 6% dividend on any profit. While it is known that the original shareholders of the Federal Reserve were the large US banks of the day, when created in 1913, it appears that today’s shareholders are a well-kept secret. Of course, while we will assume that these shareholders still exist, it probably reasonable that they work closely with the US government, although the real question might be who tells who what to do when it comes to economic policy.

It is hoped that the title on each block in the diagram is relatively self-explanatory, although its role will be explained in more details as each numeric step is outlined below. Again, the sequence of the steps shown is only intended to be a generalisation of the overall process, which in reality is more complex and subject to a range of different interpretations of which the following is but one and possibly not one supported by mainstream economists.

  1.  Bond IOUs: The government, via its treasury, issues bonds to private banks. At this point, the bond becomes a liability on the treasury balance sheet, i.e. it effectively represents an IOU that adds to the government debt.

  2. Let us assume that the private banks immediately pay for these bonds with existing currency, which  simply appears as a liability on their balance sheet against the asset of the bonds. On receiving payment for the bonds, the treasury balance still shows the liability of the bonds, but is now balanced by the currency received. While the currency received by the treasury might have been initially created by the private banks, this currency will ultimately be balanced by currency already in circulation – see steps 3-4.

  3. The private banks then need to sell the bonds to private and institutional investors. However, prior to actually selling the bonds, they have a liability of the new currency created to buy the bonds balanced by the asset of the bonds.

  4. After selling the bonds, the private banks remove the asset of the bonds from their balance sheet, while the currency received is used to cancel the currency liability of the original purchase. We might reasonably assume that currency received was already in circulation and therefore cancels the currency initially created by the private banks to buy the bonds from the treasury. However, it might be assumed that the private banks levy a charge in the form of a commission, such that some existing currency is siphoned off as profits by the private bank. In practice, steps 3 & 4 can be repeated many times, but each cycle represents an increase in government debt in the form of the outstanding bond IOU’s, unless ultimately offset by increased tax revenues – see step 10.

  5. Quantitative Easing (QE): The central bank may decide to buy back government bonds with currency that is simply created, while dutifully registering it as a liability on its balance sheet.

  6. For simplicity, it is assumed that the central bank always uses a private bank as an intermediary even when buying bonds from institutional investors, e.g. pension funds, such that the private banks probably earn another commission at this stage. However, as the bonds are returned to the central bank its balance sheet now reflects the currency created as a liability being offset by the asset of the bonds. While it might be said that neither the fiat currency issued or the bond IOU has any intrinsic value, the debt introduced into the economy is real enough. However, we might assumed that the central bank has acted independently of government and in the best interests of the economy,  although this is possibly too naive. Of course, in this situation, the government has been separated from the decision, while the central bank has balanced its books in terms of its assets and liability, such that it can also deny it has simply printed currency.

  7. As a result of steps 3-4, associated with bond IOUs,  and steps 5-6, associated with QE, currency can be injected into a deflated economy in the hope that it will help to stimulate growth, see step 9, and increase tax revenues back to the government via the treasury at step 10. However, this attempt at economic stimulation may also generate new currency at two different points:

        a. When bonds are issued via the treasury, the currency for the selling of these bonds is sourced from investors, such that this currency already exists and is therefore not new currency. However, this currency can then be injected into a deflated economy in the hope that it will stimulate growth in the economy at large. Whether this is the case often depends as to what happens at steps 8-9, where new currency can be created.

        b. When the central bank buys back previously issued bonds via QE, it effectively create new currency at that point. This currency flows back towards those who invested in government bonds, which is generally reflective of the more wealthy sections of society, e.g. individuals, fund managers and private banks. However, whether these investors will actually inject this new currency into a deflated economy where it is really needed may be questioned as analysis suggests that it may only help to push up asset prices that only makes the top 10% richer.

  8. Let us assume that the currency injected into the deflated economy by the government bond-IOU route does lead to increased investment. To some greater or lesser extent, this increased currency will eventually find its way into the currency holdings of private banks, which is then conceptually available for new loans that may stimulate growth in the economy, see step 9, which might further increase the currency holdings of other private banks to make even more loans. See Banks, Money & Loans and Private Bank Money for an explanation of how private banks effectively create new currency when issuing loans with interest.  Equally, if private banks are only require to hold 10% in reserve, a $100 million injection of currency into the deflated economy by the government at step 7 can be conceptually  leveraged up to $900 million by the private banks, i.e. a 9 fold increase of new currency into the inflating economy.

  9. Of course, the reality of a conceptual 9-fold leverage of new currency into the economy actually depends on who the private banks are prepared to loan this new currency. In the case of the 2008 financial crisis, the private banks proved to be very risk-adverse and only lent to those who could underwrite the risk with secure equity, e.g. the property mortgage market, rather than entrepreneurial start-ups or industries facing uncertain times that really needed the injection of new funds. Therefore, any attempt to inflate a stagnating economy by either issuing bonds or QE is not guaranteed to be successful, as recent history seems to support, if the private banks are risk adverse.

  10. At the end of this process, irrespective of whether it started with bond-IOUs being issued or purchasing via QE, the government and its central bank has more debt on its balance sheet, which it hopes that the increased tax revenues will help pay down over time. However, the increase tax revenues is not guaranteed and therefore other strategies are often employed to reduce the overall public debt.

While there are potential weaknesses and probable errors in the previous summation, it hopefully provides some insight as to why so many nation-state increase their debt in an attempt to stimulate growth in the economy. However, as suggested throughout the various steps outlined, injecting currency into a deflated or stagnating economy cannot guarantee recovery, if the private banks are not prepared to issue loans to the wider economy, e.g. entrepreneurs and industry, if perceived to be high-risk in comparison to loans underpinned by equity, e.g. the property-mortgage market. In this case, the injection of currency into the economy may only cause asset prices to rise, and prices to rise in general, such that the wider economy remains in recession and fails to produce the increased tax revenues required to offset the increase in government debt. As such, we will now turn our attention to the problem of debt and the mechanisms that might be used to manage it.

Note: Many economists appear to argue that QE is not just printing money, presumably on the basis that the balance sheet is matched in terms of liabilities, i.e. currency printed, against assets, e.g. bonds bought. However, government bonds are only an IOU by another name, which the government printed, just like fiat currency. If so, it would seem that the only way all the currency injected into the economy could be restored on the balance sheet would be by both the central and private banks selling back all their assets in the form of bonds to the treasury, presumably for fiat currency, which if not simply printed would have to be paid for by tax revenues. In the case of the UK, its public debt is in the order of £1600 billion, which is over twice the amount of the UK tax revenue. Of course, the tax revenue is already earmarked for public spending commitments, which is currently running a deficit, let alone paying off the increasing public debt. Therefore, the question we might ask ourselves is what is the likelihood that any government that has resorted to QE actually paying off the liability on its balance sheet?