22 October, 2017

What Happens When A Central Bank Issues More Money Than necessary?

By W.A Wijewardena

Dr. W.A. Wijewardena

A reader of ‘My View’ in the previous week has informed this writer by email that it is not imprudent for a central bank to issue money in large volumes when a country needed that money to push its growth rate up. His argument, referring to Sri Lanka’s current situation, has been that when the country is faced with the challenge of economic rebuilding after a costly war, there is no alternative but to use the power of printing money by the government and consequential credit creation to promote enterprise, industry and commerce.

When credit is available at low interest rates to people in large volumes as a result of the loose monetary policy pursued by the central bank of the country, according to him, economic activities get boosted and the benefits of such economic activities outweigh the underlying presumed costs. The economic benefits are tangible and could be seen by everyone but the presumed costs by way of inflation are just a speculation. That speculation may or may not materialise depending on the future growth in the output. In all probability if the output increases, it will have a moderating impact on inflation. Hence, why worry about an inflation which is not to be seen?  Hence, he has argued that there is nothing wrong in a central bank using a loose monetary policy in order to support the government’s initiative to rebuild the economy which is the most pressing demand of the nation.

Many believe that monetary policy should support growth

To his credit, this reader is not alone in holding this view. Even the reputed economists in the Federal Reserve System of USA and those who run many central banks in the world have been subscribing to this view dramatically changing their view of monetary policy after they had assumed office in the respective central banks.

In fact, Fed has been supporting this view throughout its history as evidenced by the policy packages it had introduced whenever the US economy had run into trouble. The Fed has to do so by law because it has to attain two conflicting goals of maintaining price stability and attaining full employment in the US economy. Accordingly, Ben Bernanke, the outgoing Fed Chairman had to change his economics which he taught to his students while he was teaching at Princeton University. Even the incoming Chairperson Janet Yellen is noted for holding this view in her university days as Professor of Economics at the University of California at Berkley.

Fed’s unending stimulus package

The stimulus package introduced by Fed to arrest the deep economic recession which USA ran into in 2007 is a testimony to what the reader in Sri Lanka has argued for. Fed started to print dollars in unprecedentedly high volumes and supplied to the economy driving the US interest rates to near zero levels. The goal was to make available cheap money to people so that they would consumes more thereby creating a new demand for goods and services on the one hand and encourage the businesses to invest more and increase the aggregate supply on the other. Thus, the new dollars supplied by Fed in the form of reserve money jumped up in multiple terms since 2007.

For instance, during the 22-year period from 1985 to 2006, such reserve money increased only from $ 200 billion to $ 880 billion. But during the nearly seven-year period from January 2007 to September 2013, the reserve money stock went up from $ 880 billion to $ 3800 billion and it is going up at the rate of $ 85 billion a month. The indications are that there will not be early tapering off of this addition of new money to US economy since the incoming Chairperson Janet Yellen is a known promoter of this policy.

Cautious US banks don’t create multiple credit and deposits

Fortunately for USA, the rate at which this reserve money is converted to final money by banks, known as money multiplier, has dropped significantly from 5 some 7 years ago to less than 1 today. Hence, money in the hands of the people in USA is strangely less than the total stock of reserve money amounting to $ 3.8 billion accounting for a quarter of its GDP. The reason has been the cautious approach by banks to extend credit after their bad experience of credit bubbles wiping out the assets completely in the financial crisis of 2007/8.

However, if normalcy returns to US financial system where banks have confidence of resuming lending, the overall money supply will rise sharply to about $ 20 trillion, some 133% of its GDP. At that level of money creation, Janet Yellen and her 12 members of the Federal Open Market Committee or FOMC will not be able to save USA from hyperinflation without causing the US citizens to lose almost the entirety of the wealth they are enjoying today.

Angered by their reckless printing of money without considering the risks it would bring to the US economy in the future, Geoffrey Pike in the blog site Wealth Daily has cried out ‘The Fed is making you poor: These 12 People are killing America’ (available here ). He has reason to cry because despite all the new money created by Fed and US government’s massive stimulus package of $ 747 billion, the US growth rate has remained below 2% per annum and unemployment at 7.2 percent as against a targeted reduction to less than 5% by September 2013. The money has leaked out of USA creating a bigger trade deficit at home and generating economic growth elsewhere.

John Law: Money creation promotes trade and employment

Many who are familiar with the recent developments in economics are under the belief that it is after the reputed British economist John Maynard Keynes that the governments and central banks started to use this money printing machine to push up economies from recession to full employment. But that is not true since the first man who argued on those lines was the Scottish economist John Law in late 17th century, some 230 years prior to Keynes. It is Law’s concept of money and his proposition on the use of monetary mechanism to promote economic growth that has been used by later-day economists without citing him.

Produce more money to generate growth

John Law’s principal work on money was published in 1705 under the title ‘Money and Trade Considered: With a Proposal for Supplying the Nation with Money’. The nation he referred to was his own native land Scotland and his proposal was to supply it with a plentiful of money to enable it to promote trade and through that strategy bring prosperity and wealth to that nation.

The reason he had to come up with this proposal was that the Gold Standard that was in use at that time had failed to produce enough money to facilitate nations to finance the ever expanding international trade. That is because unless a nation had acquired enough gold it cannot buy goods from other countries and if it is unable to buy goods, it fixes a limitation on other countries to sell their products to that country. Thus, trade is impeded and through that impediment, wealth and employment creations are also impeded.

John Law: Money belongs to the king

John Law argued that money in a society serving only as an exchange token to buy goods and services is a public good and the king has the right to manage and control that public good in public interest. If anyone hoards money when it comes to his hand without spending on goods and services, Law termed it as a criminal activity. Thus, the king has the right to prevent it by using all means at his disposal including the replacement of metallic currency with paper currency. Hence, John Law was the father of the paper currency in modern times.

Money or any other property becomes the property of people only if they use them for the benefit of the community. Hence, if people hoard metallic currency without spending it on goods and services, or in other words do not create a demand for same, the king should replace them with paper currency which cannot be hoarded for a significant periods of time.

Keynes was not the first to suggest ‘deficient demand’

Some 230 years after Law, Keynes presented the same in the form of deficient demand that leads to economic recession. But instead of using the king’s coercive powers directly as argued by Law, Keynes proposed another discretionary power of the king to rectify the deficient demand. That is for the king to print paper money and spend it through the government budgets on goods and services to eliminate the deficient demand.

John Law: King should set up a centralised central bank

Law then argued that money directly contributes to trade. Bigger the stock of money, higher the trade and smaller the stock of money, lower the trade. Hence, if paper money is created and supplied by the king in bigger volumes, trade in society will pick up increasing the level of employment and wealth in the community. The opposite will happen if the stock of money is deficient in the community. For the king to manage this properly, there should be a centralised institution under the control of the king. That centralised institution is nothing but a central bank. Already, Sweden and England had tried it with privately held central banks but it was still a novelty for other nations. Hence, John Law was the architect of modern centralised and state owned central banks too.

John Law got the opportunity of testing his theory in practice later in already bankrupt France due to prolonged wars it had engaged itself with its neighbours.

Early 18th century France: The guinea pig of testing Law’s theory

Though Law’s objective was for his native land to create a central bank, fortunately for that nation as the subsequent events had unravelled, his proposal was rejected. This was because of his bad reputation as a losing gambler and his being sentenced to life imprisonment in England for killing a man in a duel. When his proposal was rejected in Scotland, Law is reported to have fled to continental Europe and built a friendly relationship with French authorities who were at that time engaged in costly wars with other nations.

When the French economy was in a mess and King Louis XV who had succeeded Louis XIV was in readiness to receive advice even from the Devil, it was not strange that Law was able to win confidence of the young and inexperienced monarch. He was first appointed as the Controller General of Finances of France and while holding that position, he persuaded the monarch to allow him to establish a private bank called Banque Generale Privee which later became Banque Royale in 1717 with three quarters of capital consisting of government bills and government accepted notes. The bank accepted deposits in coins and issued paper money called Ecus on the strength of those coins and the government notes. Hence, it virtually became the central bank of France.

When France’s economy was stagnant and its national debt was unmanageably high at three billion livres, the currency of France at that time, against an annual government revenue of some 145 million livres, Law emerged as the saviour. He suggested that his bank will buy back French national debt using the proceeds of the IPO, the rest of the debt to be assigned to shares in ventures and new circulation currency called Ecus to be issued by the Bank in bigger volumes. That money will promote trade, increase employment and economic growth pushing France out of economic bankruptcy. Hence, it was the loose monetary policy to rescue France as is being argued by many today.

Monetising Government debt in France

What does this mean? The French Government will assign its national debt to Banque Royale in the form of bills and notes. The Bank will issue paper credit on the basis of these notes and bills. This is similar to modern practice of debt securitisation in which a bank lends money initially to a borrower and on the strength of that loan, it issues new securities to borrow more from the market. Similarly, a modern central bank too lends to a government and the government will issue bills assuming the liability for that debt.

The central bank will on the strength of these bills and notes on the asset side of its balance sheet will issue more money which is simply borrowing more from the people since every currency note issued by a central bank is an IOU exchanged for the real assets of holders of such IOUs. This practice of central banks which the reader referred to above has praised is called ‘monetising government debt’ because new money is issued on the basis of government paper in the hands of a central bank.

Governments love it because they can borrow more from the public when the public have more money in their hands. Central banks too, like the Fed in USA, will go on expanding its lending to the government and money creation similar to an inverted pyramid that sits on a very small base of real assets. Central banks will do so accepting the paper based government promises disregarding the fact that those moneys are used by governments irresponsibly.

Too much paper money production destroys France

What happened to the private central bank which John Law established in France with government blessings? It could not resist the temptation to produce more paper credit notes than what is permitted by the coin deposits with it and the available government bills and notes. It also went overseas into the French colonies in North America and established a monopoly trading company based on Mississippi River in Louisiana.

Having bought the Mississippi Company in August 1717, John Law became the Chief Director of the Company which was granted monopoly position in trading in West Indies and North America by the French Government. He gradually built up monopoly power in trading having absorbed the other rival companies. In 1718, his bank was named Banque Royale, giving the impression that it is a bank guaranteed by the French Government. This bank issued more paper credit papers than it could issue with the coinage it had as reserves, leading to price inflation and a bank run when the value of the paper credit notes fell by a half in the market.

Bursting of Mississippi Bubble

By using his superb marketing talents, John Law exaggerated the value of Louisiana company, causing a speculative bubble in the shares of the company. The demand for the company shares was so high that it in fact caused the Banque Royale to issue more and more paper credit notes. When the company generated only book profits, the dividends were paid by issuing the investors with paper credit notes. In 1720, the French Government was compelled to admit that the Banque Royale had issued more notes than it would have done with the reserves in coinage with it. This led to the burst of Mississippi Bubble and with that, the destruction of France’s entire financial and monetary system. Thus, John Law with his careless money printing was responsible for destroying the French economy and its monetary and financial system single-handedly within just four years.

This episode took place nearly three centuries ago. But its learning outcome should serve as a good lesson for anyone who suggests that there is nothing wrong in a central bank issuing more money than what is supported by the strength of its economy.

*W.A. Wijewardena can be reached at waw1949@gmail.com

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Latest comments

  • 0

    Dr. Wijewardena,

    Do we know how much money SL central Bank issuing yearly?
    What is effect of it for a man in the village?

    If USA is doing it I am sure our Central Bank would justify the actions taking USA and Ben Bernanke as an example.

  • 0

    Well look at the USA today, 60% of the populace on food stamps, the gap between the rich and the poor widening, corporates highjacking the govt, serious social discord and reduction of subsidies on utilities and growth of the spying net works etc Internal stimulation to a limit is fair but it should be invested in production. Unfortunately the money is used for consumption in Sri Lanka which is showing all the problems of america. America is economically strong but SL is weak and their policies are sustaining employment in other countries not in SL. Imitating other countries is not the answer but an economy run by competent individuals not by inexperienced accountants. The country lacks accountability at every level and all this is both foolish and unsustainable.

  • 0

    Only the Hard Working makes the Growth (Prosperity ) Not the Printed Paper Money
    As Singaporeans believed and proved only the hardworking makes the prosperity. Though we still believe much on Keynesian theories but it has not given the fruitful benefits as believed Unfortunately still we are not humble enough to accept the blunders we did, at least now we have to tighten our belts and go for austerity measures to face the bitter truth and come out of it .
    Latest Example
    Printing 5Mn of 500 Notes which is worth of 2.5 Bn LKR (with the money multiplier of around 6, it will be of 17.5 MB within next 18 Months),And it is not sure whether the CB has to think at least about the total existing money supply with the total output (GDP ) of the country , because new money should be issued only if there is a growth in the GDP. Otherwise the end result is these actions will lead to a higher inflation.
    Example from the Globe
    The best example is from Venezuela, who currently experiencing a hyperinflation close upon to 50%
    Only for last year inflation has increased by 30% (where in 2012 it was 20% ) the main reason for this hyperinflation is the high social expenses (obviously by money printing )of the new government who came to the power after Hugo Chavez.
    With the miracle of new government of President, Nicolás Maduro even Christmas has come one Month early (in November ) and has created a new Ministry called Supreme social Happiness , while increasing the Minimum salaries by 30% (20% in May and 10% in September ).
    This is a very good example to prove that the hyperinflation can be occurred at a very short period of time. If Sri Lanka also try the same strategies we also can see the miracles very soon .
    What Indian New Reserve Bank Governor says to us ( Mr Raghuram Rajan. )
    We have to learn much from the India who never tried to protect their external value (Exchange Rate) at the expense of their foreign reserves. The new governor is directing the CB to be an independent entity without dancing to what as government says.
    And the very recent steps taken by Reserves Bank India is increasing their policy rate for two times already to fight against the current inflation rate of 8%
    So even Sri Lanka also having a very close inflation rate like India (while inflation is calculated from unrealistic controlled prices from government shops like “Sathosa “and also after removing the liquor and cigarette from the basket without any logic ) ,how can we relax the Monetary policy and reduce the policy rates just by printing more and more money .

    For more details please visit bellow mention articles
    Finally, the Indian government agrees to leave the central bank alone
    India needs to end fiscal dominance over the central bank

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