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Saturday, August 07, 2010

How the Proposed Bank of England Act Works - Part One

Creating New Money

Like adding oil to a car engine, the economy needs a certain amount of 'new' money each year to continue running smoothly.

While many journalists and academics have slated the Bank of England's 'Quantitative Easing' scheme as 'printing money' and being inflationary, these same commentators are usually ignorant of the fact that the money supply has been increased by an average of 7.6% per annum for the last thirty years - almost entirely as a result of the money creation within the private banking system. Since this newly created money was all matched by the same amount of debt, it laid the foundation for the recent financial crisis.

However, had the money supply not grown at all over the last thirty years, we would have suffered thirty years of economic stagnation. So, while too much new money can cause inflation, there is still a need for an annual increase in the money supply.

Our reform would make it impossible for this annual increase in the money supply to be provided by commercial banks - in other words, we would take control over the nation's money supply out of the hands of private companies and put it back in the hands of the state.

We would then need to replace this money creation with an alternative source of new money. The following section explains how we do this.

Who Decides How Much New Money Should Be Created?

The existing [Bank of England] Monetary Policy Committee (MPC) will become responsible for making decisions on how much new money should be injected into the economy in each period of time.

They will stop making decisions to raise or lower the base interest rate and will instead make a decision to increase or reduce the money supply. They will likely take a twelve-month or two-year view of the economy, and then smooth any increase in the money supply over each month.

The MPC will continue to be politically independent and neutral. This is very important, as it prevents harmful political 'tinkering' with the economy. It is important that the MPC can not be overruled by politicians, whose decisions will be swayed by political matters rather than the long-term health of the economy.

The Committee will also still be subject to all the rules regarding transparency of its decisions, and the amount of the authorised increase in the money supply will be made publicly known.

Note that they will not be creating as much money as the government needs to fulfil its election manifesto promises - the needs of the government will not be considered. As discussed in 'Guarding Against Inflation' {*}, suggestions that this reform would cause a 'Zimbabwe situation' have no basis in reality.


How Will The Monetary Policy Committee Make The Decision?

The Monetary Policy Committee would authorise the creation of as much new money as they believe the economy (in other words, companies and households) needs to function healthily, and no more. There are two main measures that they can use to guide their decisions.

Firstly, the Committee will continue to base its decisions partly on the basis of 'inflation targeting' - the policy of trying to ensure that inflation stays within a small range - such as between 1.5% and 2.5% per annum. In other words, they should try to ensure that any change in the money supply is neither inflationary nor deflationary - neither too much nor too little. Note that for this to be effective, the measure of inflation used must be redesigned to take account of asset price inflation (such as a housing price bubble). It is pointless to attempt to make decisions affecting the whole economy using a measure of inflation that ignores inflation of ten per cent per annum in house prices when housing is the most expensive item in anyone's 'basket of goods'.

Secondly, the MPC can also refer to changes in the use of overdrafts. If the average overdraft balance was increasing, it may suggest a shortage of circulating money in the economy, and point to the need for more money to be injected into the economy. Alternatively, if the average overdraft balance was decreasing, it may be an indicator that there is 'enough' or too much money in the economy and that the Monetary Policy Committee should hold off on increasing the money supply for one or two months.

The Mechanics of Creating New Money

When the Monetary Policy Committee has authorised the creation of a specified amount of new money, it will be created in the following way:

1. The government will hold an account, known as the 'Central Government Account' with the Bank of England.

2. The Bank of England's Issue Department will simply increase the balance of this account by the amount authorised by the Monetary Policy Committee. They will not simultaneously reduce the balance of any other account - by making a credit without making a matching debit, they are creating new money.

3. The government can then withdraw the money from its Central Government Account and add it to tax revenue, and then use it in accordance with the principles discussed below.

In contrast to printing physical cash or coin - which costs around three pence for every one GBP created - a creation of money by the method is costless. To create GBP 20 billion or GBP 200 billion both requires one authorised official with the right passwords and a computer connected to the Bank of England's central accounts system. Of course, it would also require witnesses and formalities to be observed, but all in all, GBP 20 billion could be added to the economy in a little under twenty minutes.

Bill Totten


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