Does the Government Print Money to Fund Itself?

There are two very different views dominating the debate about the Bank of England’s (BoE) ‘quantitative easing’ (QE) programme — the purchase of government bonds using newly created money.

The first, as neatly summarised by GB News’ economics editor Liam Halligan, sees the BoE as having “long been engaged in the monetary financing of government debt, pure and simple.” Halligan has previously referred to it as “the most dangerous economic experiment for generations.” Echoing the same concern, the leading Eurosceptic MP Steve Baker recently wrote that “artificial prosperity . . . had built up as a result of the massive artificial monetary stimulus of recent years.”

Their claim is that the treasury’s spending is partly being funded by the BoE’s printing press, presumably because it’s unable to source enough funding, or enough cheap funding, through the usual route of borrowing in capital markets. This view remains popular in the print media, and last year, a Financial Times poll showed that most major investors in UK government bonds subscribe to it. It’s also extremely widespread amongst the public.

The other view — held by policymakers and most academics — is that QE is a tool that the BoE only uses to achieve its traditional objectives. “We do not . . . set a level of QE and asset purchases in any way related to what the government is going to borrow”, insisted Bank governor Andrew Bailey last November. Former central banker David Miles, of Imperial College London, writes that “accusations that [QE] . . . amounts to ‘printing money’ . . . are unfounded and misleading.”

These views appear to be incompatible, but their key difference is actually conceptual, not factual. Both Halligan and Miles are correct in a certain sense, but the language that’s being used obscures rather than clarifies things. This is quite a complicated issue theoretically, but the basic idea is quite simple.

We should start by outlining the role of central banks, the central hubs of all modern economies.

Contrary to a lot of popular descriptions, their staff don’t spend a lot of time thinking about the money supply, in part because “money” is very difficult to define. In the modern world, money isn’t physical assets like gold or silver, but nor is it strictly the paper currencies issued by governments. Any sufficiently-trustworthy financial promise, or ‘IOU’, can function as money.

Government IOUs tend to be the most reliable form, because stable governments have an interest in — and a long record of — maintaining their value in terms of real goods and services, which they can do because of a large tax base and a range of tools to draw upon. But broad definitions of money can include all sorts of IOUs, whose quantity is not under the central bank’s direct control. So instead, policymakers focus on interest rates, i.e. the cost of borrowing and the reward for saving.

In most developed countries the central bank’s tools are kept ‘independent’ from the democratically-elected government, to shield their decisions from opportunistic politicians trying to temporarily stimulate the economy to win an election. Their overall goals, on the other hand, are prescribed by Parliament; essentially, they’re given two — low inflation and low unemployment (with priority given to the former).

Broadly, they achieve these twin goals by adjusting interest rates. When rates fall, saving becomes less attractive and borrowing is cheaper, so total spending rises. The reverse is true when rates rise. When unemployment is high and inflation is below target, they lower interest rates to boost spending, which in turn incentivises firms to hire more workers and raise prices.

The treasury, meanwhile, takes in revenue through taxation, which it spends on transfers, like Universal Credit, and government purchases, like vaccine doses. When unemployment is unusually high, a gap between taxation and spending opens up, since more people qualify for unemployment benefits, while fewer people are earning enough to pay much tax.

Rather than raising taxes — which tends to exacerbate the shortfall in spending — the treasury often fills the gap by borrowing, either domestically or from abroad. This is done by issuing IOU contracts, known as bonds, that private lenders can purchase.

These pay a fixed amount, called a coupon, at regular intervals, but their initial buyers are free to trade them, so the price can change. It does so because the bond’s overall desirability as a financial asset, relative to alternatives like stocks and privately-issued bonds — can rise and fall. When it does, the ratio between the bond’s price and the fixed coupon it pays — effectively its interest rate — changes. This is what people mean when they refer to the government’s borrowing costs going up or down.

Now, when a central bank engages in QE, it is creating new money and using it to purchase treasury bonds from the private sector. At a glance, this reduces the government’s IOUs.

But of course, a central bank is also part of the government, and money, like a bond, is also an IUO.

The difference between government bonds and government money is sort of like the difference between a savings account and a current account at your local bank: they come with different terms and conditions, but as representations of wealth they’re essentially equivalent.

If you transfer everything from your current account into a new savings account, withdrawals might be a bit awkward, but you’re no less wealthy.

So, when a central bank creates money, it’s doing essentially the same thing that the treasury does when it creates a bond — borrowing from the private sector (for a more in-depth discussion of this point, see Stanford economist Robert Hall’s interview on the EconTalk podcast, starting at 31:45).

The goal is to alter the composition, not size, of the government’s total obligations. One type is injected into circulation, while another of equal value is withdrawn.

This means that QE, on its own, has nothing to do with the government’s debt management objectives. If interest rates had to rise for inflation to remain on target, then the central bank can simply reverse QE — reselling the bonds in exchange for the money it created — with further borrowing conducted by the treasury creating new bonds.

More likely, central banks will simply pay interest on the QE portfolio. This is the route most went down in the late 2010s, but it doesn’t matter which it chooses, because once money pays interest, the crucial between it and bonds disappears. Money creation no longer equates to borrowing at zero interest, but at positive interest.

So, what is the purpose of QE?

The basic idea is that if a central bank tries to buy a lot of long-dated government bonds, their price will rise due to the higher demand, causing the long-term interest rate to fall. Households and firms will then react by consuming and investing more now, since the reward for saving has fallen.

This is an intuitive story, but it’s hard to make sense of. In economic theory, the price of a good is determined by the intersection of upward- and downward-sloping supply and demand curves. The main objects of finance, however, are investments or assets, rather than consumable goods.

In standard finance theory, prices aren’t determined by supply and demand per se, but by the expected discounted value of the future returns over which the asset represents a claim.

In this frame, higher demand doesn’t mean higher prices. A story people often tell about why asset prices go up and down — buyers ‘outnumbering’ sellers ‘drives’ price up — misses the fact that there’s a seller on the other side of every trade.

So, standard finance theory doesn’t explain why trading volumes are so large, and in the limit, can’t explain why trading should occur at all. Someone would only offer to sell you an asset if they think, because of their private information, that its fundamental value is lower than the price they’re offering it for. In other words, they must know something that you don’t. Given this, any rational trader would know not to buy it.

Of course, vast amounts of trades are made every second of every day. Lots of proposals have been forward as to why, but none are well established yet. Chicago’s John Cochrane calls it the Great Unsolved Problem of finance theory.

Likewise, QE does seem to raise the prices of long term bonds slightly, lowering long rates. In former Federal Reserve chairman Ben Bernanke’s words, it “works in practice, but doesn’t work in theory”.

In practice, QE probably works through forward guidance — an announcement of fresh bond purchases signals to markets that the central bank has grown more pessimistic about economic growth, and it’s therefore likely to hold interest rates low for longer. In any case, the effect is quite small, and it doesn't justify the feverish attention that QE operations sometimes receive.