What do central banks do?

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[00:00:35] Fair to say you simply flooded the system with money?

[00:00:39] Yes, we did. That's another way to think about it. We did.

[00:00:43] Where does it come from? Do you just print it?

[00:00:46] We print it digitally. So we, you know, as a central bank, we have the ability to create money digitally. And we do that by buying treasury bills or bonds or other government guaranteed securities and that actually increases the money supply.

[00:01:02] This is the Debunking Economics Podcast with Steve Keen and Phil Dobby.

[00:01:09] That's the chair of the Federal Reserve, the US Central Bank, Jerome Powell, talking on the US TV show 60 Minutes about how central banks create money.

[00:01:18] This week, just how do central banks work? Do they create money in the way that Jerome Powell says they do?

[00:01:24] And when they change interest rates, how is that actually implemented?

[00:01:28] And which is the most important, a change in the money supply or a change in the interest rates?

[00:01:33] Let's have a good look at central banks this week on the Debunking Economics Podcast with Steve Keen.

[00:01:38] I'm Phil Dobby. Welcome along.

[00:01:50] So central banks, they are there to manage the stability of the banking sector, to ensure the stability of the value of money.

[00:01:58] In other words, to make sure inflation doesn't get too out of control and avoiding runaway inflation.

[00:02:06] And in some cases also, they have a mandate to maintain employment levels as well.

[00:02:10] But they are best known, Steve.

[00:02:12] Their party piece, obviously, is moving interest rates up and down.

[00:02:17] So let's look at the mechanics of that.

[00:02:19] The idea is, you know, put interest rates up, the cost of borrowing goes up, less people and businesses want to borrow.

[00:02:25] But what they are actually changing is the interest rate between banks, isn't it?

[00:02:31] Or between banks and the central bank, their overnight loan rate.

[00:02:34] So as they try and balance out the reserves that we talked about last week.

[00:02:38] So a bank might have lots of money in reserve.

[00:02:44] Another one might not have enough.

[00:02:46] One needs to cover itself so it borrows from the other bank or as a last resort, borrows from the central bank.

[00:02:52] That's basically it.

[00:02:53] And the interest rate that they're talking about is the interest rate that's charged for those sorts of transactions, isn't it?

[00:02:59] For overnight loans, yeah.

[00:03:01] You want that rate that you charge.

[00:03:02] That's an administrative rate.

[00:03:05] So once you've said it, if you're going to borrow from a central bank, that's the rate you've got to pay.

[00:03:09] If the private bank borrows off a central bank, and that will then be actually activated by – it is not actually mixed to active borrowing.

[00:03:18] I think it can do that, but what happens is they will sell bonds.

[00:03:22] So they sell bonds to the private – if a private bank has bonds, which it sells to the central bank, then the way that sale is recorded in the bank's accounts is the monetary value of their bonds goes down, the monetary value of their reserves go up.

[00:03:40] So that happens entirely on the asset side of the private bank.

[00:03:45] And what that means for the central bank is the central bank's – its liability of reserves rises, but it also has bonds it owns as well.

[00:03:56] The central bank owns government bonds and has to because of this mechanical – well, the open market operations.

[00:04:03] So the reserves of the assets, the liabilities of the central bank, which are reserves, go up.

[00:04:10] The assets of the central bank, which are bonds that it's purchased off the private banks, they also go up.

[00:04:16] So there's – and against this one thing in terms of –

[00:04:19] With money that the central bank has created in that process.

[00:04:22] Well, no money – well, there's the form of – there's no money creation in that because to have money creation, and this is a vital point which you get when you understand double-entry bookkeeping, is that for an operation to –

[00:04:38] what money fundamentally is these days is some of the balances in private bank and deposit accounts.

[00:04:46] That's what money is.

[00:04:47] So if you're going to each increase money, you've got to increase that particular liability.

[00:04:53] To do that, you've also got to have the operation that balances that.

[00:04:57] The second operation has to be on the asset side of the private bank's ledger.

[00:05:01] So you have a plus in the assets, which are loans, a plus in the liabilities, which are deposits.

[00:05:07] That's how money is created.

[00:05:10] And so if you have an operation like selling bonds to the central bank, then your bonds go down.

[00:05:16] They're an asset.

[00:05:17] Your reserves go up.

[00:05:18] There's an asset.

[00:05:18] Nothing happens on the liability side.

[00:05:20] Therefore, money is not being created.

[00:05:21] Right.

[00:05:22] So actually what the central bank wants you to do as a bank if they want to see the money supply increase is they want you to lend out more.

[00:05:28] They want you to increase both those assets and liabilities by lending out more.

[00:05:32] But that's where they're impotent on that front.

[00:05:35] The central bank operations don't – people think that if the private banks have reserves, they lend out their reserves.

[00:05:47] And as I said, that only works for reserves of cash, which they're not.

[00:05:51] So that can't be part of the mechanics.

[00:05:53] So the false sense that we talked about last week follow through to the central bank's operations then as well, don't they?

[00:05:58] So let's look at what – I mean, the central banks basically – first of all, let's start at the very basic level.

[00:06:05] They hold the banks – they hold the reserves of all the banks basically.

[00:06:10] So they're liabilities, aren't they?

[00:06:13] All of those reserve accounts for all of the commercial banks.

[00:06:19] And then for assets to offset that, they've got bonds.

[00:06:23] Bonds, they've got a bit of gold, mainly bonds, isn't it really?

[00:06:26] And then repos, which are basically short-term loans.

[00:06:30] Just a derivation of bonds really, aren't they?

[00:06:33] Just a short-term loan in effect.

[00:06:36] So they all have to balance out.

[00:06:39] So then the central bank says, well, okay, we're going to buy bonds.

[00:06:45] Their argument is that's more money for reserves in banks.

[00:06:49] That's their argument.

[00:06:51] But it does nothing.

[00:06:52] But you're saying that's not what happens.

[00:06:55] No, it doesn't affect the lending operations.

[00:06:58] But that is their method of operation though, isn't it?

[00:07:02] They say, yes, we're going to buy more bonds and this will be new money that's pumped into the economy,

[00:07:08] so more reserves in banks.

[00:07:10] And therefore, under that false argument, you say that they're not lending out those reserves.

[00:07:15] They're not lending out in relation to those reserves.

[00:07:17] So it's not going to increase their ability to lend out.

[00:07:21] The net effect will be zero.

[00:07:23] But that is the way these great minds demanding vast salaries thinks it works, isn't it?

[00:07:29] Yeah.

[00:07:30] Because that's just the model that enables them to continue on with macroeconomic models,

[00:07:36] which don't include banks or debt or money.

[00:07:38] So what they're saying is here's a mechanism that's necessary to create the system we use

[00:07:45] to avoid the double coincidence of wants.

[00:07:47] But that's the only impact it has.

[00:07:49] It doesn't have any impact on the macroeconomy.

[00:07:51] So we model the macroeconomy as a barter system.

[00:07:54] We don't have banks.

[00:07:55] We don't have private debt, definitely.

[00:07:57] And we don't have loans and deposits that's left out completely.

[00:08:03] So the banking system is missing from macroeconomic models.

[00:08:07] Now, why is it missing?

[00:08:08] It's because they think it's unimportant.

[00:08:09] Why is it unimportant?

[00:08:11] Because they think the economy is a barter system.

[00:08:13] So they're leaving out the entire financial structure of the economy to make it easier for them to argue,

[00:08:20] to justify when they do macroeconomic modeling, leaving out the banking sector entirely.

[00:08:25] So in the whole – because they don't recognize that banks create money even though they've written papers on it.

[00:08:30] And they don't recognize debt because your debt is – I gained from your – you borrow money from me.

[00:08:37] The same amount of money is still in circulation, but – which is the case of, you know,

[00:08:42] for people lending money to each other, but not the case when banks create money.

[00:08:46] Yeah.

[00:08:46] Yeah.

[00:08:47] It's crazy that I don't know, but that's what I do.

[00:08:50] So everything that – so I'm trying to figure out what central banks, what useful function are they performing then?

[00:08:56] Does that negate the whole purpose of buying and selling bonds in the open market?

[00:09:01] Because the whole reason they –

[00:09:02] No, it did.

[00:09:03] The whole reason for that –

[00:09:04] Yeah, you go.

[00:09:05] Yeah.

[00:09:06] One of the reasons they do it and the main reason is when they've set a target interest rate,

[00:09:10] then they buy and sell bonds on the market to make sure that the effective rate in the market is within –

[00:09:17] they're only between 0.25 above or below the rate they've set.

[00:09:21] But another major reason – this is the practical reason for central banks –

[00:09:25] it actually relates to how reserves are created in the first place.

[00:09:29] And reserves are created at the macroeconomic level by the government running a deficit.

[00:09:34] Okay.

[00:09:37] Now, when the government spends more than it takes back in taxation,

[00:09:41] then in the double-entry bookkeeping terms at the level of a private bank,

[00:09:44] what happens is private banks' account go up because of the spending, down because of the taxation,

[00:09:51] but there's a difference between the two in the net sense the deposit accounts have risen.

[00:09:56] That's the increase in the bank liability.

[00:09:59] What's the increase in the bank asset?

[00:10:00] Well, obviously, it can't be loans because that's what the banks actually have as their balancing item.

[00:10:06] The item which increases in value is reserves.

[00:10:09] So when the government spends more than it takes back in taxation, it creates reserves.

[00:10:13] And it does it at a very – at a dribble rate.

[00:10:16] People – this is an important point.

[00:10:18] I've found some lunatics on banking and they don't appreciate.

[00:10:22] If the government runs a deficit of 10% of GDP,

[00:10:25] and that's sort of – we had levels like that during the COVID, 10% and 20% of GDP.

[00:10:32] Then when it does that money creation, it massively increases the reserves.

[00:10:40] And then the legal systems of most countries under laws passed by parliaments

[00:10:48] have required the government to then issue bonds equivalent to that gap plus the interest they're paying on existing bonds.

[00:10:55] So when a government runs a deficit and when a government has outstanding bonds already,

[00:11:01] then it's required to sell more bonds that are equal to the deficit plus the interest on existing bonds.

[00:11:08] But they're doing it on a week-by-week basis.

[00:11:10] So even if you had something as ridiculous huge as 20% of GDP, additional money created in one year,

[00:11:16] it's done 50 times, like a 50 auctions over the year sort of thing.

[00:11:20] So it dribbles out in small amounts.

[00:11:22] Now that means that if there's a situation where the reserves that exist aren't –

[00:11:28] the aggregative reserves isn't large enough to buy the bonds the government wishes to sell at that auction,

[00:11:35] then what the central bank does is it buys those bonds in open market operations off the private banks.

[00:11:41] That reduces the monetary value of the bonds those banks house.

[00:11:46] It increases the reserves.

[00:11:47] Hey, presto, they've got enough money to buy the entire issue of bonds that the Treasury is trying to sell.

[00:11:52] Right.

[00:11:53] So the practical responsibility that the central bank has is to make sure the Treasury auctions will be fully subscribed.

[00:11:59] Right. Well, let's go through that step by step.

[00:12:01] So first of all, we talked about interest rates and buying up bonds.

[00:12:10] So bond yields are inversely related to the price of a bond.

[00:12:17] If there's – arguably, if they're seen as being too many bonds or there's just not enough demand for bonds,

[00:12:25] then like anything – even though there seems to be an insatiable demand for bonds,

[00:12:29] but say there's a limit, so there's more bonds than people are prepared to pay,

[00:12:34] then the price of the bond will go down, the yield will go up.

[00:12:39] So that's how they – so by buying and selling bonds, they are trying to control that interest rate.

[00:12:46] And does that – and that works?

[00:12:48] It works.

[00:12:49] Yeah, because again, the central bank is a bank in its own right, whereas customers are the private banks.

[00:12:57] And if the private bank – if the Treasury – sorry, the central bank says we want to buy bonds off you,

[00:13:06] then that means we're going to put a positive number in your reserve account.

[00:13:10] And when you transfer the bonds to us, because of that money we put in your reserve accounts,

[00:13:17] we then increase the monetary value of the bonds we hold, which are our asset.

[00:13:21] And they've got a limitless capacity to do that because, firstly, there are banks that can increase their assets

[00:13:26] and liabilities at will if they have a willing borrow.

[00:13:30] In this case, it's a willing seller of bonds back to the central bank.

[00:13:34] And the central bank does not face the equity limitations that a private bank has.

[00:13:38] So if a private bank gets to the point where its assets are less than its liabilities,

[00:13:43] its equity is negative, it's bankrupt.

[00:13:45] That's when it gets written off on the financial system.

[00:13:48] But the central banks can get over with negative equity.

[00:13:51] And there's a paper by – his last name is Bolat, B-H-O-L-A-T.

[00:13:55] I haven't seen him for almost a decade now, but he's a colleague, a person I know and like.

[00:14:01] And I think – I hope he's still there on the Bank of England.

[00:14:02] It's about time you caught up, Steve.

[00:14:04] Sir?

[00:14:05] It's about time you caught up then, isn't it, really?

[00:14:07] Yeah, I've lost a few contacts there.

[00:14:10] But he's wrote a paper and says, does the central bank have to be in positive equity?

[00:14:14] The answer is no.

[00:14:15] So there are times when private banks have been in negative or positive equity,

[00:14:18] which gives them far more freedom to expand their balance sheets than the private banks have.

[00:14:23] So if the – like this is one joke I make about Elon Musk's terror about,

[00:14:28] oh my God, how are we ever going to pay back the debt, the interest rates compound?

[00:14:30] Well, tell the Fed to go and buy $40 trillion worth of bonds tomorrow.

[00:14:36] Okay?

[00:14:36] And that would mean they'd put $40 trillion into the reserve accounts of all the private banks in America.

[00:14:43] And they'd put $40 trillion on their asset side.

[00:14:46] They now own all outstanding government bonds.

[00:14:48] And once the central federal bank owns a government bond, one of two things happen.

[00:14:54] Either the Treasury stops paying interest on those bonds because a lot of countries have the rule that the central bank does not receive interest on bonds.

[00:15:03] Or they do receive interest on bonds, and that's the Treasury puts a positive entry in the income, in the equity column of the central bank.

[00:15:14] They – pardon me – when they get to the end of the year, they remit their profits back to the Treasury.

[00:15:22] Yeah.

[00:15:22] So effectively, as soon as that happens, goodbye.

[00:15:25] There's no government.

[00:15:26] The government debt exists.

[00:15:27] It's owned by the government.

[00:15:28] The government pays no interest.

[00:15:29] The interest of bill falls to zero.

[00:15:30] So if Elon wants a simple solution to his dilemma, tell the Federal Reserve to buy $40 trillion worth of bonds tomorrow.

[00:15:37] Or just mint a $40 trillion coin.

[00:15:39] That's another way.

[00:15:40] That's another way.

[00:15:41] Yeah.

[00:15:42] So that – one line you'll find with bond traders is don't fight the Fed.

[00:15:48] Yeah, yeah.

[00:15:49] Absolutely.

[00:15:50] And the Fed creates – so this is – when the Fed says, right, we're going to buy up bonds because we want to influence the interest rate to be the interest rate that we want it to be.

[00:15:59] Yeah.

[00:16:00] It's nothing really to do with the bank reserves or anything to do with that.

[00:16:07] It's literally to do with the bond yields or the interest rates on bonds, which they're controlling by buying or selling.

[00:16:14] When they're buying them then, they are buying them with money that they have in effect created.

[00:16:20] Well, they're money – no, they're fund creation.

[00:16:23] It's important not to call it money because money is the sum of the assets – the sum of the deposit accounts of private banks.

[00:16:31] So if I've got $1,000 worth of bonds that I've paid for, I paid my $1,000 in cash for, I've now got $1,000 in bonds.

[00:16:42] The central bank comes along and says, well, we'll buy those off you.

[00:16:47] Here's $1,000.

[00:16:48] I get $1,000 in cash.

[00:16:50] They own the bonds.

[00:16:52] That $1,000 in cash now I've got, which I – okay, so I'm in the same position as I was before through that process though, aren't I?

[00:17:01] No, you've got cash.

[00:17:03] You've exchanged.

[00:17:03] So in that particular case, money has been created.

[00:17:05] If a central bank buys off a private bank, then the operations entirely occur on the balance – on the asset side of the private bank's balance.

[00:17:14] Therefore, it has no effect on the money supply.

[00:17:16] But if the central bank buys a bond which is held by a non-bank financial institution or by private individuals – and I've owned bonds, so you can actually go and buy bonds as an individual –

[00:17:26] then you – when you bought the bonds, your deposit account went down by the amount of the cost of the bonds and your value of the bonds which were interest earning goes up by the same amount.

[00:17:36] And if the central bank buys that back off you, then it puts money in your deposit account.

[00:17:41] And that also increases the reserves.

[00:17:46] Oh, sorry.

[00:17:46] So if it buys bonds off you, then it's putting a positive entry in your deposit account and that's a positive entry in the reserves of the private bank as well.

[00:18:00] And that then – and when the central bank, the reserves go up and they've also got the bonds, so their assets go up.

[00:18:06] Right.

[00:18:06] Okay, we're going to take a break.

[00:18:07] I'm still confused though because I bought those bonds for £1,000 and now I've sold them.

[00:18:13] It just so happens that the central bank bought them rather than Fred down the road.

[00:18:18] Either case, they're both giving me the £1,000 which is the face value of those bonds.

[00:18:22] I'm no better off as a result of that.

[00:18:25] So how is that pushing your money into the economy?

[00:18:29] Okay, well let's have a chat about that.

[00:18:30] When we come back on the Debugging E-Nawics Podcast.

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[00:19:40] This is the Debunking Economics Podcast with Steve Keen and Phil Dobby.

[00:19:46] Okay, well, we're doing a very good job before the break of demonstrating how confusing this all gets.

[00:19:52] So, the Central Bank is trying to control the price of bonds,

[00:19:57] but it's also, of course, in all of this, through its open market operations,

[00:20:01] is also trying to increase or decrease the money supply as well.

[00:20:04] Is it fair to say that's the other part of this whole operation, their reason for doing this?

[00:20:09] Yeah, yeah.

[00:20:09] And so when and are they increasing or decreasing the money supply?

[00:20:12] If I'm a bondholder and I've got $1,000 worth of bonds, which I've paid $1,000 cash for,

[00:20:18] I sell it to the Central Bank because they are actively now trying to buy up bonds.

[00:20:27] Why are they doing that?

[00:20:28] They're buying up bonds because they want the bond price to go up because they want interest rates to go down

[00:20:34] because they want to expand the economy.

[00:20:35] That would be their reason for doing that, wouldn't it?

[00:20:37] So, they're buying up bonds from me.

[00:20:40] They pay me the $1,000 that I paid for it.

[00:20:43] I'm no better off.

[00:20:46] Well, you think is now you've made a profit on the bond sale.

[00:20:48] Okay?

[00:20:49] You've made a capital gain because if you're trying to drive interest rates down,

[00:20:54] then that's rubbing up the value of bonds, which increases the value of the bonds over what you paid for them,

[00:20:59] which is why you wanted to make the sale.

[00:21:01] Okay?

[00:21:01] So, what you're selling for is a capital gain.

[00:21:04] Okay.

[00:21:05] So, my $1,000 in bonds is now $1,100 or $1,200.

[00:21:08] Yeah, you bought them for $1,000.

[00:21:11] The reserve's trying to drive the rates down.

[00:21:12] They pay you a higher price.

[00:21:14] You sell what you paid for $1,000.

[00:21:16] We paid $1,000 for it and you get $1,100 back.

[00:21:19] You're $100 ahead.

[00:21:20] Right.

[00:21:21] And that $100 has been created by new money into the economy, basically, because they have…

[00:21:26] Well, it's not the only new money because this is…

[00:21:34] When you look at the process of the central bank buying bonds, if that's going to increase the money supply,

[00:21:42] then it has to increase the liabilities of the private banks.

[00:21:44] So, if you had bonds which you had on your books valued at $1,000 and the central bank then pays you $1,100 for them,

[00:21:55] then what the central bank does is put the number $1,100 in your deposit account

[00:21:59] and puts the same number $1,100 in the reserve account of the private bank that it's doing the buying through.

[00:22:05] So, when you first bought that bond, your deposit account fell.

[00:22:11] Okay?

[00:22:12] So, that actually destroys money.

[00:22:14] When you…

[00:22:15] The way we'd be…

[00:22:16] The non-public…

[00:22:17] The non-bank…

[00:22:17] It depends how I bought it off, doesn't it?

[00:22:20] If I bought it off…

[00:22:21] Well, you bought it off…

[00:22:22] Fred down the road.

[00:22:23] Yeah.

[00:22:23] Yeah.

[00:22:24] It's a transfer.

[00:22:24] But, like, the two stages of bond sales are that, first of all, when the treasury auctions occur,

[00:22:31] they're sold specifically to cover the gap between government spending and taxation plus interest payments on existing bonds.

[00:22:38] And there's only a limited number of institutions which can and indeed must take place,

[00:22:43] I pardon that auction.

[00:22:44] They call them guilt auctions in the UK.

[00:22:48] I've forgotten the name right away in the States, but, you know, it's treasury bond sales.

[00:22:53] And so, you have what they call primary dealers as well as banks who can do the buying of that.

[00:22:58] So, you've got to have an account at the central bank to do it.

[00:23:01] So, fundamentally, when you aggregate all this stuff, and this is clearly an aggregation to call reserves as an entry in a double entry bookkeeping model of an entire financial system.

[00:23:11] That's whacking together all these various accounts, adding them up and calling that the aggregate liabilities of the central bank that reserves.

[00:23:19] So, when the…

[00:23:21] I think they've made that a bit more confusing than it needed to be.

[00:23:24] But when you have the central bank doing it, effectively, all those transactions occur on the asset side of the private banking sector.

[00:23:32] So, the deficit spending itself creates money.

[00:23:36] The bonds…

[00:23:37] The government will do the bond sales to look like it's actually borrowing the money to make the possible selling.

[00:23:43] So, when the government knows it's going to have a substantial deficit, then it knows it's going to make the bond issues.

[00:23:50] All this sort of planning stuff is done by the treasury and by the central bank to decide on the scale of auctions and so on.

[00:23:57] And it can look like they've got to sell the bonds to get the money and then they can do the spending.

[00:24:02] But, in fact, because of this capacity of the central bank to buy as much as it likes of bonds off the private banks, because bonds are outstanding, they can create the reserves, the funds that are used to buy the bonds.

[00:24:18] So, at the aggregate level, what you say is when the first primary auction occurs, reserves go down, bonds held by the private banks go up.

[00:24:27] There's no change to the money supply.

[00:24:28] But then the private banks will then on-sell those bonds for a profit.

[00:24:32] So, the bond market is the biggest market and the financial market in the world.

[00:24:36] And what happens is the banks, they go through the primary auction, they've got the bonds, they then sell them on the open market to non-bank financial institutions.

[00:24:45] And when they do that…

[00:24:45] Pension funds, which are big consumers of it.

[00:24:47] Yeah.

[00:24:47] And that necessarily means the monetary value of the bonds that banks hold go down when they make that sale.

[00:24:54] So, the deposit accounts also go down.

[00:24:56] But what then, from the point of view of the non-bank financial institution, that particular asset they had, deposits of the private banks have gone down.

[00:25:05] The other assets gone up on their books.

[00:25:08] That's the value of the bonds they hold and that gets the interest payments that they only use, you know, for pension payments and so on.

[00:25:13] So, when a central bank says, you know, the economy looks like it needs a bit of a shot in the arm, we are going to start buying up these bonds so that that's a way of us, in effect, injecting cash.

[00:25:29] Because we're going to pay…

[00:25:30] It's the double effect, isn't it?

[00:25:32] It's the effect of, well, okay, we're going to buy them at a very high rate.

[00:25:37] And so, that's extra money in the economy because people like me all of a sudden get that extra $100 or 100 quid or whatever.

[00:25:46] But also, it's pushing down the interest rates.

[00:25:48] And the interest…

[00:25:49] So, that's driving interest rates down generally, which then…

[00:25:53] And it's restoring money which was taken out of the economy by the banks selling the bonds in the first place.

[00:25:59] Right.

[00:25:59] So, this is what I'm saying.

[00:26:00] It's more than just the 100.

[00:26:00] It's the…

[00:26:01] You know, the sale by the private banks to non-banks reduces the money supply by the value of the bond.

[00:26:09] And then when you make the sale and you make a profit on the sale, then you recreate.

[00:26:13] Because you sold the bond, that means your deposit account goes up.

[00:26:16] So, you've restored the money that you usually use to buy the bonds.

[00:26:19] And plus, then if you made a capital gain, then that's where extra money turns up in your account as well.

[00:26:24] And having more money…

[00:26:25] For the profit of the sale.

[00:26:25] So, getting more money available, a bigger money supply, what does that do?

[00:26:31] Because as we talked about last week, I mean, the conventional argument would be, well, if we inject more money into the economy, then that makes banks more able to issue loans.

[00:26:42] But it doesn't at all.

[00:26:44] Which is completely wrong.

[00:26:45] Yeah.

[00:26:45] Yeah.

[00:26:46] So, what is the benefit of them injecting more cash into the economy then?

[00:26:50] Well, I think, you know, it's the amount of money for turnover in the private sector.

[00:26:55] But…

[00:26:56] I can buy more.

[00:26:57] You can buy more.

[00:26:58] You can do more shopping.

[00:26:58] But the thing is, because most bonds are owned by the non-bank financial institutions, they pay ridiculous salaries to their staff.

[00:27:08] So, the staff can go shopping with the salaries and bonuses, yada, yada, yada.

[00:27:12] But the non-bank financial institution, NBFI, itself can't go shopping.

[00:27:20] So, it's creating new money, but it's not spreading far into the financial system.

[00:27:26] It has to buy other financial assets or non-financial assets of buying housing, blah, blah, blah, what we're seeing with BlackRock and stuff of that nature now.

[00:27:35] So, they will buy either assets.

[00:27:38] They'll buy assets whether they're financial or non-financial depending on their own decision making.

[00:27:42] So, that doesn't inject money into the physical economy.

[00:27:47] It's money into the financial win.

[00:27:50] And that can be quite destructive.

[00:27:52] If you look at what happens like back in war bond sales, they were actually done to take money out of the hands of the private sector deliberately.

[00:28:00] So, all these, you know, Charlie Chaplin rallies to sell bonds in the Second World War were done so that you would reduce the amount of money in deposit accounts.

[00:28:12] But then when you bought them back again, you increase the amount in deposit accounts.

[00:28:16] That affects activity in the real economy.

[00:28:18] People can go shopping and buy those silk stockings they've had their eyes on.

[00:28:22] But when you do it with non-bank finance institutions today, you say, well, you've lost an income-eating asset.

[00:28:31] Your bonds have gone down.

[00:28:32] You've now got reserves and cash in a deposit account.

[00:28:35] That doesn't earn much money.

[00:28:36] What else can you buy?

[00:28:37] Let's go buy some shares.

[00:28:39] Okay.

[00:28:40] So, QE, which was quantitative easing, was specifically done to drive up asset prices, to drive up share prices.

[00:28:48] Which is not a great help to a large part of the population.

[00:28:52] Yeah.

[00:28:53] And I think that's one thing.

[00:28:56] Or money in circulation.

[00:28:57] Deregulation.

[00:28:58] Yeah.

[00:29:00] I think it's an area where deregulation has made the banking sector work less well.

[00:29:05] Because way back in my youth, when I was a high school student in Sydney, we learned that the banks, the rule that the Reserve Bank of Australia had at the time,

[00:29:16] that banks were required to hold, it was 28% of their assets in what are called LGS, which meant for local and government securities.

[00:29:24] And that means you put bonds issued by councils, by state banks, and by the government.

[00:29:29] They were required to hang on to 28%.

[00:29:31] Now, that's a terrible restriction.

[00:29:33] What it means is they can now sell the 100%, okay?

[00:29:36] And that means that sort of counteracts the money creation by the Treasury itself.

[00:29:41] So, I would rather bring back in controls and limit the amount of the bonds that banks are able to sell to non-banks.

[00:29:48] Because you do want that money creation by the government to circulate in the physical economy, the households and factories.

[00:29:57] You want that.

[00:29:58] If you're going to boost economic activity, that's the activity you want to boost.

[00:30:01] And yet, if the central bank, if the private banks have sold all the bonds to non-bank financial institutions,

[00:30:08] then when you buy those bonds back, you're creating money that circulates in the financial wing of the economy, not the physical wing.

[00:30:14] Well, couldn't central banks just buy other assets that aren't bonds that are more at the heart of the community?

[00:30:20] So, they're going to pay over the odds for bonds.

[00:30:22] Why don't they pay over the odds for corner stores, for example?

[00:30:26] And get the one guy who's running the corner store still to run it.

[00:30:28] It's just they own it now.

[00:30:30] And they paid over the odds for it.

[00:30:31] He's got all that extra cash.

[00:30:34] Everyone wins.

[00:30:34] I think that's actually – I mean, I don't know Japanese numbers.

[00:30:38] I don't know the Japanese system as well as I would like to.

[00:30:41] But I think that's what the Japanese central bank has been doing.

[00:30:43] So, I think I've got – I understand.

[00:30:46] I could be wrong, happy to be corrected.

[00:30:47] But I've heard that half or more of the outstanding shares in Japan are now owned by the central bank.

[00:30:53] So, you know, they've got a limit.

[00:30:55] If they're able to hang it up to your class of assets, and that depends upon what the Treasury allows them to do,

[00:31:02] then you can have them doing that sort of thing.

[00:31:04] Whereas private banks have got – private banks can buy shares, but they've got to be used –

[00:31:09] Stephen Lawton and I had a bit of a discussion about this offline a couple of days ago.

[00:31:14] And he asked me, you know, can they not buy shares?

[00:31:17] And I check, well, they can buy shares, but they've got limits.

[00:31:19] They can't use those in their Basel Rule asset values.

[00:31:24] So, they're quite constrained.

[00:31:26] Whereas back in the 1920s, banks could buy whatever they wanted.

[00:31:29] And the large part of the asset bubble of the stock market in 1929 was by banks driving up the price of shares.

[00:31:36] Then when it collapsed 10 to cent in one day, if they had that 10 to 1 gearing ratio we were talking about in one of the last podcasts,

[00:31:46] they were wiped out.

[00:31:47] That's right, yeah.

[00:31:47] So, the Glass Steel Act and all the acts that were passed in the aftermath of the Great Depression created two classes of banks.

[00:31:59] The banks we deal with and then the retail banks and commercial banks.

[00:32:04] The commercial banks became, you know, the vampire squids, the Goldman Sachs and so on.

[00:32:08] And they can buy effectively any financial asset they want.

[00:32:11] But the retail banks have limitations.

[00:32:17] And mainly what they can buy is government bonds.

[00:32:19] So, their capacity to change things is quite limited.

[00:32:23] And we started with this.

[00:32:24] Part of the reason was not just putting more money into the economy.

[00:32:27] It was trying to control the interest rate as well because they wanted to try and control the interest rate for that, you know,

[00:32:38] for what they are intending to do for that overnight rate, which is passed between.

[00:32:44] And then they have the discount rate as well, which is the – if you've actually – if a bank can't borrow from another bank,

[00:32:50] then they've got the central bank as a bank of last resort.

[00:32:52] So, they pay a bit more.

[00:32:53] They pay the discount rate to the central bank.

[00:32:56] But all of that's got to be in line with what the markets for bonds are generally,

[00:33:00] which is why they have to buy and sell them to try and control that rate.

[00:33:04] So, they're not as a diktat saying this is what the interest rate is.

[00:33:08] They're saying this is what we want it to be.

[00:33:09] This is our target rate.

[00:33:11] And we are going to buy and sell bonds by whatever quantity we need to try and reach that rate.

[00:33:16] Yeah.

[00:33:16] Yeah.

[00:33:17] And that's why they've got this limit – their balance sheet for these transactions is literally limitless.

[00:33:24] And that's not the case for a private bank.

[00:33:27] So, a private bank's got to watch, you know, how exposed is it with its – if it tries to expand its loans too much,

[00:33:33] does it get to a too high level of gearing?

[00:33:35] Is it fragile to – you know, if a number of loans go bad, will that destroy their equity base?

[00:33:41] Are they fragile to increase in interest rates?

[00:33:43] Those calculations aren't necessary for the central bank.

[00:33:46] So, they've got this limitless capacity.

[00:33:48] If they wanted to – as I said, you know, if they wanted to buy all the outstanding treasury bonds tomorrow, they could do it.

[00:33:56] Okay.

[00:33:57] So, that is why people say don't fight the Fed.

[00:34:00] And what the Fed is doing is trying to make sure that the rates at which bonds are sold are within 0.25 above or below the target rate they've set.

[00:34:09] And they – consequently, their balance sheet is up and down, isn't it, as a result, as they buy and sell those bonds.

[00:34:16] So, does that make sense?

[00:34:18] I mean, are they – is the theory right and is it the best way of doing it?

[00:34:24] We've talked in the past about why not just have a flat interest rate?

[00:34:29] Why have this huge variation?

[00:34:32] This is where economic theory pokes its nose into the system because the extent to which they're varying interest rates is because economic theory, neoclassical economic theory, tells them that that will control the rate of economic activity.

[00:34:47] And this –

[00:34:49] Because of the willingness and the availability of funds to give loans.

[00:34:52] Yeah.

[00:34:52] And this goes back to the misinterpretation of Keynes by John Hicks in what's called the ISLM model.

[00:35:00] And what Hicks did when he misread the general theory – and he admitted he misread it, by the way.

[00:35:06] This is not a – he wrote a night of paper saying he invented the model in 1936, so 37 as – well, he published the model.

[00:35:16] He invented it in 35.

[00:35:17] But he published the model supposedly as a summary of Keynes, and that said that what controls investment is the rate of interest.

[00:35:25] And then that meant that, therefore, if you could move the rate of interest, you could change the level of investment in the economy, and that means you could do macroeconomic management that way.

[00:35:34] Now, that's the way this nonsense that varying the interest rate will be a fine-tuning mechanism for the economy got into practice.

[00:35:42] Because lower interest rates, more people are going to take out loans.

[00:35:44] Well, the idea is – the intellectual idea is that the lower interest rate reduces the net present value of future – sorry, if you had a lower interest rate, that's going to increase what you calculate as net present value of investments.

[00:35:59] So there would be a set of investments which were net present value negative at 5%.

[00:36:04] All of a sudden it would become positive.

[00:36:06] Positive you go.

[00:36:06] Because they did – yeah.

[00:36:07] And therefore – yeah.

[00:36:08] Because they needed – yeah.

[00:36:09] Because they needed a lower – for them to work, they needed a lower interest rate than was available.

[00:36:14] So if you lower the interest rate, then all of a sudden that business level snaps into action, and so you've therefore got more activity.

[00:36:19] Yeah.

[00:36:19] But the reason that's, like I was saying, is an effective model for the neoclassicals is let's assume we know the future.

[00:36:26] Okay?

[00:36:26] That the only uncertainty is the rate at which you discount the future.

[00:36:30] Therefore, interest rates are a control mechanism.

[00:36:31] Now, Keynes' point was we don't know the future.

[00:36:34] You know, we project current trends forward.

[00:36:39] We don't know what's going to happen in the future.

[00:36:41] So we have uncertainty there.

[00:36:44] And it's the level of uncertainty you feel that is far more important than the interest rate you're going to pay.

[00:36:50] So do you think central banks in that case shouldn't be meddling with interest rates?

[00:36:54] Yes, I do think that.

[00:36:55] Yeah.

[00:36:57] It's overdone.

[00:36:58] But there is a positive, isn't there, if they are at the same time saying,

[00:37:01] but we are also controlling the money supply.

[00:37:04] That is a good thing, isn't it?

[00:37:05] When the chips are down, we want more money pushed into the economy, presumably, so that people can buy more stuff.

[00:37:11] Well, but that's the only group that can do that effectively is the Treasury, not the central bank.

[00:37:16] The central bank is effective as a conduit of treasury money creation.

[00:37:19] But when it tries to do it, the central bank can only, depending on where bonds are held in the private sector,

[00:37:27] its operations are with the financial sector, not with the real sector of the economy.

[00:37:31] So its actions don't increase the amount of money that circulates buying goods and services.

[00:37:36] It increases the amount of money that circulates buying assets.

[00:37:40] And you get asset bubbles out of this stuff.

[00:37:42] It's not the only source of asset bubbles.

[00:37:44] The banks are quite good at creating their own.

[00:37:46] But the impact of QE was to try to re-boost asset prices, which had fallen because of the global financial crisis.

[00:37:55] Now, that's the case where the neoclassicals didn't see the damn thing coming.

[00:37:58] And then tried to control it using their ideas how the money system works.

[00:38:01] And they stuffed up the economy after the global financial crisis.

[00:38:04] So the better way, then, is that the government overspends or underspends, depending on the state of the economy.

[00:38:09] So it takes out that – but it means that that function goes from the central bank to the treasury.

[00:38:14] They make the call on how much extra money needs to be created.

[00:38:17] So they overspend by that amount, and the Fed buys up those bonds.

[00:38:21] That's the most effective mechanism.

[00:38:25] And the Fed is buying and selling all the time.

[00:38:27] So if you look at the Fed balance sheet, 2018, I assume this is trillions.

[00:38:30] I've scrolled it down.

[00:38:31] I just wrote 4.4.

[00:38:32] That would be 4.4 trillion, I would have thought.

[00:38:35] But 2022, 8.9 trillion.

[00:38:38] So, of course, just after the pandemic.

[00:38:40] So more or less doubled, more than doubled, actually.

[00:38:43] 2024, as they try and unwind all of that, 6.9 trillion.

[00:38:46] These are big moves, aren't they?

[00:38:48] They're big.

[00:38:49] They're very big.

[00:38:49] And that's, again, because the Fed's balance sheet is effectively unlimited.

[00:38:54] So they can make those sorts of transactions.

[00:38:57] But the way in which they do it, which actually gets to the physical economy, goods and services, factories, houses, people, is when the treasury spends more than it gets back in taxation, runs a deficit.

[00:39:10] And I want to get rid of that bloody word and replace it with fiat.

[00:39:14] The government creates fiat money by spending more than it gets back in taxation.

[00:39:19] And that puts money into positive accounts, which is backed by reserves in the first instance.

[00:39:24] And then what the central bank is enabling that to happen, it's a conduit between the treasury's account and the accounts of private individuals.

[00:39:34] So that's the mechanical role that it has.

[00:39:37] And it's critical that that role is carried out.

[00:39:40] If you abolish the Federal Reserve, you need another institution to take over that role in the first instance.

[00:39:45] So that's the mechanical role they should have.

[00:39:49] But they do not have the capacity to control economic activity.

[00:39:53] And that's when they get middling, and that's neoclassical economics getting in the way.

[00:39:57] All right.

[00:39:58] Well, I thought maybe we'd have an example of the central bank perhaps doing the right thing.

[00:40:02] But even they're wrong.

[00:40:06] Sometimes doing the right thing but for the wrong reasons.

[00:40:08] But largely doing the wrong thing for all the wrong reasons.

[00:40:10] And it is the issue, isn't it?

[00:40:12] The main problem is that when they are creating money, it's just not going very far.

[00:40:16] Yeah.

[00:40:17] It's going to the wrong places.

[00:40:18] Yeah.

[00:40:18] You want to get money, so never give it to people who are poor.

[00:40:21] Don't give it to a private bill.

[00:40:22] Don't give it to Goldman Sachs.

[00:40:24] Yeah.

[00:40:24] Buy the corner store.

[00:40:25] I think that was – I don't mind taking credit for that one.

[00:40:27] I think that might be the best idea of the day today.

[00:40:30] There you go.

[00:40:31] All right.

[00:40:32] Very good.

[00:40:32] Catch you next time, Steve.

[00:40:33] Okay, man.

[00:40:34] Bye, guys.

[00:40:34] Bye.

[00:40:35] Bye.

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