Inflation, interest, money supply: History.

Inflation, interest, the multiplier, broad money, quantitative easing.


In Jane Austen’s novels (written nearly 200 years ago) it seems to be a truth universally acknowledged that annual income is equal to 4% of capital.  For example in Pride and Prejudice, Lydia’s marriage settlement of one thousand pounds “in the 4 per cents.” is equivalent to forty pounds a year.  The implication is that this is real income, and the inflation part of interest is zero.

According to a graph in Robert Beckman’s book The Downwave, the long-term trend of wheat prices in England was flat between 1260 and 1510, and between 1590 and 1940. The 20th century exception was probably due to Keynesian policies, and the Tudor one to the influx of Spanish-American silver and gold.  The two other outstandingly long deviations from the mean were the high prices from about 1790 to 1820 (the time of the Napoleonic wars), and low prices about 1880 to 1910. The repeal of the Corn Laws in the middle of the 19th century didn’t seem to make much difference. There were lots of other short-term fluctuations, between about half and twice the long-term mean, but the mean price in the first half of the twentieth century was about the same as the mean in the first half of the 17th century.

The creation of too much M4L money by irresponsible banks seems to me like the influx of Spanish-American silver and gold when money was related to the gold standard.  It’s self-defeating for the banks because it causes high inflation and/or low interest rates.  We may now be returning to the norm of zero long-term inflation but non-zero real interest rates.  At present the main cause of inflation is the reductions in interest rates because of the fear of recession, which enable higher mortgages, which cause higher land prices.

(Alison Marshall, November 2001).

Although monetary aggregates are no longer officially targeted for monetary policy purposes, analysis of these quantities plays an important role in the Bank’s regular assessment of the outlook for inflation. In its regular monetary policy analysis, the Bank primarily examines the banking sector’s sterling liabilities and assets with the UK private sector. These quantities, known as M4 deposits (M4) and M4 lending (M4L) respectively, constitute a sub-section of the banking sector’s overall balance sheet. . . .

M4 comprises sterling notes and coin and sterling deposits at, and money market paper issued by, UK monetary financial institutions (MFIs) and held by the UK non-bank private sector (known as the M4 private sector-M4PS). The MFI sector is made up of the Bank of England and other banks and building societies. Transactions that affect M4 must therefore involve an MFI and an agent in the M4 private sector. . . .

(, accessed November 2001).

Interest (usury).

Usury, the charging of interest, has like the Jewish people had a long history of being a scapegoat for financial and other problems. Like prostitution and alcohol, it has proved to be difficult to suppress.  It was forbidden by the Christian religion in medieval times, which was why Jews were moneylenders. It is still forbidden by the Islamic religion, I think.  It has been going on for hundreds of years in England, which with 2 exceptions has not experienced long-term inflation, and has been very successful and perhaps no more unjust and oppressive than most other nations.  The injustice and oppression have been due to population growth and Selfish Genes, rather than usury.

I don’t see why paying a capitalist for lending his money is considered different from paying a farmer for growing food, a nurse for nursing, a musician for entertaining, etc.  The amount of money that can be spent is not fixed, even if there is a gold standard and a fixed quantity of gold.  Total spending equals the amount of money multiplied by the velocity of circulation.  The moral justification for usury in the absence of inflation is that it is an incentive for lenders and a way of deciding who gets to be a borrower. Real interest rates are only immoral if lending and borrowing are immoral.

However there is a school of thought due to Schumpeter, that there can only be profits if there is innovation.  Schumpeterian innovation theories are one of the groups of theories for explaining long-wave Kondratieff economic cycles.  Others are based on investment, price, Marxism, and social structure. There isn’t a consensus about which is the right explanation, or even whether long-wave economic cycles really exist.

High interest rates may make the rich richer and the poor poorer, and ideas for preventing extremes of wealth and poverty include low or no interest rates, progressive taxation, land tax and other resource taxes, citizens incomes, and economic growth.   Economic growth is not always bad, although clearly there is a lot of non-Green economic activity which we would like to disappear.  If there is population growth or a depression, then there should be economic growth.  But it shouldn’t be used as the solution if the rich have cornered most of the money and aren’t recycling it, or to create jobs for people who would rather be students, artists, full-time mothers, or just idle like some of the rich, but haven’t got citizens incomes or any other income to live on.  Taxes on resources, and if necessary on real interest and other income, can be used to stop the rich getting too rich and to pay for citizens incomes.

(Alison Marshall, November 2001).

. . . as well as receiving interest on loans, banks pay interest on deposits.  So really they are just transferring interest from borrowers to savers, though they make a profit from this service.

(Alison Marshall, February 2008).

All the clearing banks keep accounts at the Bank of England.  When the banks settle daily differences between themselves in the clearing system – that is, in the exchange of cheques written by each other’s customers, or of credits moving from one bank to another – they do it using their accounts at the Bank of England. . . .

Because the Bank is the final provider of cash to the system it can choose the interest rate at which it will provide funds each day.  The interest rates at which the Bank supplies funds are quickly passed throughout the financial system, influencing interest rates for the whole economy. . . . Changes in short-term interest rates are the principal instruments of UK monetary policy.  Other techniques have been used in the past . . . .

(, accessed November 2001)

The new Bank of England interest rate, 0.5%, announced this week, is the lowest in 315 years. The highest was 17% in 1979. Before the 1970s the interest rate always stayed within the range 2 to 10%.

(Alison Marshall, March 2009. Data from the Financial Times, 6 March 2009).

. . . the principle of Islamic banking – that you share in the profits of a venture rather than charge interest . . . will, after the excesses of the last boom, seem rather attractive to many.

(Hamish McRae, Independent, 30 October 2013).

The multiplier.

. . . A required reserve ratio is the fraction of deposits in savers’ accounts which must be kept immediately available and not lent to borrowers. In fractional reserve banking there are two limits on bank lending. The first is the reserve ratio. The second is a limit on the total expansion of the money supply, the money multiplier, which follows automatically as a result of the reserve ratio.

If the reserve ratio is 1/10, the money available for lending is 9/10 of the deposits. Back in circulation some of this money may be used to pay back bank loans, and some may be deposited back in banks as further savings. These new deposits allow further lending of an amount which cannot exceed 9/10 of the new deposits, or 9/10 x 9/10 of the original deposits. That’s 81/100 of the original deposits. The total of all the deposits that could be generated from one unit of an original deposit by many cycles of lending, spending, and saving is 9/10 + 81/100 + 729/1000 + 6561/10000 etc.

If the required reserve ratio is 1/5, this total is 4/5 + 16/25 + 64/125 + 256 / 625 etc.
If the required reserve ratio is 1/3, it is 2/3 + 4/9 + 8/27 + 16/81 + 32/243 etc.

In general, if the required reserve ratio is R, the fraction of a deposit which is available for lending is 1-R, and the total of all the new money generated from one unit of an original deposit by all the cycles of lending, spending and saving is less than or equal to (1-R) + (1-R) x (1-R) + (1-R) x (1-R) x (1-R) etc. It can be shown mathematically that the total of this infinite series plus the original unit is 1/R. The expansion of the money supply from 1 to 1/R is the multiplier effect and 1/R is the multiplier.

So if the required reserve ratio is 1/3, 1/5, or 1/10, the fraction of each deposit which is available for lending is 2/3, 4/5, or 9/10, the multiplier is 3, 5, or 10, and a deposit of $1000 cannot be expanded beyond $3000, $5000 or $10,000 by any number of cycles of lending, spending and depositing.

If there is no required reserve ratio, R is zero and 1/R is infinite, but banks can still lend no more than the total of all the deposits in all the cycles of depositing, lending, and spending. The opposite extreme is full reserve banking, in which the required reserve ratio is 1, and banks can’t lend any of the deposits at all.

(Alison Marshall,, February 2008).

Broad money.

There are currently two types of money:

Central bank reserves, or base money, are created by the central bank and only used by the banking sector.
Commercial bank deposits, or broad money, are created by commercial banks and used by everyone else.

( ).

Banks have to pay for borrowers’ spending immediately, in daily settlements at the central bank, using central bank money (base money). The payments are funded from deposits in the lending bank’s accounts which haven’t already been used to fund other loans. These deposits which were backed by base money become deposits backed by the debt owed by the borrowers. But they have also become spending backed by base money. So one lot of money has doubled and become two lots. The only way to stop the creation of money in this way is to ban lending by private banks.

( Alison Marshall, March 2014. )

. . . Banks can meet . . . reserve requirements by having sufficient deposits in place. . . also . . . by borrowing reserves from other banks in what’s called the Fed Funds market.

The Federal Reserve targets the interest rate of this kind of borrowing in an effort to meet its monetary policy goals of low inflation and full employment. The idea is that a higher the interest rate a bank must pay to borrow reserves, the higher the interest rate customers will pay for loans.

(John Carney, Senior Editor,, 3 Apr 2012. )

From the 1920s a peculiarly American misunderstanding developed according to which the quantity of bank reserves issued by the Fed could somehow control bank lending and deposit creation. This was called the “exogenous money” approach (the money supply is “exogenously” controlled by the central bank through restriction of the quantity of reserves supplied). It became the starting point for Milton Friedman’s monetarism . . . money targets were . . . abandoned by . . . developed nation central banks by 1990.

There was always another tradition, dating back to the Banking School of the early 19th century through Marx and then Keynes, and on to Schumpeter, Gurley & Shaw, Minsky, N. Kaldor, B. Moore and finally to yours truly at the end of the 1980s. It is called the “endogenous money” approach that insists central banks cannot control private money creation by banks through control over reserves. . . the Fed’s control is based on “price”, not “quantity”: it can set the interest rate at which it lends reserves to banks, but cannot determine the quantity.

(L. Randall Wray, )

Between 2006 and 2009 the money multiplier, defined as “broad money relative to central bank money” or “the link between central bank money . . . and money in the economy”, was highest, at about 64, in early 2007, and lowest, at about 25, in late 2008.

So the ratio of broad money to the total of central bank money plus broad money varied between 25/26 and 64/65. That‘s between 96.2% and 98.5%, in three years in which there was a transition from a major bubble to an exceptionally large crash.

(Alison Marshall, 2009 and 2011. Data from the Financial Times, 6 March 2009).

Until global credit markets froze late last year, Britain’s banks were great fans of mortgage-backed securities. Gone were the days of taking in £1 of deposits to extend £1 in loans. Instead, banks funded some 40% of new mortgages . . . by bundling up loans and selling the securities they backed. In 2000 around £13 billion-worth of mortgages were securitised in this way; by 2006 the figure had jumped to £257 billion and was growing at a pace of £78 billion a year.

(The Economist, 2 August 2008.)

. . . the Bank of England’s new Prudential Regulation Authority . . . has set a leverage ratio of 3%, requiring Barclays to have £1 in capital for every £33 it lends out.

. . . US watchdogs are weighing up a leverage ratio of 6% for their biggest banks.

(The Guardian, 31 July 2013.)

Quantitative Easing (QE)

If a central bank is to maintain a target interest rate, then it must necessarily buy and sell government bonds on the open market in order to maintain the correct amount of reserves in the system. . . the central bank buys bonds by simply creating money—it is not financed in any way.

(, accessed 8 August 2015).

Central bankers around the world . . . are . . . operating on the perilous boundary between monetary policy and budgetary policy following the purchase of vast amounts of government bonds in “quantitative easing” schemes. . . Since 2007, central banks have increased their assets by 400 percent in the UK and the US, by more than 200 percent in Japan, and by more than 100 percent in Europe.

(Ferdinando Giugliano, Sam Fleming, Claire Jones. Financial Times, 9 November 2015. Data from the IMF.)

. . . quantitative easing . . . has, by and large, made the rich richer because it pumps up asset prices.

(Ian King, The Times, 26 January 2015).

The Bank of Japan . . . adopted quantitative easing . . . on 19 March 2001 . . . by buying more government bonds than would be required to set the interest rate to zero. It later also bought asset-backed securities and equities . . . The BOJ increased the commercial bank current account balance from 5 trillion to 35 trillion yen . . . over a four-year period starting in March 2001.

(, accessed 12 august 2015.)

In the mid-1990s, Prof Richard Werner . . . was working as an economist in Tokyo. Japan’s real estate bubble had burst and property and share prices were tumbling.

. . . Prof Werner . . . urged the Japanese government to enter into private long-term agreements to borrow from commercial banks, instead of issuing government debt.

The Bank of Japan’s version of QE, in contrast, involved creating money out of nothing at the central bank.

. . . in an additional twist, the Bank of England also later adopted Prof Werner’s QE label – but, again, to describe a policy with which he didn’t agree. . . The Bank of England’s interpretation of QE also involves the creation of central bank credits, as in Japan. But in the UK these have been used to buy government bonds from commercial banks rather than from the government directly.

( UK QE has failed, says quantitative easing inventor.
22 October 2013. )

. . . the combination of fiscal authorities and commercial banks can create all the money required by the economy. Indeed it can create far too much, potentially triggering inflation.

. . . increasing bank reserves does not force banks to lend. . . QE . . . cannot adequately replicate the . . . effects of direct government spending.

. . . why not end bond issuance completely, and fund government borrowing requirements entirely from bank lending, as Richard Werner of Southampton University has suggested?

( )

. . . Done traditionally – by buying government bonds on the secondary market – QE is slow . . . It works by forcing investors to move their money to riskier areas . . . If it ceases to function – because somewhere else in the world one of your trade partners is doing their utmost to steal your growth – then you have to start thinking unconventionally. You could, as Corbyn suggests, print money and use it to finance infrastructure spending; you could – as former Federal Reserve chairman Ben Bernanke once suggested – drop it from a helicopter for people to spend.

. . . two . . . impacts of Corbyn’s . . . version . . . higher inflation and a weaker pound.

( Paul Mason )

Further reading.

Inflation, interest, money supply: Currencies and Targets.
Money-printing, currencies and trade, sectoral balances, Brexit.
Inflation targeting, deflation, alternative targets.

Monetary sects.
Modern Monetary Theory, Positive Money, other monetary sects.

Positive Money.
Objections to a monetary reform campaign.