Going cold turkey would finish off a dysfunctional global financial system that’s now hopelessly addicted to emergency infusions. The only solution is surgery on the system itself.
The world economy is in a mess. The system, notionally governed by the invisible hand, no longer appears to be governed in any meaningful way at all: private excess puffs up bubbles which public indulgence ensures can never burst. We seem condemned to volatile commodity prices, wild capital flows, worsening imbalances in debt, trade, taxation and income, and—before long—the next sovereign debt crisis that looms. And then there is inequality. While millions of companies and households locked down during the plague, the total wealth of billionaires rose by $5tn to $13tn in 12 months, the most dramatic surge ever registered on the annual Forbes billionaire list.
Despite these riches, compared to before the pandemic, there’s less real economic activity: we truly are collectively poorer. At the same time, a year after the great panic of March 2020, many asset prices are surging. Wall Street and the City of London are again awash with liquidity—and in speculative mood. One new vogue is for something called SPACs, or “special purpose acquisition companies.” That descriptor is so vague as to bring to mind the South Sea Bubble companies of 1720, which are (almost accurately) remembered as selling themselves as “carrying on an undertaking of great advantage but nobody to know what it is.”
How is this possible? Because exactly as after the great crisis of 2008, the civil servants in our central bankers spotted the dreadful potential of unchecked panic, and rode to the rescue of private speculators by flushing the system with magicked-up money, the process we’ve come to know as quantitative easing.
Increasingly, the commentary—on both the right and the left—fixates on the role of QE. In a way, that’s understandable. It is a crucial link in the chain of events, and in the face of Covid-19, the policy—which has been deployed on and off ever since the great financial crisis of 2007-09—has undoubtedly been pursued to an extraordinary degree. By June this year the US Federal Reserve’s balance sheet had doubled in size since the pandemic was declared, and swollen by fully 800 per cent since 2007. This prompts the voices of orthodoxy, like Peter Schiff and Larry Summers, to fret about inflation and debauching the currency. At the same time, some radical thinkers such as Guy Standing are outraged at the way in which the QE-induced rise in asset prices is enriching the “have-yachts” over the have-nots, who continue to survive on precarious, stagnant wages. Central banks stand charged with morphing from guarantors of stability to underwriters of inequality.
And critics both left and right worry about the danger of getting hooked. Through successive QE bailouts for failures caused by the original banking meltdown, the Eurozone crisis, the Brexit vote and now Covid, we have seen that QE can be easier to start than stop: when the Federal Reserve tried to “taper” its way out of dependency in 2013, the authorities concluded that the resulting stock market “tantrum” was more dangerous than submitting to the addiction.
It is certainly distasteful to see the public authorities making sure that wealthy gamblers cannot lose. Nonetheless, it is deluded for anyone—left or right—to imagine that there is any safe way to kick the QE habit without at the same time overhauling our entire chaotic and unregulated global financial system, which is what gives rise to the real need for it. In the end, there is no way out other than to do what Roosevelt did in the aftermath of Depression and war, and transform the international financial system itself.
What’s new, what’s not
To put QE in proper perspective, it is important to understand what’s new about it—and what’s not. Central banks—backed by royal charters and the state—have always had the power to create credit and expand the money supply.
They have, since at least the founding of the Bank of England in 1694 provided credit to their clients, both in government and in commercial banks. And they have done so through the markets by accepting (safe) collateral in exchange for the money they create—a routine process known in the jargon as Open Market Operations (OMOs). Central bankers can also run OMOs in reverse, selling the securities on their balance sheets in exchange for cash, thereby taking some out of circulation, contracting the supply of money, and so raising its “price”—the rate of interest. Through such means, central banks have used their power of credit creation to help fund the government, keep commercial banks afloat and then, from the 20th century, to keep the economy in balance too.
At one level, QE is just another name for OMOs—newly “minted” electronic money paid into the accounts of the central bank’s clients. In exchange for this increased liquidity clients offer up collateral in the form of bonds. By buying up these securities, central bankers contract the market’s supply of them. The resulting shortage increases the price of bonds but lowers their yield—the interest that’s paid on them. In that way, the process puts downward pressure on interest rates paid by government on its debts, as well as more generally.
If these have long been routine operations, what’s really new? The difference between OMOs and QE is in <the scale> and the <wider array> of the assets involved. Whereas Open Market Operations typically focus purchases on short-term government debt, QE programmes snap up government debt of <all> maturities, including long-term bonds. In the US, the EU and UK, central banks also widened their purchases to include riskier private, corporate bonds in the central bank’s list of eligible collateral.
As to the scale, already by 2009, the Bank of England had purchased bonds to the value of £200bn. By August 2016, after the Brexit vote, purchases rose to £445bn. In March 2020 when the pandemic caused the global financial system to wobble dangerously, purchases rose to £645bn. By November 2020 the Bank had acquired assets of £895bn. This stock of purchases is now of the order of half the annual flow of national income.
Moreover, with QE, the old two-way traffic of OMOs seems to have become a one-way street. While central bankers are acquiring government and corporate bonds, they are not, as yet, selling them back into the market. The fear is that if they were to do so, they would flood it, and thereby lower bond prices and increase yields—making it harder for borrowers, including pre-eminently the government, to service their debts. Hence we see the eruption of market “tantrums” at the very hint of bond disposals. In Japan, the system is so dependent on central bank largesse, and the establishment so reluctant (or impotent) to change the system, that QE appears to have morphed from a programme into a permanent feature of the economy. There’s no reason to assume this couldn’t happen here. Perhaps it already has.
Back to basics
So how does QE work? And what, fundamentally, is it doing? To answer that we need to go back to basics regarding the nature of money. This is tricky terrain for economists, because—remarkably—they are not routinely trained in the theory of money and banking. You can—and most do—get through an economics degree, even an economics career, without ever pausing to think in any serious way about either. As Claudio Borio of the Bank for International Settlements explained in 2019: “Bar a few who have sailed into these waters, money has been allowed to sink by the macroeconomics profession. And with little or no regrets.”
To understand how grave is that intellectual vacuum, imagine the chaos if physicists working on space projects had not been trained in the theory of gravity—fundamental to physics in the way that money is fundamental to the economy. To the extent that mainstream economists think about money at all, they are divided on it.
Some, like Bank of England economists, do understand that money originates as <a social construct>; that credit—or the promise to pay—is based on trust which is in turn underpinned by regulation, and backed by the institutions of the state. This includes commercial <bank money>. When banks make loans, they have always acted as “magic money trees,” creating new deposits in the accounts of those who borrow from them—in effect new money.
But the stability of this commercial system of money creation depends on trust in the promise to pay, or repay. without which savers would panic about the banks over-stretching themselves and demand their money back. This trust is achieved with the backing of a central bank; the licensing and regulation of banks and credit creation; the legal enforcement of the ‘promise to pay’ contract and the amount of money a bank needs to set aside, in the event of non-repayment. Equally important to stability is the health of the economy. In a depression many debtors will go bust, defaulting on loans, and shaking faith in the banking system.
The Bank of England understands all this, but in doing so stands out from the economics crowd. Most orthodox economists rely instead, whether consciously or unconsciously, on the antiquated commodity-exchange theory of money. Traditionally based on gold, this way of thinking treats money not as credit (“a promise to pay”) but as a system of exchange based on an underlying commodity: one that is both scarce, and therefore—supposedly—stable in price. This is why from the conservative point of view, QE—the creation of more fiat money—is so alarming. The great difficulty for this camp, however, is that it is precisely their worldview that has created the system that can’t get by without central bank infusions.
The commodity economy
Cryptocurrencies such as Bitcoin are the supreme example of where the commodity-exchange theory leads. They are today very big business: the <Wall Street Journal> reported a combined valuation across such currencies of $2 trillion this spring—that is, approximately equivalent to <all> the US dollars circulating the world as cash. Bitcoin “miners” hope to replicate gold, the scarce asset that for so long underpinned the world’s money, with their digitally-created, but apparently finite, commodity. Cryptocurrency is money, they argue, because it can be used <in exchange> for goods and services. However, unlike credit or bank money or QE, its great limitation is precisely that it is finite. If the world’s economic activity were to be contracted to equal the amount of cryptocurrency (or gold, or silver) in circulation, then just as during the gold standard, the world would experience prolonged and painful depressions.
Cryptocurrencies are creatures of “the dark web,” whose whole functioning is designed to the avoid regulation. It is a form of money based not on trust, but on <distrust> of public authority. Advocates hope that digital currencies can one day replace the current system—taking any vestige of political accountability for economic governance and financial stability along with it.
While cryptocurrencies are worrying, they do not represent a systemic threat. That is not so for the global economy’s greatest structural flaw – the vast “shadow banking” system which has grown out of the same flawed monetary theory as that cryptocurrency experiment.” It is a system made up of pension funds, hedge funds, insurance companies and other investment vehicles. Being in the shadows no longer means being on the margins: the $200 trillion stock of assets they manage vastly exceeds annual global income of $86 trillion.
Central bankers have permitted and sometimes encouraged this sector to expand beyond the regulatory frameworks of governments. But the real roots are deeper, tracing back to the great structural shift of pension privatisation. Between 1981 and 2014, 30 countries fully or partially privatised their public mandatory pensions. Coupled with cross-border capital mobility, the move to private retirement savings generated vast cash pools for institutional investors. Today one asset management firm, Blackrock, manages in excess of $8 trillion of the world’s savings. Such companies have entirely outgrown the capacity of traditional “main street” banks to provide services. No traditional commercial bank could absorb these sums; few governments are willing to guarantee individual accounts of more than $100,000. The new form of “banking” answered the need to accommodate vast pools of globalised capital.
Like giant pawnbrokers, an earlier form of unregulated credit, shadow banks exchange the savings they hold for safe collateral. But the scale is very different, and instead of watches and wedding rings, they lend out on the strength of government bonds and other securities.
Replete with cash, they can temporarily lend to businesses and others in need of “liquidity.” To make the loan worthwhile for the lender, the seller of the bond writes an IOU offering to repurchase the security later, at a higher price. This mark-up is, in effect, the interest rate or the price of the loan. These are the repurchase or “repo” markets at the heart of the shadow banking system. Note that this system avoids reliance on the <social construct> of credit, upheld by trust and enforced law, which the old banks had to work within. Instead, the system is one of <deregulated exchange> in which cash is just one more commodity—no more regulated than any other.
Securities are swapped for cash over alarmingly short periods, an instance of that perpetual churn of trades that has, though economic history, often been a sign of speculative frenzy overpowering sober judgments about individual investment or the broader economic outlook. In addition, operators in the system have the legal right to re-use a security to leverage additional borrowing. This is akin to raising money by re-mortgaging the same property several times over.  Like the old banks they are effectively creating money, but they are doing so without any obligation to comply with all the old rules and regulations that commercial banks have to follow.
So we have power without responsibility, but—worse—we have parasitical power. Because, as Professor Daniela Gabor has also explained, this “shadow money relies on sovereign structures of authority and credit worthiness.” Why? Because private financiers rely heavily on government bonds as the safest collateral in their repo trades. It is estimated that two out of three euros borrowed through shadow banks are underpinned by the collateral of euro-zone area sovereign bonds. Any decline in the value of government bonds as a consequence of shadow banking activity will influence the government’s cost of borrowing, and—ultimately—fiscal-policy decisions.
Worst of all, the shadow money that comes out of these institutions is now so systemically important to the economy – private and public – that when this ‘money’ threatens to dry up—as it does from time to time—it cannot safely be ignored. Which brings us back to Quantitative Easing—the remedy that central bankers reach for in the face of this threat.
The reason why emergency injections of money are increasingly needed is that the whole shadow banking system is structurally prone to volatility and debt crises. The borrower’s promise to repurchase an asset at a higher price is relatively easy to uphold when the value of that asset remains stable. But the value of assets can rise or fall suddenly, which can prefigure self-amplifying feedback loops, with catastrophic consequences.
Back in August, 2007 the great financial crisis was triggered when a French bank, BNP Paribas, issued a press release explaining that “The complete evaporation of liquidity in certain market segments of the US securitization market has made it impossible to value certain assets fairly – regardless of their quality or credit rating.” (My emphasis). This announcement caused inter-bank lending worldwide to freeze, and required immediate central bank intervention.
The sudden loss of confidence in the value of assets severely destabilised both main street and shadow banking – where the exchange of cash for assets relies heavily on the fair valuation of assets.
The traditional bank run at Northern Rock, with savers queuing round the block to empty deposits, was merely a symptom of a crisis that had already taken hold: savers had got wind that the institution was in trouble, because no bank was more deeply exposed to the “wholesale money markets” than Northern Rock. The front door looked like a bank; the back office was deep in the shadows.
Instead of the familiar financial panic triggered by a bank run—savers all withdrawing their deposits at once—the underlying problem was something akin to a “run” on the repo market. Shadow bankers were surprised to find the mortgage-backed securities they accepted as collateral had plummeted in value. As the value of sub-prime mortgages fell, contagion spread to credit securities unrelated to subprime markets. The entire model threatened to collapse, spelling ruin for the global economy. Central banks were forced to intervene, reaching for QE as their preferred weapon.
But in doing so central bankers, supposed “guardians of the nation’s finances,” accepted as given this sprawling, chaotic private system.
Little has been done since then to stabilise and regulate the system. As a result, another moment of grave crisis arose last March, when the tiny, invisible coronavirus triggered another potentially catastrophic shadow bank run. As one of the institutions charged with holding the ring, the New York Federal Reserve, explained nervously: “the global economy experienced an extraordinary shock…and <asset prices adjusted sharply>.”  (Emphasis added). Once again, central bankers were forced to ride to the rescue.
Our collective vulnerability to this monster has now been plain for more than a dozen years, and yet we’ve done little to tame the beast: indeed, it has continued to grow, rising from an estimated 42 per cent of the global financial system in 2008 to nearly half in 2019. The global Financial Stability Board (FSB) monitors (but does not regulate) the system dislikes the moniker “shadow banking” and hopes to re-brand the system as “non-bank financial intermediation,” which scarcely sounds any less, well, shadowy.
It is not, however, what we call the system but what we allow it to do that has produced today’s volatile, disruptive and obscenely unequal globalised economy. As long as the shadow system is allowed to stand, there really is no alternative to taxpayer-backed central banks rescuing private markets. If the vast system topples again, it could disastrously contract the credit available to the real economy, and bring everything crashing down.
The only way to call time on QE, if that is what we truly want, is to deconstruct and then reconstruct, regulate and stabilise the whole financial system, so that the extraordinary privilege of credit creation is always balanced by responsibility not to take undue risks. And if footloose capital responds by skipping across borders and away from oversight, then we may also need to look at controls on that front too. Only then will the world stand any chance of kicking the QE habit, addressing all those dangerous imbalances, and finally escaping this grim shadowland of money.
 Financial Times, 14 May, 2021. ‘The Billionaire Boom: how the super-rich soaked up Covid cash’ by Ruchir Sharma.
 Gabor, as above.