Central banks’ monetary policy as a means for economic control

Recently, more and more people voice their criticism towards the central banking system. The criticism is focused on the fact that central banks and banks create money out of thin air in the process of credit creation and asset purchase as discussed in my previous article. But which implications does the power of money creation have on the ability to control the economy? This article lays out my findings focusing first on the central bank’s ability to influence the economy by setting interest rates. In this process, commercial banks act as intermediaries having their own incentives. Then, and even more importantly, the impact of central banks’ asset purchasing programs on the economy are discussed which are better known under the term “quantitative easing”.

“Economic control is not merely control of a sector of human life which can be separated from the rest, it is the control of the means for all our ends.” Hayek, The road to serfdom

This article was covered at the Value of Bitcoin conference and is available as video on YouTube.

This article is also available in German.

Detail of the U.S. one dollar bill

“The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the Bank of England’s monetary policy affects how much households and companies want to borrow. This occurs both directly, through influencing the loan rates charged by banks, but also indirectly through the overall effect of monetary policy on economic activity.” Bank of England, Quarterly Bulletin, 2014 Q1

The central bank’s ability to indirectly influence the economy by setting interest rates

Central banks exercise indirect control on the economy by artificially low interest rates. This allows banks to easily refinance themselves to eventually give out credit. So, central banks influence how much credit is created by setting the interest rate. Artificially low interest rates lead to great distortions in the economy namely boom and bust cycles and misallocation of resources.

Central bank’s control on the economy through interest rates is indirect because the amount of credit created eventually depends on the demand for credit. An article by the Bank of England explains this concept very well from which I took the following excerpt:

“Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.”

To adequately understand the extent to which central banks influence the amount of credit created by banks, it is crucial to understand the business model of banks.

Business model of banks

As any company, a bank intends to maximize its profit by minimizing costs and maximizing revenue. A bank generates revenue from the interest payments on the credit they issued to their debtors. Banks can increase their revenue by either increasing the interest rate or by increasing the amount of credit given out.

Banks are competing among each other in attracting debtors which is why a bank would lose potential debtors by arbitrarily increasing the interest rate on credit. So this opportunity is limited due to the competitive environment. As a result, banks have an incentive to create as much credit as possible to increase their revenue through the related interest payments.

A bank intends to maximize its profits

The costs of banking are comprised of the bank’s operational costs, the interest on their customers savings account (before they were set to zero) and the interest they need to pay for receiving a credit from the central bank. This central bank money is crucial for a bank’s operation namely to transfer their customer’s funds from one bank to another. This aspect will be highlighted in the next sections. Before that, the bank’s ability to create money out of thin air through credit creation is briefly recapped as discussed in length in my previous article.

Banks create money in the process of credit creation

In the process of credit creation, banks note the amount of the loan on the asset side of the bank’s balance sheet and insert this money in the bank account of the debtor which is found on the liability side of the bank’s balance sheet. So, the credit sum is added to both sides of the balance sheet: the “claims on customers” on the asset side (the debt) and the “claims by customers” on the liability side of the bank (the loaned money).

When debt is repaid, then the bank’s claims in relation to this debt is reduced. This reduction in claims is noted on the asset side of the balance sheet. In this process, the money that was generated through credit creation is destroyed.

The bank does not generate revenue directly with the debt repayment but rather with the interest rate on the debt which is the main revenue stream of banks. However, the debt repayments are related to the reserves a bank holds at the central bank. If the debt is not paid back, then the value of the claim must be corrected downwards which reduces profits and therewith equity. The relation between reserves and customer transactions is discussed in the following.

The necessity of reserves to enable transactions of customers

“A bank’s business model relies on receiving a higher interest rate on the loans (or other assets) than the rate it pays out on its deposits (or other liabilities). Interest rates on both banks’ assets and liabilities depend on the policy rate set by the Bank of England, which acts as the ultimate constraint on money creation.” Bank of England, Quarterly Bulletin, 2014 Q1

Let’s dig deeper to understand when banks issue a credit. First, banks assess the creditworthiness of the debtor (credit risk) which is then priced into the interest rate the debtor receives. The bank will only lend out money if the business is assessed as profitable. This depends on the return of the investment which we consider to be constant for simplicity. Besides that, the most important factor is the interest rate at which the bank can refinance itself from the central bank. The rate at which banks can refinance themselves at central banks is essential because banks require central bank money for settlement between banks. This “central bank money” is called “reserves”. The reserves are the money that a bank holds at the central bank. This relates very much to the concept of a consumer depositing money at a bank. Just as the consumer holds money in the bank account of the bank, the bank holds money in the bank account of the central bank.

Reserves are the facilitator of interbank transactions. Reserves are in particular relevant when a bank’s customer transfers money to someone having a bank account at another bank. A lack of reserves would pose a threat to the bank’s ability to process transactions (liquidity risk). This concept is illustrated in the figure below.

The figure shows what happens on the banks balance sheets when a customer transfers money from his account to another account at a different bank. In the example above, money is transferred from “Citibank” to “Star Bank”. As expected, Citibank loses deposits of its customer on the liability side. But Citibank also loses reserves it holds at the central bank. This is because Citibank has to transfer the same amount of reserves to Star Bank as the customer transfers funds. This has vast implications for banks on their demand for reserves. Also, this mechanism explains very well why banks lend money among each other namely to balance shifts of customer’s funds.

We have discussed three important concepts:

1. Revenue stream of banks (primarily interest payment on debt)
2. How banks create money in the process of credit creation
3. The necessity of reserves to enable transactions of customers

Now these three aspects are brought together.

A bank needs reserves — which is central bank money — to fulfill transactions by its customers. This limits a bank’s ability to create debt. A bank will only create as much debt until it does not run out of reserves which would impair its ability to process transactions of its customers. This is the case because the generated debt is placed in the entry “deposits by the people” as discussed in the recap of my previous article. This deposit can subsequently be transferred to another bank through normal business transactions. Then, the bank needs to transfer reserves as well. So the bank has a demand for reserves to process transactions. The demand for reserves increases with new debt since the bank must withhold reserves to process the debtor’s business transactions. This is why banks are obliged to hold a percentage of their liabilities (customer deposit) as reserve at the central bank called “reserve requirement”.

A bank will give out as much debt as possible to increase its revenue through interest payments on this debt. At the same time, the bank needs reserves to process transactions. These reserves come at a cost. The bank will only give out credit if the costs of reserves are lower than the revenue from the debt. If the costs of reserves are reduced, more of the possible businesses through debt creation become profitable, i.e. more debt will be lent out.

We have discussed the importance of the refinancing rate on banks’ decision to give out additional debt. In order to understand the macroeconomic implications of the refinancing rate in more detail, the mechanisms of banks competing among each other must be understood.

Competition between banks

“In order to make extra loans, an individual bank will typically have to lower its loan rates relative to its competitors to induce households and companies to borrow more. And once it has made the loan it may well ‘lose’ the deposits it has created to those competing banks. Both of these factors affect the profitability of making a loan for an individual bank and influence how much borrowing takes place. “ Bank of England, Quarterly Bulletin, 2014 Q1

Banks are in competition with each other. Banks compete for two things: the interest on loans and the reserves that comes with deposits. To attract more debtors, banks can lower their interest rate on debt relative to other banks. At the same time, banks need to make sure that they can serve transactions for which they require reserves. They receive reserves either through borrowing at the central bank or by attracting deposits. New deposits that originate from another bank come with reserves as explained in the former chapter. To attract more deposits, a bank can increase the rate they offer on bank deposits. The Bank of England states “By attracting new deposits, the bank can increase its lending without running down its reserves”. The bank thereby needs to evaluate whether it is more reasonable to attract new deposits through appealing interest rates or to borrow reserves directly at the central bank. In the past, the former was more reasonable for banks, however, this has shifted recently.

Attracting new deposits is merely a redistribution of reserves which should not have macroeconomic implications. In contrast, lowering the refinancing rate allows banks to take on more debt from central banks which expands the amount of reserves in circulation which then influences the economy on a macroeconomic level. We always need to look where new money is created for understanding the macroeconomic implications and this is precisely the case when new credit is created — both when central banks lend reserves to banks and when banks create new credit and give it to their customers. As a result, the competition for reserves by attracting deposits is negligible on a macroeconomic level.

As soon as the central bank lowers the refinancing rate, banks can borrow reserves at a cheaper rate. As a result, banks can expand their business by giving out more debt since they can refinance themselves at a cheaper rate to serve the subsequent transactions of debtors. Since banks are in a competitive environment, banks will reduce the interest rate on debt to attract more debtors. This is the mechanism through which a lowering of the refinancing rate leads to a lowering of the interest rate on commercial debt.

Reduced interest rates on debt attract new debtors demanding debt money. This in turn leads to an expansion of the debt money in circulation. Moreover, artificially low interest rates make investments profitable that destroy capital. Investment opportunities that were not profitable have become profitable due to the reduction in capital costs. Such a distortion is never sustainable and the boom must eventually turn into a bust which is explained very well in the article “Bitcoin and The Business cycle” by Ben Kaufman.

In the following, you can find information on the banks refinancing rates at central banks. Data on the recent development of the Federal Reserve’s (Fed) overnight bank funding rate can be found here. The current overnight bank funding rate is at 0.05%. Information on the European Central Bank’s (ECB) marginal lending facility, which is the interest rate for banks to borrow money overnight and the rate on refinancing over one week through main refinancing operations can be found here and here. Both forms of funding require collateral in form of securities. The current rate of the marginal lending facility is at 0.25% and the main refinancing operation is at 0%.

The central bank’s ability to directly influence the economy through asset purchases

“Once short-term interest rates reach the effective lower bound [which is 0.5%], it is not possible for the central bank to provide further stimulus to the economy by lowering the rate at which reserves are remunerated. One possible way of providing further monetary stimulus to the economy is through a programme of asset purchases (QE).” Bank of England, Quaterly Bulletin, 2014 Q1

Before delving deeper into the implications of quantitative easing (QE) on the economy, the concept of QE is explained. Quantitative easing essentially means that the central bank buys assets in large quantities from the market. In this process, banks act as intermediary. The bank can either sell assets it already had in possession to the central bank or it buys assets on the market which the bank then sells to the central bank. But with which funds are these assets bought from the market? By creating them out of thin air which I explained in my previous article to which I make a quick recap here.

Central banks and banks buy assets from the market with funds created out of thin air

Banks can simply create the money to buy assets as discussed in an article from the Bank of England. A bank does so by adding the value of the assets on the asset side of the balance sheet and by inserting the funds for the assets on the seller’s bank account.

The same principle holds when a central bank buys assets from a bank. The central bank adds the value of the asset on the asset side of the central bank’s balance sheet and inserts the funds in the bank’s bank account which is called “reserves”. As explained in chapter “The necessity of reserves to enable transactions of customers”, these reserves are placed in the bank accounts which commercial banks hold at the central bank.

Note: A figure explaining this concept can be found in my previous article. Chapter “Note on whether fiat money is debt or money” shows a differentiation between different money forms namely the money created at central banks (base money) and the money created by commercial banks (broad money).

Central banks buying overvalued assets distort the market

We have seen how banks and central banks can buy assets infinitely through their monopoly of creating money out of thin air. We have also discussed that low interest rates lead to malinvestments and therefore artificial boom cycles that eventually must go bust. Quantitative easing is a means to prevent the boom going into a bust by artificially inflating demand for junk assets which artificially pushes their price upwards. In a bust, the overvaluation of assets would normally correct, namely in the following process: Investors would sell their assets which results in a sell shock — the bubble bursts. But since the central bank buys junk assets on a grand scale, this sell pressure is countered. The bust is artificially prevented. The recent chart on the S&P 500 index shows this mechanism very well. The S&P 500 index showed the lowest value on March 23, 2020 which is the day when the Fed announced buying ETFs to “stabilize the market”.

Chart on the S&P 500 index taken from Trading View

If the financial world would be in alignment with the real world, a reduction in production — as during a lock down — would reduce the cash flow of a company and therefore comes with a devaluation in its stock price. But the financial world does not reflect reality anymore due to incredible market manipulation by central banks through artificially lowering the interest rate and artificially altering demand through asset purchases on a grand scale.

This applies in particular to government bonds that are purchased in great quantity by the Fed during quantitative easing. This constant demand for government bonds induced by the central bank keeps interest rates on government bonds artificially low. This has great implications on the risk rating of all assets since the base risk rate is per definition equal to the interest rate of government bonds.

Central banks buying junk assets corresponds to bailing out investors’ malinvestments

“QE involves a shift in the focus of monetary policy to the quantity of money: the central bank purchases a quantity of assets, financed by the creation of broad money and a corresponding increase in the amount of central bank reserves. The sellers of the assets will be left holding the newly created deposits in place of government bonds. They will be likely to be holding more money than they would like, relative to other assets that they wish to hold. They will therefore want to rebalance their portfolios, for example by using the new deposits to buy higher-yielding assets such as bonds and shares issued by companies — leading to the ‘hot potato’ effect discussed earlier. This will raise the value of those assets and lower the cost to companies of raising funds in these markets.” Bank of England, Quaterly Bulletin, 2014 Q1

The above quote explains very well how individual investors receive new liquidity through the quantitative easing program. Central banks buy the assets that investors discard in a large scale in order to “stabilize the market” meaning preventing the bust. Those assets that are sold on a large scale are in reality downgraded and considered as malinvestment by the selling investors. This means that central banks bail out investors on a large scale. QE allows investors to liquidate their junk assets at a high price which eventually allows them to reallocate their capital to more profitable investments. The bank serves as an intermediary in this process buying assets from individual investors and then selling them to the central bank.

The economic takeover by central banks

I first lay out the concept why a creditor receives power through giving out credit: Assume a bank lends out money to a middle class person allowing him to buy a house. This debt is securitized with the house. Now, the bank who gave out the debt has rights towards the borrower, namely the right to receive the money back which the banks created out of thin air in the first place. If the borrower cannot pay back the money, then the bank may dispossess the debtor and seize the house.

Central banks exercise direct control on the economy through the (selective) purchase of assets. This provides funding to the related parties issuing or selling these assets and transfers ownership to the Fed. This applies to all asset classes that are bought in the quantitative easing program such as government bonds, mortgage-backed securities, bonds and stocks (or more precisely ETFs). In the last years, the ECB even engaged in subsidizing projects considered “green” through green bond purchase programs.

Through the ability to selectively purchase assets, central banks can bring structural change to the economy by influencing the financial system. The ECB declares very openly:

“The Eurosystem may carry out structural operations through the issuance of debt certificates, reverse transactions and outright transactions. These operations are executed whenever the ECB wishes to adjust the structural position of the Eurosystem vis-à-vis the financial sector (on a regular or non-regular basis).“

Note: Outright transactions are used to finance governments via government bonds bought on secondary markets. They were introduced for “saving the euro” under Draghi. Reverse Transactions are operations whereby the central bank buys or sells assets under a repurchase agreement or conducts credit operations against collateral.

More details on the asset purchase program of the ECB can be found here. On this website, there is a section on “Corporate sector purchase programme” where you find a list which corporate securities were bought by the ECB (in the FAQ under “List of corporate bond securities held under the CSPP/PEPP”).

The Federal Reserve almost doubled their assets as seen in the recent movements in their balance sheet. During the lockdown, the FED created more than USD 2.800.000.000.000 (2.8 trillion). Recently, Neel Kashkari, a representative of the Fed announced that the Fed has no limitations in printing money. The majority of this money is used to buy government bonds. The government can distribute the money they received from these government bonds at free will and lobbyists are waiting in line. In the United States, big corporates stand in line asking for bailouts, among that airlines, hotels, cruise companies. Central banks ability to infinitely purchase assets corresponds to an economic takeover never seen in history before.

The power structure of money creation

We can conclude that the power structure of money creation is as follows: First in line are the central banks as lenders of last resort followed by banks who also have the right to create money out of thin air. Governments benefit the most from this system since they get the cheapest credit. This leads to an enormous concentration of power to these central authorities. This conflict of interest explains very well why governments have no incentive to outlaw such banking procedure although it may be considered “appropriation of someone else’s property or outright embezzlement or, more directly, counterfeiting”. (Rothbard, 1962, p. 809)

Our monetary system is based on debt in two ways:

1. Federal Reserve notes are backed by future tax payments which are debt of the government served through the tax payments of the people. Essentially, the taxpayer is the collateral for Federal Reserve notes.
2. Increasing the money supply leads to inflation thereby pushing the people of the country more and more into debt to finance their living.

We conclude that central banks can exercise tremendous influence on the economy through dictating monetary policy. Their power is directly related to their ability to create money out of thin air.

Great thanks to my proofreader Márton Csernai and Keyvan Davani. My great appreciation also goes to Alexander Bechtel for supporting me in my process of going down the fiat rabbit hole through our conversations and chats.