Stability versus Flexibility aka Euro versus Pound

For the past 10 years I’ve been undecided as to whether Britain should join the European single currency, the Euro.

At first I was leaning towards the Euro, thinking that a level playing field of prices across Europe would encourage competition, making prices more transparent across a larger market, and therefore bring down prices in general.

Then, for a period, I felt that being constrained by a single interest rate for such a large and diverse economy would be harmful and having the flexibility of our own national currencies would assist us in adapting to any challenges we face.

However, since the start of the credit crisis and as the pound falls against a basket of currencies, I’m now leaning back towards the Euro. I’ve realised that governments (particularly our current one!) are too often tempted to print money to inflate their way out of a debt crisis, thus punishing the thrifty and rewarding the reckless.

I think that stability should be the most desirable attribute of a currency. It allows good businesses to concentrate on what they do best, rather than having to worry about the constantly fluctuating value of their imports / exports / savings. It allows people to plan knowing that they can buy a fixed number of goods with their income, and that they can set aside enough for retirement.

So the decision between the Euro and the pound, it would seem, boils down to a simple choice: Stability versus Flexibility.

As Britain and our European neighbours deal with the recession, it’ll be interesting to see which performs best. Countries such as Ireland, Spain and Greece may prefer lower interest rates than the Euro affords them, but if they perform relatively better than Britain does in the medium term, it would suggest stability is more important than flexibility.

How to borrow from the Bank of England

As regular readers of my and / or Brendan’s blog and twitter feeds may know, we have been looking into how to set up a bank. The primary reason being that if the Bank of England embarks on a policy of quantitative easing (otherwise known as printing money / helicopter money), then we want to get a piece of the action. We certainly have plenty of ideas for cash yielding investments to spend it on!

Anyway if we get past the formalities and set up our bank, how do we go about borrowing money from the Bank of England?

Unfortunately, I couldn’t quite find a simple answer to this on the Bank of England’s website, but I think the process comes down to the following 3 steps:

If you read through the eligible securities section on their site, you will see that it basically just includes things like government bonds. This is not really much good to us, as we would need to use our cash to buy the bonds in the first place, in order to borrow the same amount back. However, there may be a solution, the Discount Window Facility (DWF).

The purpose of the DWF is to provide liquidity insurance to the banking system. The Discount Window Facility is not intended for firms facing fundamental problems of solvency or viability. Eligible banks and building societies may borrow gilts, for up to 30 days, against a wide range of collateral in return for a fee, which will vary with the collateral used and the total size of borrowings.

Institutions eligible to participate will be banks and building societies that are required to pay cash ratio deposits (CRDs) and which otherwise meet the requirements for eligibility, as determined by the Bank, for the Bank’s Sterling Monetary Framework facilities.

The key point here is that they say they will accept a wide range of collateral in exchange for government bonds (gilts). Presumably, the gilts could then be used to borrow hard cash using their standard lending facilities.

If they are willing to accept poison assets such as dodgy loan books from mortgage lenders, then I don’t see why they wouldn’t accept shares in companies, or loans to businesses.

Issues to solve:

  • What is required to become a bank (or more correctly, a monetary financial institutions)?
  • Will the bank accept shares in private companies as collateral, or a loan book that is made up of advances to start ups and other small businesses?
  • If the loans are for 30 days, can they be rolled over each month?
  • Are there any other schemes to borrow money from the BoE on a longer term basis?

Here’s the application form.

Bank of England Statistics Database

I just found a cool tool on the Bank of England site for anyone interested in financial / monetary stats. Basically the Interactive Stats Tool lets you search through a huge amount of statistical releases and then download them in either CSV, Excel, XML or HTML formats.

Here’s some examples of what you can get:

You can even merge multiple datasets together in the same results page:

Here’s some figures on the Money Supply:

If you find any more interesting ones, be sure to post them as a comment!

What are Ways and Means Advances to HM Government?

Ways and Means Advances to HM Government is an entry that appears on the Bank of England’s Balance Sheet. As of the end of 2008, the figure stood at £369,847,840. Prior to 2000, this was basically the Government’s overdraft facility. The Bank of England provided a short term loan to balance the governments day to day spending.

An extract from the Treasury archives says:

When daily central government expenditures, receipts and net borrowings produce an end-of-day shortfall, the fine-tuning is provided by overnight borrowing from the Bank. Essentially this ‘Ways and Means’ advance is made by running down other assets held by the Bank that back the note issue. A daily surplus in turn reduces outstanding Ways and Means borrowings. (If there were no Ways and Means borrowing outstanding, a surplus would be put on deposit with Banking Department). Changes in the level of the Ways and Means advance happens automatically at the end of each day as the Bank calculates central government’s final cash position and adjusts the Ways and Means advance accordingly. Both borrowing and lending is done at the Bank’s 14-day repo rate.

In April 2000 the responsibility for government cash management moved from the Bank of England to the Debt Management Office. The balance of the “Ways and Means” account was frozen and is gradually being repaid. More info can be found in the 2008 Debt and Reserves Management Report:

The Ways and Means Advance is the Government’s overdraft facility from the Bank of England. Before the responsibility for Government cash management was transferred to the DMO, in April 2000, the Bank of England managed the daily changes in the Government’s net cash position by varying the Ways and Means overdraft. To finance changes in the level of this overdraft, the Bank undertook daily operations in the short-term money markets.

However, once the DMO assumed the role of Government cash manager, it no longer needed to use the Ways and Means Advance for this purpose, as the DMO uses market instruments to manage the Government’s cash position. At the time of transition, the outstanding balance of this overdraft was £13.4 billion.

The amount of the Ways and Means Advance was frozen (as announced in 1997 ) at the time of the transition to the new cash management system. At the same time, the Government also expressed its intention to repay the balance of the Ways and Means Advance. This balance was left effectively unchanged at £13.4 billion until January 2008.

In 2007-08, the Government made a partial repayment of £6 billion of the Ways and Means Advance. The rationale for repaying part of the Advance was to provide the Bank of England with additional flexibility to manage its own balance sheet. From the Bank’s perspective, the presence of a large asset that cannot be traded limits its flexibility to manage its balance sheet.

The interesting part is that the BoE uses this asset to back it’s bank note liabilities. So when the government repays the money, it must switch to other assets. This is described in a treasure note as:

Prior to the transfer of cash management from the Bank of England to the Debt Management Office the Ways and Means facility had two functions. It was an overdraft facility for the Government’s cash management function. But it was also an asset backing the Bank’s note issue. The Bank still require assets to back the note issue and would replace a shortfall below £17 billion in the Ways and Means facility with other assets.

What is the Cash Ratio Deposit Scheme?

As part of my ongoing research into money I’ve been trying to understand the Bank of England’s balance sheet, and while looking through it I noticed an account called Cash ratio deposits.

At first I thought this was something to do with Reserve Requirements (sometimes known as the cash asset ratio or liquidity ratio), where banks need to keep a certain amount of their assets as cash reserves in their vaults or with the central bank in order to be able to service withdrawal demands. However, although the name sounds similar, it is actually something entirely different.

The Cash Ratio Deposit (CRD) Scheme was set up in 1998 as part of the Bank of England Act that passed into law during that year. The purpose of the CRD scheme is described by the Treasury as follows:

Under the cash ratio deposit (CRD) scheme, institutions place non-interest
bearing deposits at the Bank of England. The Bank of England invests these deposits
and the income earned is used to fund the costs of its monetary policy and financial
stability operations, which benefit sterling deposit takers.

It only applies to Banks who’s elligible liabilities exceed £500 million. They must place assets equivalent to 0.11% of these liabilities as non-interest bearing deposits with the Bank of England. As of the end of 2008, the total CRDs listed on the BoE’s balance sheet (the Bank Return) were worth about about £2.5 billion. They aim to make about £100 million a year from investing these funds in order to pay for their financial stability operations.

So why do we have this somewhat complicted scheme instead of a simple fee or using seigniorage income? The Treasury attempt to answer this in a review document from 2003.

Almost universally, central banks fund their activities from general income including that arising from seigniorage (no interest is paid to holders of banknotes) and foreign exchange reserves. In the United Kingdom the income from both these sources passes to the Government: theprofits of note issue are paid in full from the Bank of England to the Treasury, and the Exchange Equalisation Account belongs to the Government, not the Bank of England.

Interesting, the government takes all the profits from printing money in the UK. It would prefer the private banks to pay for these financial stability operations.

A change from cash ratio deposits to a fee-based scheme would require primary legislation.

Is it really that hard?

The BoE looks to make about 6% a year (good luck in 2009!) from investing their CRDs. Why not simply charge institutions with more than £500 million in eligible liabilities – 0.11% * 0.06% of that amount as a fee?

I’m sure it would be a lot less effort than than trying to invest these funds successfully.

Why can’t governments just print money to fund spending?

This is the first post of what I hope will become a series of posts on my blog to discover what money is and how it works. We take money for granted as something that can be exchanged for goods and services, but it is in fact a complicated instrument who’s real value and supply is always changing.

I’ve wanted to write some blog posts like this for a while, but with all the financial turmoil that has hit the world recently, and the mind boggling amounts of money that is being used to prop up the banking industry I think now is particularly good time.

European leaders announced today that they would be bailing out their banks to the tune of nearly £1.5 trillion…. so the theme for my first post is:

Rather than raise taxes or borrow, why don’t governments just print money to fund their spending?

Central banks can literally create or destroy money. They do this every day in order to manipulate the money supply in the economy in an attempt to steer inflation to within a target range. The only problem with creating new money, is that the more they create, the less each unit becomes worth. If they create too much of it, and give it away too cheaply, then it’s purchasing power diminishes and people lose confidence. This can ultimately lead to hyperinflation and the destruction of the currency.

It happened to Germany after World War I, when the government attempted to print money to balance their budget. This lead to hyperinflation peaking at 3,250,000 % per month (prices double every two days). The currency became so worthless that people would need a wheel barrow full to buy a loaf of bread, and would use it as an alternative to firewood to fuel their stoves.

John Maynard Keynes described the situation in his book, The Economic Consequences of the Peace:
“The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance.”

So when a government needs more money, rather than create new money and risk hyper-inflation it will borrow the money through the issuance of government bonds. This by itself doesn’t increase the total money supply.