Printing money: not as straightforward as it sounds

There’s been lots of talk of ‘money printing’, as a sort of short hand for central banks creating money. However while it is certainly true that as late as the Napoleonic Wars in Western Europe (and somewhat more recently in Eastern Europe and some Emerging Markets), governments have sought to finance deficits by ‘clipping coins’, debasing metal coinage or simply printing more cash, in economies that no longer rely on cash for the bulk of transactions, the notion of printing money is a great deal more complex and also more flexible.

In essence, when the authorities state that they want more money within the economy, they are saying that they wish to expand the monetary liabilities of the banking system as a whole that are held by the public, and not just those issued by the central bank. Hence, when we talk of money creation in a modern economy, we need to consider the actions of both the central and commercial banking systems as a whole. In fact, in a modern economy, the only monetary liabilities of the central bank that are actually held by the public are coins and cash which make up only a very small proportion of the total money supply (perhaps only around 5% of the money supply in an OECD economy), so there’s little point in expanding these particular liabilities. Instead, it is much more important to raise the volume of deposits held by the public and these are generally held in the commercial banks. Hence, when markets talk of the need to ‘print more money’, this doesn’t mean central banks printing more physical money, but instead means commercial banks expanding their balance sheets on the back of central bank encouragement.

This encouragement has been substantial. In rough number terms,it would seem that the combined holdings of the US, Japanese and Euroland banking systems of their domestic government bonds has increased by around US$200bn over the last three months and that this has accounted for at least one half of all the growth in the notional combined money supply over the period. In Europe and Japan, the banks’ bond buying over the last year has probably accounted for all the growth in liquidity in these economies and in Europe it is very clear that the pace and scale of this activity has been accelerating since the summer.

To cut to the chase, the recent shift up in global liquidity has resulted from central and commercial banks creating money, funding governments’ deficits without the need to tap investors in the primary markets. This funding route implicitly leaves more money in the hands of ‘real money investors’ than would otherwise be the case and these real investors therefore find that they have higher cash balances than they might have expected (at least in aggregate) and this in turn leads to re-balancing of portfolios in favour of risk assets, both at home and abroad.

However, the fact that so much of the total monetary growth being recorded within the OECD is the result of this simple monetization effort also tells us that there is relatively little credit growth elsewhere within the financial system, be it in the real economies (particularly in Europe) or even within the financial system itself. Hence, we are not seeing much activity in the leveraged fund community at present. That particular credit channel – as would be expected – seems to be quite weak at present.

We can draw tentative conclusions for financial markets. First, in terms of fund flows, markets will be led by real money investors, not leverage. Secondly, where flows occur across borders, and into EM in particular, flows may have a higher weighting to equity instruments (which tend to be the province of real money investors) rather than debt instruments (which hitherto have tended to be dominated by leveraged flows). This is a different scenario than what we experienced with QE1 and QE2. Thirdly, we may expect that the liquidity boom will end when the banking system slows or curtails its rate of acquisition of bonds – but meanwhile, to maintain any given rate of liquidity growth, the banks will have to buy larger absolute nominal quantities of bonds each month.

As big picture conclusions, we seem to be in the midst of debt monetization boom and this activity is giving rise to a surge in liquidity within financial markets. Unlike the QE1 and QE2 periods, this latest liquidity boom does not involve an increase in leverage flows within the financial system itself, perhaps as a result of the ongoing collateral shortage, and hence “real money” investors predominate, with the result that more of the liquidity is deployed in equity markets and relatively less in cross border debt market flows that once dominated currency and EM markets in the 2009-11 period. One confirmatory or consistent bit of evidence is that EM currency reserve growth hasn’t picked up as it did during previous ‘risk on’ rallies.

Looking forward, we can assume that the liquidity boom will continue until the rate of debt monetization cools, for whatever reason (be it central bank policy shifts, inflation worries or resurgent concerns over fiscal discipline) and this gives those that have been slow to restructure portfolios an opportunity to act.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla