How bank lending and QE actually works

What follows is basically a re-post of the first half of this, except I’ve reworked and extended some parts for a UK audience.

How bank lending works

1. Banks do not take in deposits from savers and then lend them out. Loans create deposits. When a bank creates a loan, it simultaneously creates a deposit. This is how credit grows, by banks expanding their balance sheets.

For example. You walk into a bank and want a loan to buy a car. The loan officer approves you. He does not go and get some depositors funds and transfer them to your account. He credits your account with a deposit, and creates an asset, the loan. The bank has a new asset, the loan, and a new liability, the deposit. They created the deposit by making the loan. Two new entries have been added to the ledger, and the bank has created the money you get in your account.

2. It is often said that banks take in deposits and then lend out a proportion of it, keeping some back as reserves, but bank lending is not constrained by bank reserves. The process described above is never interrupted by the bank manager worrying about reserve requirements. The bank will get its required reserves later by borrowing them in the interbank market, or trying to attract depositors. System wide, if banks are short of required reserves, ultimately the Bank of England will have to provide them by buying bonds on the secondary market (like it has done with QE). Reserves are provided to the banking system, with a lag, following bank credit expansion.

3. The money multiplier (where it is said that if the reserve requirement is 10% for example, a bank can take a deposit of £100, then lend out £90, take that £90 as a deposit, then lend out £81 and so on) is an exploded myth. Banks never make lending decisions on the basis of their reserves. As described above, if a bank needs to meet its reserve requirement, it borrows them at the Bank of England base rate. The Bank of England will always supply reserves at the target rate (now 0.5%), and so banks don’t worry about this. If a bank is in trouble with solvency and other banks refuse to lend to them, the bank will make use of the discount window and borrow at a penalty rate. But in normal conditions when a bank’s solvency isn’t questioned, banks will acquire reserves through the overnight loan market from other banks, and the Bank of England will provision whatever reserves are required by the system-wide demand to meet their target rate.

Banks create loans, and worry about reserves later. Reserves follow private bank credit expansion, they do not lead it.

Quantitative Easing (QE)

4. When the Bank of England does QE, it purchases UK Government debt on the secondary market. This has the effect of pumping new reserves into the banking system. It’s often said that QE is  inflationary, or even hyperinflationary, but this stems from a misunderstanding of the bank lending process described above. There is a belief for example that if a central bank were to inject £100bn say into the banking system, then the banks will create multiples of this amount in loans. But because, as above, the money multiplier story is a myth (at least in the way it’s presented) and because banks don’t lend out reserves, QE cannot be inflationary. This is what we have seen following QE. The government has injected £375bn of new reserves into the banking system, but the wider measure of the money supply has been growing much slower than before the crash.

The inflationary impact of QE is not clear cut, and there are those who argue it might even be slightly deflationary, as it reduces interest income to holders of government debt (gilts) because through QE the Bank of England are buying  gilts on the secondary market in exchange for new reserves (which pay a lower rate of interest), which in turn reduces income and spending in the economy. This is manifested in the £35bn in gilt interest the BoE has returned to the Treasury recently, which George Osborne has decided to use to reduce the deficit rather than recycling it back into the economy.

The description of the system outlined above is not commonly understood, including by politicians, and in misunderstanding it, a lot of the policy-making that follows is often misguided and sometimes counter-productive. I think the impact that additional monetary policy can have for example is wildly overblown, and the constant references to how the banks are not lending at the moment seems to misdiagnose the reasons why this is so. Maybe a topic for another day.


Does paying big bonuses result in higher performance?

The issue of bonuses is quite a divisive issue (divisive in the sense that most people think they have got way out of hand, while a small minority think they are needed to attract the best people). George Osborne placed himself in the latter camp when he flew to Brussels recently to argue against imposing a cap on bankers bonuses of 200% of their annual salary. But is there any evidence that paying high bonuses results in those incentivised by them achieving higher levels of performance?

Now most people who have taken any sort of course in economics will have had it drummed into them pretty early on that people (referred to as consumers) always act rationally and seek to maximise their utility. Often economists use models to help them predict what will happen in certain situations that are based, in part on these assumptions. But there is a branch of economics known as behavioural economics which does not just accept these assumptions as facts, and actually try to set up scientific experiments (a novel idea I know) to see how people actually behave in certain situations.

A recent series of blog posts on Robert Nielsen’s site led me to a book by behavioural economist Dan Ariely called “The Upside of Irrationality“. His earlier work establishes the evidence that people are not in fact rational in the way many economists assume they are, and actually act irrationally in many situations. In The Upside of Irrationality (which I recommend to anyone), Ariely outlines some of his experiments into this irrationality. Chapter 1 of the book is called “Paying more for less: Why big bonuses don’t always work”, and its conclusions are very interesting.

Ariely and his team set up an experiment where volunteers would be asked to perform a series of tasks requiring varying levels of skill in return for payments based on performance (examples of tasks included remembering and repeating a sequence of flashing lights and throwing balls at a target). Each task had thresholds for performance. There was a good standard and a very good standard which would results in a bonus if achieved, but if participants failed to achieve the good standard, they would receive nothing.

Participants rolled a dice to determine the size of the bonuses they would be playing for – either a maximum of an equivalent of a days pay, two weeks pay or five months pay (the experiments were done in India where wages are very low).

So what were the results? Did those playing for the highest bonuses perform the best as we might expect? After all their incentives to do well were the greatest. Actually no. What Ariely’s researchers found was that although there was not much difference in performance between those playing for the low and medium-sized bonuses, those playing for the largest bonuses performed considerably worse. Such was the pressure they were under, they choked when they needed to perform. Note though, that the people in this group actually received the most money, but the “bang for the buck” was much lower than for those receiving lesser incentives.

Another interesting element to the research was that initially, they wanted to give the participants the money up front and then take it back if they failed to reach the required levels. Arguably, this reflects the reality of banker’s bonuses in that they have come to expect these large payments regardless of performance. For example, RBS recently announced it was paying bonuses of  £600m despite making a loss of £5.2bn. The researchers had to abandon this early on though after those playing for the big bonuses either failed utterly, or cheated by running off with the money after failing to perform well!

What does this show then? It seems that the evidence shows that paying very large bonuses is unlikely to maximise the performance of staff, and that they can in fact worsen it significantly, particularly if they those receiving them come to expect them in all situations. What was found in subsequent experiments though was that big bonuses did result in improved performance when the tasks being performed were mechanical in nature.

Research was conducted with MIT students where they were asked to perform two tasks, two times each, once for a small bonus, and once for a large one. The first task was just clicking keys on a keyboard, the second involved solving maths problems. The results showed that in the key clicking task, students performed better when a high bonus was offered, but in the other task, where some brain-power was required, as above, the higher bonus had a negative impact on performance. As Ariely writes:

“The conclusion was clear: paying people high bonuses can result in high performance when it comes to simple mechanical tasks, but the opposite can happen when you ask them to use their brains – which is usually what companies try to do when they pay executives very high bonuses. If senior vice-presidents were paid to lay bricks, motivating them through high bonuses would make sense. But people who receive bonus-based incentives for thinking about mergers and acquisitions or coming up with complicated financial instruments could be far less effective than we tend to think – and there may even be negative consequences to really large bonuses.”

The results then seem clear, those currently receiving large bonuses would probably perform better if their bonuses were much lower, while those currently receiving no bonuses (low-skilled workers) would perform much better if the were. The sky will not fall in if bonuses within the EU are restricted, and shareholders of these big companies would do well to appraise themselves of Ariely’s research before approving large payouts for company employees.

I’ll end with this quote Ariely cites in his book from US Congressman Barney Frank, who in a speech to in 2004 to an audience of bankers said:

“At the level of pay that those of you who run banks get, why the hell do you need bonuses to do the right thing? Do we really have to bribe you to do your jobs? I don’t get it. Think what you are telling the average worker – that you, who are the most important people in the system and at the top, your salary isn’t enough, you need to be given an extra incentive to do your jobs right”

Hear, hear.

Iain Duncan Smith sends a message to welfare claimants – “Know your place”. Sadly, it seems Labour agrees

After the courts ruled DWPs workfare regulations were illegal, Ian Duncan Smith quickly introduced new ones to ensure his spiteful and counter-productive welfare to work schemes could continue unabated. This still left his department open to claims for back-payment of benefits which had been stripped of claimants following them being sanctioned for “not doing enough to find work”. Reportedly, the claims could have amounted to as much as £130m, which assuming an average back-payment of £500, implies that as many as 260,000 people have had their benefits sanctioned illegally.

Rather than do the right thing after months and months of doing the wrong thing, IDS has decided to stick two fingers up to all those people who were given benefits sanctions unlawfully, and is introducing retroactive legislation to ensure DWP is no longer liable to repay any monies to claimants who suffered as a consequence of his department’s incompetence.

The reason given for doing this is to protect taxpayers and also to avoid further welfare cuts to make up the shortfall. This is false though, because we know that nearly every pound going to those at the bottom is spent, and every pound that is spent eventually comes back to the Treasury as tax. There would be no loss to the taxpayer.

No, the real reason for this legislation is to say to those on welfare: “Know your place. You will do what to tell you to do, no matter how unreasonable, and if you don’t like it just stop claiming. We don’t care if you find work or not, just stop being a burden. And don’t try to fight back, you will never win.”

The actions of Cait Reilly and others were heroic, and clearly got IDS rattled. The last thing he and the Government want to see is those at the bottom standing up for their rights and challenging what is being done to them in the name of deficit reduction. It sets a dangerous precedent, and so any means to shut it down becomes necessary, even the introduction of unprecedented emergency laws.

The most shameful part of this story seems to be that the Labour Party looks set to vote through this terrible bill on the nod. After all their bluster about condemning bedroom taxes and other welfare cuts, when it comes to the crunch, it seems like Labour are more than willing to line up behind the establishment and vote against those they were put in Parliament to represent. I hope I am wrong about this and Labour politicians have an attack of the conscience between now and the time of the vote, but I won’t hold my breath.

UPDATE: It now looks as though Labour might abstain in the vote on the legislation, which has the same effect as voting for it, so not a particularly bold move from the official opposition. Sitting on the fence will do nothing for those being screwed by this latest Government shambles.

The Youth Contract – Giving public money to private firms in return for?

The Youth Contract is the Coalition’s response to youth unemployment. A key element of the Youth Contract is the offer of a wage subsidy of up to £2,275 to businesses who take on an eligible unemployed 18-24 year old for 6 months. The plan was to provide 160,000 of these subsidies over a three year period. The programme began in April last year, but details about how it’s doing have been thin on the ground. Finally, and without fanfare, the DWP published an “Early Evaluation of the Youth Contract wage incentive scheme” (a summary of the findings can be read here). Some of its findings are quite interesting and tell a slightly different story to the one the Government spun at the programme’s launch.

The researchers surveyed 279 employers who had recruited somebody eligible for a wage subsidy and had been sent a claim form. They also interviewed Work Programme providers and Jobcentre Plus staff. Here are some of the findings:

  • Only 56% of employers had actually heard of the wage subsidy scheme before they began recruiting;
  • 63% of employers had recruited the person on a permanent basis, while 31% were temporary or fixed term contracts;
  • The main reason for taking on someone eligible for subsidy (given by 30% of employers) was to gain some extra money. 22% said it was to give an unemployed person a chance;
  • Jobcentre Plus staff did not believe the wage incentives were creating new jobs, nor encouraging employers to retain staff;
  • Only 9% of employers had created new jobs as a result of the wage incentive scheme;
  • Only 7% of employers would not have hired a young unemployed person but for the wage incentive;
  • There was some evidence that some employers were taking on a person for 6 months, then letting them go before hiring another person and claiming another wage subsidy, even though this is against the rules.
  • Only 20% of employers said they have difficulties with recruiting young people.

What can we conclude from all this then?

New jobs are not being created as a result of this scheme. Employers with vacancies are just using the scheme as an extra revenue stream. At best we are talking about a young person being taken on where otherwise the employer might have hired someone over 25. At worst, the employer would have hired a young person anyway, so the wage incentive just represents a transfer of money from public to private sectors with no additional benefit whatsoever accruing to the Government (or the young person). 

So on the one hand you have a jobs scheme that creates no jobs, being talked up because it costs less than Labour’s previous scheme, and on the other, you have Labour’s Future Jobs Fund which actually created over 100,000 additional jobs (albeit for only a 6 month duration). Cheaper is not always better. The Youth Contract demonstrates one area of welfare spending that is not being cut – corporate welfare. Lets not forget as well that for every young person from the Work Programme completing 6 months work with an employer, the Work Programme provider gets a nice juicy outcome payment, so there’s a double helping of corporate welfare. As Private Eye is fond of saying “Trebles all round!”

There is an alternative to this kind of nonsense. Its called a Job Guarantee.


Keynes on “The Means to Prosperity”

Here’s Keynes from the opening of his 1933 pamphlet “The Means to Prosperity”. You can read the whole thing here.

“If our poverty were due to famine or earthquake or war—if we lacked material things and the resources to produce them, we could not expect to find the Means to Prosperity except in hard work, abstinence, and invention. In fact, our predicament is notoriously of another kind. It comes from some failure in the immaterial devices of the mind, in the working of the motives which should lead to the decisions and acts of will, necessary to put in movement the resources and technical means we already have. It is as though two motor-drivers, meeting in the middle of a highway, were unable to pass one another because neither knows the rule of the road. Their own muscles are no use; a motor engineer cannot help them; a better road would not serve. Nothing is required and nothing will avail, except a little, a very little, clear thinking.

So, too, our problem is not a human problem of muscles and endurance. It is not an engineering problem or an agricultural problem. It is not even a business problem, if we mean by business those calculations and dispositions and organising acts by which individual entrepreneurs can better themselves. Nor is it a banking problem, if we mean by banking those principles and methods of shrewd judgement by which lasting connections are fostered and unfortunate commitments avoided. On the contrary, it is, in the strictest sense, an economic problem, or, to express it better as suggesting a blend of economic theory with the art of statesmanship, a problem of Political Economy.

Keynes was writing this at the height of the Great Depression, and although the circumstances were somewhat different than today, there are many similarities in the way Governments (sadly) are reacting today and how they reacted in the 1930s.

David Cameron’s speech on the economy this week included the claim that external factors were preventing a recovery while the Government’s policies were having no negative impact on growth. While Cameron received a rebuke for this from OBR chairman Robert Chote, Cameron’s underlying message of “there’s no alternative” still seems to resonate. This was just the kind of wrong-headed thinking Keynes was trying to rail against in the 1930s, and his key messages about positive government action remain as relevant today as they were then.

How inequality harms societies

Yesterday I put up this video about inequality and how contrary to what we hear about those at the top creating all the wealth, it’s actually consumers like you and me that drive economic activity when we spend. Today I came across another video on inequality (h/t Mike Norman Economics) and thought I would share it here.

This vid is of another TED talk this time given by British social researcher Richard Wilkinson in 2011. Wilkinson co-authored a book called The Spirit Level in 2009 on how more equal societies achieve better social outcomes than less equal ones, and this video presents that thesis in 15 minutes.

Wilkinson presents a number of charts showing what the data tells us about inequality. This one struck me as the most clear demonstration of the correlation between inequality and social outcomes. It plots income inequality against an index of indicators of social wellbeing for a number of countries:



Inequality is a theme I hope to return to soon. It is one of the most important issues facing many Western nations and on a day when George Osborne flew to Zurich to lobby against restricting banker’s bonuses, while at home further questions about the impact of the Government’s bedroom tax on the poorest in our society were raised, it seems reasonable to question our politician’s commitment to taking the issue of inequality seriously.

Consumers are the real creators of wealth and jobs

I came across this video a while ago, but was reminded of it recently when watching some awful right-winger from the Tax Payers Alliance or some other lobbyist for the top 1% going on about how we mustn’t over-tax the wealth creators. The video is of a 5 minute TED talk on inequality given by millionaire tech investor Nick Hanauer in March 2012. This talk was spiked by TED for being too ‘partisan’, but it’s a brilliant counterpoint to the spin we hear from the Government and others most days about wealth creators.

Here’s an extract from the talk:

“I have started or helped start, dozens of businesses and initially hired lots of people. But if no one could have afforded to buy what we had to sell, my businesses would all have failed and all those jobs would have evaporated.

That’s why I can say with confidence that rich people don’t create jobs, nor do businesses, large or small. What does lead to more employment is a “circle of life” like feedback loop between customers and businesses. And only consumers can set in motion this virtuous cycle of increasing demand and hiring. In this sense, an ordinary middle-class consumer is far more of a job creator than a capitalist like me.

So when business people take credit for creating jobs, it’s a little like squirrels taking credit for creating evolution. In fact, it’s the other way around.

Anyone who’s ever run a business knows that hiring more people is a capitalist’s course of last resort, something we do only when increasing customer demand requires it. In this sense, calling ourselves job creators isn’t just inaccurate, it’s disingenuous.”