Monday, 27 February 2012

Accounting and reality

In a few posts recently, Richard Murphy argued that because the Bank of England is wholly owned by the Treasury, the government debt (gilts) that it has bought under the Quantitative Easing programme is effectively cancelled because it would be eliminated from both sides when the Bank of England's accounts were consolidated with the Treasury accounts. This is correct from an accounting point of view. It leaves a large cash liability on the Treasury's accounts which represents the additional base money now in circulation and is exactly equal to the amount of the debt purchased. But the debt itself disappears. Murphy's worked example showing how this works is here.

But in the real world, things don't just disappear like that. Locked away in the Bank of England's vaults are a large number of pieces of gilt-edged paper. And tucked away in bank deposit accounts, or floating around somewhere in the financial system, is the additional money that the Bank of England created to buy the gilts.

Now those gilts have maturity dates. When they expire, they have to be repaid. So when those pieces of paper locked away in the Bank of England's vaults reach their maturity date, the amount of money they represent must be removed from circulation.

But this is really quite difficult to do. How on earth are you supposed to remove money from bank deposit accounts or suck it out of financial conduits? That money belongs to the people who sold the gilts back to the government, or to whomever has received that money in the course of normal financial transactions. Allowing the gilts to expire and recording the corresponding cash reduction in the Bank of England and consolidated Treasury accounts would create an imbalance with the wider economy. There would be more money in circulation than recorded on the Government's books. And since cash is a liability from the central bank's point of view, and there would be more cash actually in circulation than its assets, the Bank of England would be insolvent.

There is only one way a central bank can withdraw money from the wider economy - selling assets for cash in open market operations. But if its assets have expired, it has nothing to sell.  So the government would either have to replenish the Bank of England's capital from general taxation - which might involve tax rises, unless the economy was growing strongly enough to generate enough tax revenue - or it would have to issue more gilts to replace those that expired.

These new gilts cannot immediately be bought by the Bank of England, as it is not allowed to participate in a primary auction. So the immediate effect of gilt expiry would be a "spike" in government debt as new gilts were issued for the same amount, bought by the private sector and then purchased in the secondary market by the Bank of England - assuming that the private sector buyers want to sell, of course. Alternatively, of course, the government could raise taxes to recapitalise the Bank of England. Either way, the expiry of gilts held by the Bank of England requires real money to be contributed by government just as it does for gilts held by the private sector.

And no, the Bank of England can't just magic new capital into existence. Central banks create money for the wider economy, but they can't create money for themselves. The capital they need has to come from the wider economy via the government. It's a circular flow.

For that reason, the notion that government debt purchased by the Bank of England can be treated as "written off" is simply wrong. From an accounting point of view, yes, the debt is eliminated from both sides of the consolidated accounts. But out in the real world, the physical bits of paper still exist, and the real cash balances are still very much in circulation. Writing those off interferes with the flow of money from the real economy to government/central banks and back again.

Generally I find accounting concepts and practices very helpful when looking at the way in which our financial system works. But in this case, the accounting view does not conform with reality - and it is therefore very dangerous.

You see, the conclusion that Richard Murphy came to was that as the gilts purchased by the Bank of England can be regarded as written off since they are eliminated on consolidation, we can regard the UK's debt as much less than it appears to be. And therefore we can issue much more, can't we?

No, we can't. The real money is still there in circulation. The gilts are still locked in the Bank of England's vaults. And eventually they will expire - at which point government is either going to have to provide more money from taxation to maintain the Bank of England's capital and prevent an imbalance in the government accounts, or it is going to have to issue more gilts to replace them.

So the debt hasn't really disappeared at all. It is still out there in the real world. And it won't go away just because an accountant says it does.


  1. Its an awesome post and you had shared a very good information I will surely bookmark your page to share this information about accounting
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  2. Frances, some US Republican candidates (OK, one) have suggested that the US Govt cancel the treasuries it has bought - - so RM is not alone.

    PS, I have commented in another place on the value of reading the works of Murphy. I suppose someone has to do it, but look at what happened to Inspector Dreyfus in the Pink Panther films - might be safest to leave it to Mr Worstall, who is past saving in this regard.

    1. Oh I don't know: I like Tim Worstall - especially his "effing and blinding".

    2. I'm not saying I don't like him - I even agree with him sometimes, just worried what prolonged exposure to RM can do to a person.

  3. Frances Coppola, Your article assumes the cash in private sector hands that corresponds to those bonds suddenly starts to have an inflationary effect on the date of maturity of those bonds. I’m baffled.

    Those bonds represent a debt owed by the Treasury to the BoE. If the bonds are just torn up, the Treasury and BoE agree that the debt no longer exists, that does not have any effect on the private sector’s tendency to spend its holdings of cash.

    I actually made “tear up” point in a letter in the FT a few days ago:

    “Since cash is a liability from the central bank's point of view…”. Got doubts about that. £20 notes state that Uncle Mervyn will pay the “bearer on demand the sum of £20”. But if you go along to the BoE and ask for anything of substance in return for your £20 note, like £20 worth of gold, the security staff will escort you off the premises, while Uncle Mervyn sniggers at you from his third floor window.

    “There is only one way a central bank can withdraw money from the wider economy - selling assets for cash in open market operations. But if its assets have expired, it has nothing to sell.” Don’t agree. Even if a central bank has no assets to sell, it can simply announce it is willing to pay above the going rate of interest to anyone willing to lend to it. That will withdraw cash from the private sector. As to where it gets the cash to pay the interest, it can perfectly well pay the interest out of funds borrowed. That of course is a Ponzi scheme, which by definition means it cannot go on for ever. But if it proves necessary to continue the scheme for an extended period, the central bank just needs to ring up the finance minister and tell the latter to confiscate some money from the private sector via extra tax, and give it to the central bank, else the central bank won’t be responsible for the consequences.

    By the way, I’m a first cousin of Thea Musgrave. Have you ever tried singing her stuff? I don't like it, but everyone to their own tastes.

    1. Hi Ralph,

      A number of points here. But firstly can I remind you that this post is about the difference between the way things are accounted for and how they are in reality? Some of the points you have raised are questioning the accounting on the assumption that the accounting must match reality. It doesn't.

      1) There would be no inflationary effect if the gilts were allowed to expire as I described. I don't know where you got that from as I haven't suggested it anywhere in the post. However, if those gilts expired normally there would then be an accounting imbalance between the private and public sector records of "cash in circulation". It was that imbalance that I was addressing.

      If the BoE and Treasury mutually decided to write off the debt, however, there would be no private/public sector imbalance as the Treasury's cash liability would remain the same. Whether this de facto increase in the money supply would cause inflation is hotly debated, but it would depend on the state of the economy at the time the debt was cancelled. The BoE would be technically insolvent, though, as its cash liabilities would exceed its assets.

      From an accounting standpoint cash is a liability of the public sector. Yes, in a fiat system it is only redeemable as more of itself. But it is still on the liability side of the balance sheet and represents a claim by the private sector on the public sector.

      2) It is completely correct to say that a CB can only withdraw money directly from the economy through open market operations. Interest rate rises have a similar effect indirectly, but higher interest payments reduce the deflationary effect somewhat - and as you say, it's ponzi, so eventually real money would be needed, which would require either further issuance of government debt or tax rises. I did say that in the post.

      I've heard of Thea Musgrave but never sung anything by her as far as I remember. Small world, though, isn't it!

  4. [I realise that my points below don't directly contradict what you've said above, but I think some of the argument is not clear. I'm not sure whether my comment helps, but here we go anyway.]

    It's not quite right that the Bank of England would be insolvent if these gilts were cancelled - at least, not in the sense we normally understand it. A central bank doesn't technically need any assets to cover its liabilities, if the liabilities are not callable.

    A readable and interesting article on this can be found at:

    The Bank and Treasury could perfectly well agree to cancel these debts - the issue, as Ralph alludes to, is what would happen as a result: almost certainly, high inflation.

    Even aside from the extreme situation of the gilts being cancelled, it is clear that the liability and asset side of the Bank's balance sheet will not balance at all times: the liability side is fixed, but the value of its assets fluctuates as gilt prices move. At any given time the Bank could have a positive or negative net worth, depending on market conditions.

    In practice, the Treasury would provide the backstop to any Bank of England losses - if the Bank did need to withdraw liquidity from the private sector and had no gilts left, the Treasury would recapitalise the Bank either with cash from taxes or by printing new gilts and giving them directly to the Bank (actually, the Bank could issue its own bonds though as you and Ralph have pointed out, this just kicks the can down the road). Whether you call this recapitalisation a fiscal or a monetary tightening is neither here nor there - it's probably a bit of both - but there is no "imbalance" involved. There wouldn't be any mismatch between public and private versions of cash - the government's records would still match the (increased) amount of cash in circulation.

    In this sense, Murphy is right that the balance sheet of the Bank and the Treasury are effectively consolidated.

    On the other hand, you are also right that the Bank of England can't create real capital. But what it can do is create unsterilised money, which would have the effect of redistributing claims on resources among entities in the real economy. If it does this by cancelling gilts, it would be effectively printing a bunch of new money for the government to use to buy things or cut taxes. The way the "real resource books" would be balanced, so to speak, is that prices would increase, so the private sector's existing money balances would buy fewer real resources.

    [comment split in two as it's too long]

  5. The Bank retains gilts as assets mainly for convenience, so it can quickly adjust monetary conditions in either direction, and so that its independence is more credible as it does not have to ask the government's permission to tighten conditions.

    In the real world, when the gilts mature the government will make a cash payment of £300bn to the Bank of England (which it will have to finance either from taxes or by rolling over the bonds in the market, either of which will have a tightening effect) [of course they won't mature all at once, but you know what I mean]. On a smaller scale, the process of reversing QE is going on all the time, as the government will already have started making coupon payments to the Bank on those gilts - also reducing the amount of money in circulation. In the US, where Treasuries tend to have a shorter maturity, the Fed has already had to specifically increase the size of its QE programme so that redemptions of Treasuries do not inadvertently have a deflationary effect.

    The real reason that the gilts won't be cancelled is not to do with Bank of England insolvency: it's that if they were, the effect would be to permanently increase the money supply by £300 billion. This would amount to directly monetising government debt and is likely to be hugely inflationary (you say this is hotly debated, but I don't think there is a great deal of doubt about it). So in practice, Murphy is wrong, even though in principle he is right.

    Ralph raises the question of whether this inflation would suddenly take place at the date of maturity of the gilts. No - it would either happen when the cancellation is announced (to the extent that you believe in some variant of Ricardian Equivalence) or over time, as the government gradually raises taxes or cuts spending less than it would normally have to do.

    Ultimately, Murphy's suggestion is simply a traditional call to finance public spending by printing money instead of through future taxes. Nothing illogical about it, just (debatably) irresponsible.

  6. Thanks Leigh, that's very helpful. I don't think we are far apart, are we?

    Re the BoE: I did say "technically" insolvent in the comments. I realise that whether or not central bank insolvency matters in practice is debateable. My main point though was the same as you have made - the backstop is the Government. If the Bank of England were to require additional capital, it would have to be provided from tax revenue or further gilt issuance.

    I admit I forgot about the deflationary effect of interest payments. And obviously if the Treasury actually pays the Bank of England when gilts are redeemed, that must also be deflationary. So I stand corrected on the "imbalance".

    I have had quite a few debates about whether or not cancelling the gilts would be inflationary. Most people conclude that one-off cancellation of the entire stock of purchased gilts would probably be inflationary and would also be likely to spook investors, raising yields on the remaining debt and possibly causing a run on sterling. But there is less consensus about gradual and/or partial cancellation.

    I agree with Murphy that technically the BoE and Treasury balance sheets are consolidated and that purchased gilts are effectively cancelled from an accounting point of view. The point of this post is that eliminating purchased gilts from the consolidated accounts doesn't cancel them in reality, and decisions need to be made about how to manage those gilts in the real world.

    In the post I also expressed concern about Murphy's notion that monetising debt would create an opportunity to issue lots more debt for fiscal expansion. I think this is extremely dangerous. Do you have a view on this?

  7. Indeed, we are not really disagreeing.

    The inflation question mainly depends on whether people and companies want to hold higher cash balances than they used to - in other words, has the velocity of money fallen? If velocity has fallen, then a larger money supply is required to maintain the same GDP and price level.

    However, it seems unlikely that velocity has permanently fallen to the extent that a tripling of the monetary base would have no inflationary effect. It may well have fallen temporarily to that extent, and accordingly I am a supporter of QE in general. But QE is expected to be (mostly, at least) reversed within a few years as the economy recovers.

    You are right to point out that as cash is a liability of the government, total UK debt has not fallen just because gilts have been exchanged for money. There is an important question in monetary theory about the extent to which bonds and money are substitutes for each other. Since banks can hold gilts on their balance sheets and issue their own bank-created money, then maybe the effect of substituting £300bn of bonds for £300bn of money isn't that huge after all. But the difference (in the textbooks at least) is that people and firms don't want to hold cash, because it earns no return. So it is spent instead of being kept in bank reserves. This is less of an issue now, when gilt returns are so low, but as they return to normal, velocity should rise.

    The money supply does, of course, grow over time as the economy grows (and not necessarily in direct proportion). So it could be that some gilt cancellation, or more likely other forms of permanent monetary growth, will be appropriate over time.

    On your last question: sounds like Murphy is getting into MMT territory. I don't have a firm view on MMT in theory, but moving from our current regime of tax- and debt-financed government spending to monetary finance would at the very least be highly disruptive. Investors and markets would take years to figure out what kinds of commitments (from governments, from banks, and from each other) are credible in the new regime. Undoubtedly there would be large inefficiencies in capital allocation, possibly a longer recession and definitely inflation. I'm not sure what the advantages of this kind of system would be to outweigh all those costs.

    All that said, I do think the UK could support more debt and public investment right now. We just shouldn't fool ourselves about the fact that we will have to pay it back.

    On a comical note, I liked this:

    truth goes through three stages. In the first stage, it is ridiculed. In the second stage, it is violently opposed. And in the third stage it is accepted as self-evident.

    Of course, nonsense also goes through three stages. In the first stage, it is ridiculed. In the second stage, it is still ridiculed. In the third stage, it is mostly forgotten but kept alive by fools and charlatans.

    It's not possible to tell solely from the ridicule which category a theory is in.

  8. Hi Frances. I followed you home from Timmy's. Please don't call the police.

    Here's how I thought QE worked, if I've got it wrong, please put me right. The BoE creates a company called something like QE2012 Ltd. and lends it freshly printed money. QE2012 Ltd. buys gilts. At some point in the future, probably on a Friday afternoon when some good growth figures have been announced, QE2012 Ltd. ceases trading and the government gets to keep the money. Yes?

    1. Haha. I'll let you off this time!

      Yes, asset purchases are made by a separate company, not directly by the BoE.

      Exactly how these purchases will be unwound is a matter of debate and the BoE has not yet said what its plans are. I don't think it's quite as simple as you suggest. It may be that the government will indeed "get to keep" some of the money, but personally I think for market confidence it will be necessary for the Bank of England to be seen to be reversing QE by selling gilts at some point.

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