Does Public Money Creation always lead to hyperinflation? It didn’t in Britain (A History of Public Money Creation 1 of 8)

Throughout history, governments have used their ability to create money to fund public spending. While none of these policies were called, “People’s QE”, “Strategic QE”, “Sovereign “Money Creation”, or “Helicopter Money” (what Positive Money collectively refers to as Public Money Creation), they shared the common trait of using newly created state money to finance government spending, rather than relying on commercial banks to create new money through lending.

Significantly, the times when Public Money Creation has resulted in high inflation or even hyperinflation (inflation of over 50% a year) have been well documented. However, the times when governments have created money in a careful and responsible manner to grow the economy are usually ignored or overlooked.

This neglect of the positive history of Public Money Creation is one of the reasons the subject is still largely taboo. Consequently, there has been little effort to understand the relationship between state-led money creation and inflation; it has become a widespread and strongly held misconception that money creation by the state will always result in hyperinflation. Rigorous analysis and the application of economic theory have been thus dispensed with – only to be replaced by this fundamental misgiving.

At Positive Money we want to set the record straight and bring to light the many case studies where Public Money Creation has successfully boosted the economy without leading to economic disaster. This will hopefully challenge the knee-jerk reactions of many economists to any suggestion of Public Money Creation, and encourage them to bring theory and analysis back into the debate.

Accordingly, throughout the coming week we will be releasing a series of concise posts with case study examples illustrating the circumstances where state led money creation has helped grow the economy. In today’s post, we will discuss some of the theory behind money creation and inflation, and then look at the British case study.

In Series 2, we show how the wrong lessons have been learned from Weimar and Zimbabwe country case studies. In Series 3 we go far back in history, looking at ancient China and the Roman Empire. Series 4 will look at the examples of Guernsey and Pennsylvania in the 18th and 19th century. Series 5,6, and 7 will look at the pre-WWII case studies of Japan, Germany and the USA respectively. Series 8, will review the more recent country examples of New Zealand and Canada.

Bringing the Theory Back In

We clearly need a more reality-based analysis of the potential for Public Money Creation. Instead of assuming that government money creation will always lead to hyperinflation, economists need to start asking why the proactive creation of money by the state has successfully resulted in growth in certain circumstances and not others?

At an extremely simplistic level, mainstream economic theory often suggests that long-term price inflation is the consequence of the stock of money increasing faster than the supply of goods. With more money in their pockets, consumers will demand more goods and services. ‘Price setters’ (i.e. firms and sellers) will notice the increased level of demand relative to their available supply, and raise the price of their goods and services, resulting in inflation. In this situation, there is an increased amount of money “chasing” the same amount of goods and services being supplied. So, according to this simple theory, increasing the amount of money in the economy faster than the supply of goods and services results in inflation.

Yet as prominent economist John Maynard Keynes suggested, creating new money does not always trigger price inflation. If new money is created and spent on the production of new goods and services, then the supply of goods and services is increasing alongside demand. In this situation you have an increased amount of money chasing an increased amount of goods and services being supplied. Inflation will not occur if the rate of growth in supply is broadly consistent with rate of growth in the money stock.

This helps explain why many governments, as the case studies throughout this series will show, have been able to successfully grow their economy through the careful and responsible use of money creation. Their economies were operating below full capacity, and the new money was created and allocated to the sectors that were performing below their potential. The new money created was able to tap into the sectors where resources and inputs lay idle, therefore increasing the supply of goods and services. As supply (the production of goods and services) and demand (the creation of new money) broadly increased alongside in tandem, high levels of inflation were avoided.

State Led Money Creation in Britain: The norm, not the exception

In our proposal “Sovereign Money Creation: Paving the Way for a Sustainable Recovery”, we show that the proactive creation of money by the British government was actually the historic norm, rather than the exception. The following is based on the analysis provided in the abovementioned proposal:

In a paper that looks at the long-term evolution of central banking around the world, Stefano Ugolini (2011) highlights how the process of financing fiscal deficits with money creation has been surprisingly common:

“According to the modern idea of central banking, those who borrow from the monetary authority are other banks – which, in turn, redistribute credit to the whole economy. Over the centuries, money-issuing organizations have chiefly supplied credit directly to the state; and even when loans to the banking system have become predominant, central banks have often accorded them provided that the banking system would, in turn, redirect at least part of them towards the government.

This disguised obligation has generally taken the form of eligibility criteria for the procurement of credit: in practice, central banks would lend to customers mainly on the security of government bonds, Treasury bills, or the like. With respect to this, the history of the Bank of England is illustrative. During most of its first century of life, the Bank almost exclusively performed direct lending to the government.

Only since the 1760s did the sums lent to private customers start to become more substantial; yet, within its portfolio, commercial credit (trade bills) still remained a trifle with respect to government credit. … The presence of government loans and securities on the Bank’s balance sheet continued to be overwhelming throughout the first half of the 19th century; it was only after the reform of 1844 that the Bank entered the commercial credit market more actively. … With the explosion of war finance in the 1910s and the decline of international trade in the 1930s, Treasury bills almost completely ousted trade bills from the discount market … thus making the Bank operate almost exclusively on Treasury securities …

Therefore, on the whole, the Bank of England never ceased to play the role of ‘great engine of state’, famously credited to it in 1776 by Adam Smith. …. All this suggests that throughout the history of central banking, the monetization of sovereign debt has long played a much more important role than it has generally been recognized.”

The United Kingdom has a particularly strong history of financing part of its spending with money creation. From the mid-1100s to 1826 the crown partly financed itself through the creation of tally sticks – an early form of currency – which were used to make payments that could later be redeemed against taxes levied. Likewise, during the First World War, the Treasury issued ‘Bradbury’ notes in order to finance part of its spending. More recently still, up until the year 2000 the Bank of England regularly used money creation to finance part of the government’s spending, by providing the government with an overdraft facility (the Ways and Means Advance).

Indeed, up until the year 2000, when EU law forced its cessation, the UK government financed a proportion of its spending through an overdraft facility at the Bank of England known as the Ways and Means account. When used to cover the government’s immediate spending, the liabilities of the Bank of England (i.e. central bank reserves) would increase, creating a form of new money in the process, just as the use of an overdraft at a commercial bank creates money by increasing deposit liabilities. As the Bank of England explains:

“Ways and Means’ is the name given to the government’s overdraft facility at the Bank …. Prior to the transfer of the government’s day-to-day sterling cash management from the Bank of England to the Debt Management Office (DMO) in 2000, the outstanding daily balance varied significantly, reflecting net cash flows into and out of government accounts that were not offset by government cash management operations [i.e. borrowing from financial markets]. After the transfer of cash management from the Bank to the DMO, borrowing from the Bank was not used to facilitate day-to-day cash management and the balance was stable at around £13.4 billion until the facility was [mainly] repaid during 2008. … The facility remains available for use…”

(Cross et al. 2011) [Our addition in square brackets]

Financing a part of a fiscal deficit with money creation was therefore normal policy up until 2000. Although the advance was only meant to be a temporary solution, with repayments made as either tax receipts came in or bonds were issued (hence the fluctuations in its balance), as figure 1 shows a significant sum remained outstanding at all times.

Figure 1: Ways and Means Advance to HM Government

To sum-up, in Britain the proactive creation of money by the government to fund public spending has actually been the norm, rather than the exception. Hopefully, once this notion has been more widely accepted, mainstream economists will begin approaching this subject from a more scientific line of enquiry, opposed to drawing erroneous conclusions by applying the same old misgivings.