Posted by: Dirk | January 29, 2015

ECB vs BoE: the clash of monetary theory

The recent press release by the ECB that accompanied its decision to start quantitative easing (QE), which basically is an instrument to reduce long-term yields (and therefore, interest rates), contains the following lines:

The ECB will buy bonds issued by euro area central governments, agencies and European institutions in the secondary market against central bank money, which the institutions that sold the securities can use to buy other assets and extend credit to the real economy. In both cases, this contributes to an easing of financial conditions.

This is very interesting, because the monetary theory that this is based on is neoclassical. Other central banks do not follow this monetary theory and instead have opted for other theories, like the Bank of England (BoE). The BoE roughly follows Post-Keynesian theory, as a quote from one of their primers on money creation makes clear:

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial
banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. The reality of how money is created today differs from the description found in some economics textbooks:
• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

The latter basically means that central bank money can not be used by banks to make loans to the private sector (households and firms). That is in stark contrast to what the ECB has claimed above. It seems pretty clear that both cannot be right, since either banks lend out reserves or they don’t. Of course, what should follow now is a little ride through central bank and bank balance sheets, but that has been done by others like Randall Wray (in English) already (my own book is available in German only).

Given that Britain stayed out of the euro, after much intellectual debate (see Walters and Godley) which ended with widespread agreement to stay out, this is a very interesting discussion. After all, the future of Europe depends on whether the euro zone can be turned into a functional economic and social unit!



  1. Reblogged this on sdbast.

  2. So, the only part that is false is: “and extend credit to the real economy. ”

    But if we asume that banks, who do extend credit to economy, are insolvent (many loans failed which ate their capital, many assets did not pay off also which ate their capital) Buying their failed asets at full, face price is preventing the recognition that banks are insolvent. Even tough ECB is putting the floor to quality of asets it will buy, still it will provide some income and save banks just enough to be open for business.
    So QE is about saving banks which do provide credit to economy. It will keep doing that.
    Indirectly ECB is right, but wrong directly.
    The problem of zombie banks not loaning to economy anymore was solved long time ago (by changing mark to market rules), now QE is about saving them, allowing them not to loose capital in worthless assets anymore. ECB is just late with rationale that banks are needed to provide credit to economy.

    Sure, it would be much cheaper to create new banks that would keep providing loans at much beter rate to economy, and let these insolvent banks close. But then they would loose market share in other countries around EU, which national governments want to keep. New banks would stay within national borders and then would have to kompete for other markets again. That is a no-no for governments that spread power of their banks over the whole EU.
    So it is the competition of nations pride and power over other countries that is preventing the real proper solutions to insolvent banks. and realy extend credits to economy at much better terms then they are now.

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