My name's Francis Hunt. I'm looking to talk to you about monetary policy and fiscal policy, what these concepts of economics actually mean and how they pertain to where we are naturally in our current economic environment. So let's start right at the beginning. When you hear government ministers or major economic people, such as the head of the Fed or the Bank of England, referring to monetary policy and fiscal policy, what are they referring to?
So let's start with monetary policy. Monetary policy specifically deals with the cost of money, and the cost of money is an interest rate based price. In other words, if someone is borrowing, how much will they pay for the use of those funds? And, often, to the counter-bound balance of that, a lender, what is he asking as a price for making his funds available?
Now typically, the banking system has as the banker of last resort the central bank of that country. So our banking system is obliged to hold certain reserves with the central bank to prove that they're liquid and that they're in a position to trade and have sufficient financial backing. Their overnight deposits are paid with the reserve bank, and they get paid an interest on that.
The central bank, or reserve bank as it may be known, is also the lender of last resort to banks when they are having short-term cash surpluses or shortfalls. In other words, they will deposit excess with the central bank, or they will request additional equity. Now the rate that they borrow from the central bank is the determined bank rate that gets spoken about extensively in many, many countries. The Fed lending rate, for example, in the US is 0.25% percent, and over here in the UK it 0.5%, and in Euro land it's 0.75%. That is the rate that banks can borrow from the central bank and the rate of interest that they would be obliged to pay.
So this is all about controlling the price of money. Sustained periods of very low interest rates see an excess of lending. This is what happened under the Greenspan era. A succession of minor crises and some major ones saw him continually using monetary policy, in other words reducing the cost of credit to pump cash into the system. What actually happened is we had a surplus of liquidity, and the risk that goes with the borrowing, because the interest rate is also meant to reflect the price of risk of loss, started to disconnect and decouple from the actual risks. We have a lot of money chasing a few opportunities. Those opportunities get overpriced, and there's too much competition chasing after them to participate, and there's too much speculative money chasing risky assets. This is what happened in the run-up right the way through the dotcom boom, up to 2000, and then the secondary massive cuts in interest rates that led to the housing boom, which made borrowing very, very cheap.
So what other tools does the central bank have outside of the interest rates and setting the interest rates and pushing them up if people are getting too exuberant, which was supposed to happen, but probably didn't, and dropping them when we have lost all confidence? They also have the ability to up the amount of reserves that a bank holds, so the reserve ratio, and forcing a bank to be more stable and more solid and have bigger financial banking, so reducing the amount of leverage. For every pound that a bank gets deposited, they can often lend 10 times. So this ratio and these reserves are also tools that see and control the access, the price of credit, and the amount of credit.
So using your reserve ratio might change the amount available. It doesn't change the price. Changing the interest rate that you pay and you demand if the primary commercial banks are taking money from the central bank does push up the cost. So if the central bank ups rates, the commercial banks have to charge more on the cards that they are giving credit to, [lines] to, and at the same time pay more to their depositors. So this takes some of the excessive liquidity out of the system.
So monetary policy is controlled normally in the UK, for example, by the Bank of England. There's a policy team called the Monetary Policy Committee, and it has all the key heads, usually people highly qualified in economics and responsible for being the economic brain trust and for implementing policy and recently was decoupled from political control. It used to be controlled by the party in power in the UK. The Federal Reserve System is how it works in the US, and the ECB is how it works in Euro land. So these people are meant to be apolitical, meaning that they don't subscribe to any particular political view, but they're doing the right thing by the citizens for the economy in question in terms of how much credit is being available and what confidence is like.
They're also targeted on inflation. This was the primary focus of monetary policy was to target on inflation, and this is the stated constitution, if you want, for central banks. However, recently it's become quite clear that inflation is secondary, and, given our massive amounts of economic weakness that we're facing around the globe, there now appears to be a hidden agreement in a practical sense regarding stimulating growth. And this is where the quantitative easing policies, which is, once again, flooding the market with more cheap and easy money, is here to stimulate growth and is actually counterproductive for future potential inflation. In other words, currency destruction is, by definition, inflation.
So if you think of Zimbabwe, a loaf of bread made in South Africa sells for an obscene amount in Zimbabwean dollars and a stable amount in rands, just a few miles over the border. The condition is not the shortage of bread. It is the devaluation of the Zimbabwean currency. This was done because too much was printed, and we are currently in an environment wherein an epic amount of quantitative easing and printing is going ahead. So this makes
monetary policy very, very interesting.
LESSON BY FRANCIS HUNT