Dr. Stephen Kinsella:

I thank the joint committee for its invitation to speak to it. It is really good that we are having this discussion.

As a small open economy on the edge of Europe, it is very important that we take cognisance of the large-scale macro-financial changes we are seeing on the policy landscape. I have circulated a very small discussion document about which I will speak in a while. I will not necessarily read every word of it, but I will take the committee through it as it is written.

The first thing to be said is that it is very exciting when one tells an intermediate economics student that what one has been teaching them for the previous year has been a lie. One watches the shock as one realises this has been happening. Standard school textbooks tell us that banks exist to facilitate the interaction of savers and investors. While that is true to a certain extent, it does not give rise to the theory and practice of why and how money is actually created. Money is not created via something called fractional reserve banking in the modern economy. That is just not how it works. The way it works these days is that money is created largely by commercial banks such as AIB or Bank of Ireland in creating loans. When a bank extends a plumber an overdraft of €1,000, it creates a corresponding deposit on its balance sheet. This allows it and the Central Bank to see that money is being created, particularly once it is paid back, which is a very important point. When money is being paid back to the bank, effectively, deposits are being destroyed because they are written off against loans. It is very important that we understand money is a social institution. As we will talk about money later, it is very important that this comes up. Money relies on trust to function, but we have been labouring under a misconception, particularly as economic modellers, that the Government can create money. There are such things as Central Bank reserves and digital reserves, but these days more than 95% of the currency in circulation that is part of the monetary base comes from loan creation by private banks. For this very reason they are central to the functioning of the economy.

Since currency is effectively created through the private banking system, there is no effective limit on its creation. When many thought about the idea of quantitative easing, they said the Central Bank was going to print euros, hand the money to the banks in exchange for some bonds and that this would lead to inflation because an increase in the monetary base should lead to an increase in inflation. That is precisely what has not happened. It is not a fact that the commercial banks have been given more money to enable them to do this. The Central Bank has increased its reserves and that has permitted a series of asset purchases.

We have a modelling fallacy to which students are exposed. Students are told that the Government or the Central Bank can control the supply of money, but they cannot. The way we manage monetary policy is that we set the interest rate on Central Bank reserves, to which every other interest rate is key, for example, trackers. In normal times the way the Central Bank operates is that it raises the interest rate when it thinks the economy is overheating and lowers it to create more lending at a given moment. That is what happens in normal times, but we are not in normal times. In fact, we have not been in normal times for about five or six years. To give the committee a sense of just how abnormal it is, the interest rate set by the Bank of England is at its lowest rate since 1696 when the bank was created. It is, therefore, an incredibly odd time in the history of monetary policy. We call this state of affairs "zero-bound". We cannot reduce the real interest rate the Central Bank charges much below perhaps 1% or 2% and that changes the dynamics of how the average person wants to hold money.

If one wants to do that for a sustained period, one must say the euro in someone's hand is only good for a month and he or she must spend it. In effect, that creates a discount rate. One can see how that would change the life of the average person in society. With the interest rate effectively useless - it is a bit like pushing on a piece of string - in a situation where the price level is falling way below its mandate and growth is stagnating, a central bank must consider alternative options. Increasing the size of the balance sheet has been one of those. We call this quantitative easing. Given that a central bank can manipulate the size of its balance sheet ad infinitumand is the only power that can do so, it simply buys assets like government bonds in the open market, changing the pricing of the bonds and, therefore, changing the relationship between those. Not only can it change the price in real time, by intervening in a bond market and increasing or lowering the price, it can also change how investor expectations react to those prices. Those two things are crucial.

If members look at the first chart in the document I am showing them, it sets out a piece of really interesting research by Krishnamurthy et al from 2012. It looks at the US experience of quantitative easing. One can see that quantitative easing causes a portfolio change. By exchanging central bank reserves for government debt or any other asset, one gets this very large portfolio change where the banks and financial intermediaries that now hold the reserves simply start moving their money around. They move it into gilts, corporate bonds or equities and one can see that the demand for cash is pretty flat there. The US QE example is the largest and it has the most developed markets, but it is important to say that every experience of quantitative easing has been different. It is not fair or accurate to compare the US experience of quantitative easing to that of the Japanese because the institutional differences are so vast. The way they operate is different. My colleagues will speak to how the ECB's QE is being done. Overall, QE is a success if the amount of inflation one wants to see is increasing and, obviously, one is not having very large changes in inequality. This is something that everyone has been concerned about because in effect one is handing people who are, if not cash rich, certainly asset rich a great deal of cash.

There are many channels through which QE can work and we can talk about that, but I give an example in the handout of the impact on balance sheets . I look at the situation before asset purchases in asset and liability space. At the top of the table, members will see a pension fund. Look at the assets and look at the liabilities. The pension fund simply swaps its government debt, which in this case was Irish Government ten-year bonds, for deposits, which are handed out by a central bank from its reserves. The bank simply does that by expanding the size of its reserves which it can do because it is the central bank. One is using the central bank's balance sheet elastically. It changes the balance sheet of the pension fund, but as members will see at the bottom of the table, it also changes the balance sheet of a commercial bank, which is suddenly far more liquid with many more deposits and reserves. It is this mechanism that the central bank wishes to exploit to increase inflation, which is crucial.

I turn to the idea of expectations. Figure 2 shows the ten-year bond spreads for Germany and Ireland. Germany is in blue and Ireland, predictably, is in green. The ECB's QE was announced in late January. As members will see, the market had already priced in the fact that QE was going to happen. QE changes market expectations not only when it is going to be enacted but in terms of how much and when it is going to be turned off. Again, my colleagues will speak to this. It is about what the future might hold given that the markets are being deluged with this kind of liquidity for this long. Figure 3 shows the ECB's measure of expected inflation. After QE is announced, we see it dropping and then it comes back up after 21 January, so inflation expectations are increasing. If members look at where they are right now, it is slightly below 1.6 or 1.7. That is in five years' time. If one is an investor, what one is telling the European Central Bank is that one thinks there will be inflation at or near 0% for the next three or four years. What that tells one is that one can expect to see QE for a bit longer.

Finally, one of the other very large things that QE does is affect the exchange rate. For a small, open economy like Ireland's, and we are one of the most open in the world, a weaker euro is better on every level for exports, tourism and everything else. If one is Ireland, QE has been unambiguously good. Given that all the other major central banks in Europe will be doing some kind of easing, including the Sweden's Riksbank, the Swiss National Bank, Norges Bank and others, the major players in the European system are easing their monetary policy. The conditions are there for a reasonably large level of inflation. For a small indebted nation like Ireland, positive inflation levels are brilliant for debt dynamics. At this initial stage at least, QE has been a clear winner from the Irish perspective, particularly with respect to the interest rate.