A lot of economists and other academics feel that there is something not quite right about quantitative easing, but they cannot quite put their finger on what is wrong. They have therefore become vulnerable to QE myths:-
- QE was used to bail-out the banks
- QE is giving money to rich people to gamble on the stock market
- QE has created stock market and property bubbles
And if you are taken in by these myths you then want to know why we do not use:-
- QE to finance infrastructure
- QE to give 175 euros per month for 19 months to each citizen of the Eurozone
- QE to write down government debt
So let us start by looking realistically at what is correct about QE. After the collapse of Lehman Brothers the interbank market froze and banks stopped lending to each other in case they were lending to the next bank who was going to lose the support of its Central Bank. This led to a monetary contraction that was threatening to introduce a sustained period of deflation (a fall in the average level of prices) across the world. A simple solution was for the Central Bank to print money.
Traditionally the cash component of the money supply can be increased by buying back debt, usually government debt. The USA announced a policy of QE and the UK followed. The first problem to solve is how much debt to buy back. Although not all economists agree, there is a time lagged relationship between the rate of change in the money supply and its effect on monetary demand, nominal national income and the average level of prices. This lag may be as long as 12 to 24 months. So how much cash, or as the Bank of England preferred to describe it, how much electronic money should we create? As it is an imprecise science and bearing in mind that the Bank cannot avoid getting it wrong, the best thing to do is to put too much cash into the economy rather than too little. Too much too quickly was exactly what the Bank of England did and the effect was just what a monetarist would expect which is inflation overshooting its target. On the preferred RPI measure inflation rose to just over 6% in 2011. So QE had done what was expected of it as it had avoided deflation in the UK and it will now avoid further deflation in the Eurozone.
The initial success of QE was the beginning of its downfall as it can do nothing else other than help manage the average level of prices. Research papers, mainly by Keynesian sympathisers, suggested that monetary policy could and should be used to continue the process of closing the output gap and stimulating growth in the economy. Fiscal deficits had failed to do this since they were advocated at the 2009 G20 meeting in London, and in the UK the baton for stimulating the economy was passed from the Treasury to the Bank of England. Buoyed by their success with QE and a new Governor the Bank took on the role of boosting the economy. Interest rates were kept at a record low and various schemes such as “Funding for Lending” were used to encourage monetary expansion through bank lending rather than QE.
At this point it is necessary to explain the role that QE plays within monetary policy. Monetary policy is managing the overall level of aggregate monetary demand. Monetary demand is comprised of the money supply and the speed with which it is passed on from person to person or what economists refer to as the velocity of circulation of money. The money supply is made up of two key components which are the amount of cash in the economy and the amount of bank lending that has been built up on this cash base. The Central Bank has total (if we exclude counterfeiting) control over the amount of cash in the system, it has much less control over the amount of bank lending which shows how ineffective interest rate policy is, and it has virtually no control over the velocity of circulation of money. So the Bank`s very transparent way of controlling cash during a period of time when monetary demand was growing too slowly highlights the success of QE and it is why the same policy was continued in the USA and started belatedly in the Eurozone.
Currently the fact that economies are not growing is now being blamed on QE and failed monetary policy, whereas the evidence is that QE has been successfully used to manage the average level of prices; and arguably monetary policy could never do the things with which it had been tasked. Monetary policy is benign and can only produce price stability.
One final question to answer is whether or not QE was a new untried policy when it was first used after the Financial Crisis. The answer is no. It was just a new name for half of a policy named open market operations which is where a Central Bank injected cash by buying back government debt (QE) and withdrew cash from the economy by selling debt. This was done anonymously through a broker as and when it was required to maintain monetary stability. Open market operations was therefore a type of QE/QT policy where QT is quantitative tightening. However QE has had such a bad press of late, being associated with the myths highlighted in the first paragraphs, that it is now difficult to use it effectively as the ECB found out when it was slow to react to an impending deflation in the Eurozone.
The Bank of England, The ECB and the Federal Reserve have all used QE effectively at different times. Unfortunately they have not done well in their use of interest rate policy which is the real cause of property and asset bubbles. Central Banks need to take responsibility for this incompetence.
If a Central Bank performed effectively then stable prices will create the right environment for relative price changes to work and for the economy to grow and flourish. If they are ineffective you may well ask the following question: why should a Central Bank be rewarded when it prints money to buy back government debt and then receives interest and repayment of that debt from the hard-earned income of future taxpayers: just by printing money it has created a future liability to the real economy and an unearned payment to itself? Of course we would not be asking this question if it was doing its job effectively.
John Hearn 27/4/15