Printing money conjured up images of wheelbarrows full of paper cash, so what is QE, and does it work?
It was presented almost as a panacea: a mechanism by which a potentially painful fiscal retrenchment to address government’s annual deficits and total debt, caused by several years excess spending, could be helped to be relatively painless, and at the same time repair bank balance sheets ravaged by the 2007-08 financial crisis so that they could resume lending into the economy to engender economic growth. The results have been mixed at best, and, for some, disastrous.
But, the question often gets asked, what exactly is quantitative easing (QE)? Politicians and economists seeking to downplay the “It’s just printing money” simplification are right in some senses, but have been less than straightforward in admitting its similarities of earlier, albeit less sophisticated, methods of expanding money supply and injecting it into the economy.
Partly, that’s because economic folklore contains terrible memories about the commercial and personal destruction wreaked by uncontrollable money supply expansion. To see what happens when money supply expansion becomes uncontrollable, read Adam Fergusson’s “When Money Dies”, about the post World War 1 collapse in the value of money in Austria and Weimar Germany. The tales of wheelbarrows of notes needed to buy a loaf of bread in early 1930s Germany are well-known. What isn’t is that, in 1920s Austria, shops had to close for one hour twice a day, to re-price stock because the value of the currency was falling so fast – in those kind of circumstances, economic life simply comes to a halt. But the slide into that abyss from a position of thinking just a small amount of inflation from an expanded money supply can be tolerated because it monetizes debt away can be appallingly rapid.
Under QE, the central bank, in the UK’s case the Bank of England (BoE), basically, creates cash electronically on its balance sheet. But using that cash to directly finance expenditure – in effect creating money at the behest of government to help finance its spending – is regarded as economically beyond the pale, so QE uses a more roundabout method to help the government finance itself. It has become the major buyer of gilts, bonds issued by the Government at a fixed rate of interest, or coupon. This has two main effects. The increased demand for gilts drives up their price, which has the effect of lowering the actual yield on them represented by the fixed interest rate: this in turn enables the Government to fund its borrowing at a lower rate than would otherwise be the case, and also, since the yield on gilts is a significant determinant of the general level of interest rates, contributes to lower interest rates in the wider economy – so prompting borrowers to borrow and banks to lend. So, at least, runs the theory.
Unfortunately, things haven’t quite worked out quite like this, on several fronts, which we can look at briefly. Investors operating in the bond markets have worked out that the government relying on the BoE to function as the principal market for its bond issuance probably means that it is not addressing the underlying deficit and debt nearly as assiduously as it should be, and that the rate of interest it pays on its borrowing is therefore benefiting from being artificially depressed. Their counterparts in the currency markets have responded by marking down the value of the £ sterling. On a trade-weighted basis, the Pound has fallen precipitously since the advent of QE, including an approximately 13% fall against a basket of currencies in 2013 alone. Because Britain imports much of its raw material needed for economic production, especially oil and gas, which are priced in US dollars, that raises their sterling coast, contributing to inflation.
The aim of rejuvenating the lending capacity of the banking system might have been better not timed simultaneously with requiring banks to rebuild their balance sheets and hold greater reserves against a future crash. The effect of this is not unlike your doctor telling you to put on weight and lose weight at the same time. Because of the way in which international banking regulation differentiates between the risk of various categories of assets held in reserves, buying gilts either direct from the Debt Management Office as Government Bond Broker, or depositing cash at the BoE and holding gilts in exchange, has been a preferred way for banks to recapitalise their balance sheets. The Government then evinces surprise and annoyance that banks are reluctant to lend into the wider economy.
Among the hardest hit by QE, though, have been (1) savers and (2) present and prospective pensioners in schemes relying on self-funding through investment returns rather than state largesse as in the public sector. With interest rates depressed, as we have seen, almost into negative territory even on nominal terms, never mind being well into negative territory already in real, inflation-adjusted terms, anyone who has saved rather than consumed with the intention of being self-reliant in retirement has been punished for prudence. Furthermore, with retirement annuity rates, hugely dependent on interest rates at the time the annuity is contracted from a cash sum, having been decimated by QE’s effect on lowering interest rates, anyone with a private or company defined-contribution pension scheme finds their pension pot buys a pension in some cases only a third of what it would have been only a few years ago.
At the micro-level, the penalising of the thrifty and self-reliant over the indebted and extravagant has been one of the most malign societal effects of QE. At the macro level, though, the resolute refusal of the economy to respond as predicted surely proves how right Friedman and Hayek continue to be. Successive doses of so-called stimulus -the UK economy has now had a £375bn stimulus from QE – have a smaller and smaller effect, or need to be larger and larger to replicate the same effect. And there really is no comfortably pain-light route out of a recession caused by the bursting of a too-easy-credit debt-fuelled asset bubble, without the painful unwinding of malinvestment and misallocation of resources which the distorted price signals of excessively loose monetary and credit policy created.