Tuesday, 3 March 2009
The complex manoeuvres our desperate financial gurus are getting up to pass comprehension at times!
About two months ago I warned readers that they’d better get used to a new term (to me at least!) which will be chucked around freely in monmths to come - “Quantitative Easing”. It’s now passed into the expected general use as the abbreviation “QE”. It’s an expression wqhich some call “degrading the currency”, others scorn it as the “Zimbabwean option” while yet others as “printing money”.
Since Roger Bootle in yesterday’s Telegraph went to some trouble to explain it I thought it might be generally helpful to circulate so that we can all understand what it is they’re actually doing up there in the stratosphere of high finance.
Here he sets out what QE is supposed to do, what it is likely it WILL do, and what we should do and think about it. He’s reasonably lucid but one sentence may appeal, viz:- “ the rational thing for the public to do might well be nothing”. (I note he has omitted the preliminary step of pulling the bedclothes over your head!)
XXXXXXXXXXXX CS
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3.3.09
QE is a useful tool for the Bank as it tries to fix the economic plumbing
The UK is about to embark on a policy of so-called "quantitative easing", perhaps as soon as this Thursday's MPC vote.
By Roger Bootle
For something with such an obscure name, this policy has already caused an extraordinary amount of controversy. I can imagine that they will soon be arguing about quantitative easing down the Dog and Duck. So what are we to believe? Is it a case of Zimbabwe here we come?
Quantitative easing (QE) refers to the monetary policy options available to a central bank when conventional monetary policy has run out of ammunition. Just about everything in economics is about combinations of price and quantity. Conventional monetary policy focuses on changing the interest rate, i.e. the price, at which the central bank will supply money to the system. With certain minor qualifications, official interest rates cannot go negative. Accordingly, once they have reached zero, there is no further that such price-focused easing can go. But the central bank can still vary the quantity of money it supplies to the system – hence the expression "quantitative easing".
In practice, what this policy involves is the Bank of England buying assets in the markets. Because central bank money is the base of the whole monetary system, it can pay for these assets by simply creating deposits with itself, at the click of a mouse. In this way, it expands the size of its balance sheet.
So how can such a policy work to lift us from recession? There are three main channels. First, provided that the assets are bought from non-banks, then private bank deposits rise. If you are a monetarist, then you will believe that this alone will be enough to get the economy's wheels turning. People and institutions want to hold limited amounts of money in relation to their wealth and spending, so if they find themselves with more than they want then they reduce their holdings by increasing their spending or buying assets, either of which will land someone else in the system with excess money holdings, which they will seek to reduce in the same way.
This is the story which many a student is told in what the Americans refer to as Economics 101. And sometimes the system can work in just this way. But not always. The story starts with someone willingly giving up assets in exchange for money. They may do nothing further afterwards to adjust their portfolios.
Notice that this is altogether different from many a textbook example when the money just descends like manna from heaven – or at least from a helicopter which Milton Friedman once assumed as the source of an increase in the money supply. And it differs from the Zimbabwe case, where cascades of notes do rain down on the populace.
Second, the fact that the Bank is buying assets will tend to drive up their price, i.e. drive down their interest rates. By lowering these interest rates the Bank could hope to stimulate more borrowing and spending, in the usual way. Mind you, in today's conditions, borrowers may not be very responsive to lower rates. But if the Bank buys otherwise illiquid private sector paper then it may open up avenues of funding which would otherwise have remained closed. Moreover, lower long rates will tend to support the prices of other assets in the system, such as equities and commercial property and thereby increase wealth levels.
Third, QE will leave the banks with increased deposits at the Bank of England. In normal conditions, banks hold only the bare minimum so the extra quantity should prompt them to increase lending. But we are not in normal conditions. In today's economy the banks could easily decide just to sit on these extra reserves.
There is a further wrinkle to QE. Once the Bank is prepared to engage in QE this potentially removes the short-term limits to fiscal expansion. For suppose that the government increases its borrowing and this borrowing is financed by the Bank. This is the equivalent of printing notes and distributing them by helicopter – or dishing them out to the supporters of Zanu-PF. Because in this case, the private sector ends up with more money without having to give up anything in return.
Moreover, this appears to get round the bond markets' limited appetite for gilts and the danger, if the policy were pushed too far, of precipitating a default by the government. The central bank buys the gilts willy nilly. Accordingly, you would think that such a policy could be pursued without limit, and hence that it would be bound to work, eventually. So it would – but with a major qualification, which emerges from the answer to the inevitable question about the inflationary consequences of this policy.
QE is not bound to cause inflation in the way people imagine. In a depressed economy, the effect of increased spending prompted by a successful policy of QE would be a boost to output rather than prices. But what about when the economy recovers? At that point, with so much money sloshing around, there would be a danger of inflation picking up – unless the Bank reversed policy, by effectively sending the helicopter out again, dangling a gigantic suction hose, to hoover up the excess cash. In practice, that would mean the Bank selling off its huge holdings of assets.
In other words, if QE is not to cause inflation in the end, then it does not get round the constraint on the amount of fiscal expansion, because eventually the debt which the government incurs will have to be offloaded onto private sector buyers. Getting the Bank to buy government debt does not get the authorities out of the insolvency bind – unless they are prepared to accept a burst of much higher inflation. It merely buys them time.
Given all this, a policy of QE might not have that much effect. If the public believes that the authorities will not risk default and a burst of inflation, then it will believe that the extent of possible fiscal action is limited, and indeed may even be reversed, and that extra money injected into the system will be reabsorbed. In that event, the rational thing for the public to do might well be nothing. This is apparently what happened in Japan. QE was pursued on a massive scale without any obvious benefit.
This is not to say that the Bank is wrong to pursue QE. On the contrary, I think that it should be throwing the kitchen sink at the economy – and that includes both zero interest rates and QE. But don't think that QE is a magic wand which will cause our troubles to disappear. The key to recovery is sustaining bank lending at a higher level – and that will take more than just drowning the system in cash.
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Roger Bootle is managing director of Capital Economics and economic adviser to Deloitte.
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