In my last two blogs, ‘The State of UKBanks & The Long Haul to Recovery’, and ‘Quantitative Easing, Bank Lending& UK Government Borrowing’ I pointed out:
a) That following the financial crash of 2008, the UK’s four largest banks suffered a massive drop in their capacity to lend – some £1.8 trillion between December 2008 and December 2009;
b) That in the two years since then – up to December 2011 – they only recovered £191 billion of this capacity; and
c) That despite the Bank of England’s programme of quantitative easing or QE, all of this additional capacity has effectively been taken up by the UK government in order to finance its fiscal deficit.
I further argued:
d) That the UK economy would not be able to return to its pre-2008 levels of growth until the banks recovered at least part of their former lending capacity;
e) That this could not happen while the government continued to borrow at a rate faster than the banks could grow their assets; and that
f) If an incoming Labour government actually wanted to implement its advocated strategy of increased fiscal stimulus, this could only be achieved through even greater levels of QE.
Since then, people have naturally come back to me asking why such a strategy of fiscally stimulating growth using QE would be such a bad thing; and despite my innate distrust of easy fixes I had to admit that I didn’t really know the answer. It occurred to me, therefore, that, despite its highly technical nature, it might be a good idea to devote a blog to exploring some of the pros and cons of QE with the aim not only of helping others to understand it better, but of getting a better handle on it myself.
So, to start with, what is Quantitative Easing?
Put simply, it is the creation of money ex nihilo by a central bank. One moment the money doesn’t exist; the next it does. Magic!
As a result, many presenters and pundits on mainstream news and current affairs programmes quite regularly describe it as the electronic equivalent of ‘printing money’, with all the connotations this brings with it. References are quite often made, for instance, to that period during the Weimar Republic when it is said that Germans had to go shopping with wheelbarrows, not to carry their groceries, but the bundles of bank notes that were required to pay for them. Whether this story is apocryphal or not, I leave you to decide; but for at least three generations of Germans it has come to represent the inescapable truth of what happens when a government tries to defy one of the most basic laws of economics: namely that the total amount of money in circulation within an economy is always equal, in value, to the total amount of goods and services available for this money to buy. If you increase the amount of money in circulation without increasing the amount of goods and services, therefore, these same goods and services simply end up costing more. Which is precisely what happened in the Weimar Republic when the government tried to finance its fiscal deficit simply by printing more bank notes.
QE, however, differs from simply printing money in two respects. The first is that the new money which the central bank creates is used to purchase assets on secondary markets. This is very different from what happened during the Weimar Republic, when the newly printed bank notes went straight to the German treasury to pay public sector salaries and pensions. In the case of QE, the treasury first has to sell it bonds to commercial banks, from which the central bank then buys them. This means that, in principle at least, the central bank can always sell the bonds on again, or request the Treasury to redeem them when they fall due, thus taking the new money out of circulation again once it is no longer needed, something which is not quite so easy in the case of printed bank notes.
The second way in which it differs from simply printing money is that, when it was conceived, in Japan in the late 1990s, it had a very specific purpose: to increase the money supply during a period in which the bursting of a housing bubble had led to a financial crisis and period of economic contraction very similar to the one we are now experiencing in the UK. Economic activity had slowed appreciably, money for borrowing was in short supply, and the economy had not only fallen into recession but into a deflationary cycle, from which it is very difficult for any economy to escape.
This is because deflationary cycles – in which prices actually fall – have something of the effect of self-fulfilling prophesies. If people know that something they want or need is going to be cheaper the following week, they naturally put off buying it until retailers, desperate to obtain sales, do in fact reduce their prices. This then reinforces the popular perception of prices falling, which further accelerates the cycle. At the same time, with sales so low, more and more businesses, from manufacturing to retail, are forced to close or lay off staff. Unemployment rises, people have less money, and put off buying things even longer. The result is a vicious circle from which it is almost impossible to escape.
That is not say that the Japanese government didn’t try. They tried just about every form of fiscal stimulus imaginable. They tried tax cuts. Which didn’t work. They tried extensive building programmes: building bridges to nowhere and motorways no one used – or so it is said – though this too may be apocryphal. They then tried setting interest rates at zero, thinking that if people weren’t earning interest on their savings and credit was free, they’d avail themselves of the opportunity to borrow. But still nothing worked, not least because, with all these fiscal stimuli, and a contracting economy in which public expenditure, particularly on pensions and benefits, was consuming an ever increasing proportion of GDP, by the late 1990s Japan had the largest annual deficit of any country in the G20, with an accumulated national debt of 188% of annual output, the vast majority of it, of course, funded by Japanese banks. It was only when economists at the Bank of Japan realised that, even with interest rates set at zero, people and businesses couldn’t borrow money if the banks were lending it all to the government, that this new, revolutionary idea began to take shape. In 2001, the Bank of Japan thus embarked on the world’s first ever exercise in quantitative easing, buying up Japanese Treasury bonds from its own commercial banks in order to provide these banks with additional liquidity for lending to the private sector.
And it worked. By 2006, when the programme was suspended, the Japanese economy was growing at 1.9% per annum, and the long deflationary cycle had finally flipped over into inflation.
The problem for us, however, is that we still don’t know what, under normal circumstances, would – or should – have happened next. For within eighteen months, the financial crisis hit the USA and Europe, quickly followed, in Japan, by the worst earthquake and Tsunami the country had ever experienced, which together forced its economy back into recession. By 2010, as a result, its QE programme had to be resumed. We can only therefore guess at what might have happened had the Japanese economy continued to recover. Yet it is in what happens during this recovery phase that the real dangers of QE lie.
To understand this better, we first need to look a little more closely at how the money supply within an economy works. The most important thing to understand is that it is the product of two variables: the monetary base – which is the total amount of money the central bank has made available for use within the economy – and the rate at which this monetary base effectively circulates. To illustrate: I deposit £1 in my bank account. My bank then lends this to a company which uses it to buy a piece of equipment. The manufacturer of this piece of equipment then uses it to buy raw materials and to pay my salary, which I deposit in my bank account. The same pound thus gets used over and over again even while it remains nominally mine. And it is this multiplying effect on the monetary base which produces the effective money supply.
In a balanced, well-managed economy, this multiple is usually somewhere around 1:35, and it is the job of the central bank to keep it more or less at this level. If it rises above 40, for instance, the economy is usually said to be overheating, with a risk of increased inflation, and the central bank therefore raises interest rates. This then slows down the rate of economic activity and the multiplier returns to normal. If it falls much below 30, threatening stagnation or recession, the central bank then lowers interest rates in order to stimulate economic activity. Up until its introduction by the Bank of Japan, the real problem for central banks, however, was what to do if economic activity still remained flat even after interest rates had been reduced as low as possible – or indeed to zero. Quantitative Easing solves this problem by temporarily increasing the monetary base, as shown in Table 1.
Table 1: The Effects of QE on Money Supply in a Recovering Economy
What Table 1 represents, in fact, is a fictional economy going through a number of stages:
- In the first line, we have a smoothly running economy, with a monetary base of £40 billion, and an average multiplier of 35, giving us an effective money supply of £1.4 trillion.
- Next – as the result of a housing bubble, for instance – we see the economy overheating, with a multiplier of 45, producing an effective money supply of £1.8 trillion, which, in turn, would already be causing inflation to rise quite steeply.
- At this point the central bank would therefore intervene, raising interest rates, which, as a result of mortgage defaults, perhaps, could actually be the cause of the financial crash that we see next, with economic activity decreasing to a multiplier of just 25, and an effective money supply of just £1 trillion.
- Having reduced interest rates again – presumably without much success – the central bank then tries QE, adding an extra £16 billion to the monetary base, which, even with the reduced multiplier of 25, restores the effective money supply to the original £1.4 trillion.
- As a consequence, economic activity very quickly returns to normal and a multiplier of 35. On the new monetary base of £56 billion, however, this produces an effective money supply of £1.96 trillion; and although the goods and services this represents may now also be growing, possibly at 1% or 2% per annum, this nowhere near matches the increase of 40% in available money.
- The result, somewhat inevitably, is hyper-inflation, and it is this possible effect of sudden economic recovery upon an artificially inflated monetary base that is the inherent danger of QE.
What this means, therefore, is that as soon as the central bank sees that a recovery is underway, it has to start a process of Quantitative Hardening or Firming: taking money out of the system again. The problem, however, is that although, as I stated earlier, this is perfectly possible in principle, in practice it could be a little more difficult.
The obvious way to go about it is for the central bank to simply put the bonds it purchased through QE back on the market. However, it has to be very careful how it does this, particularly if its government is still having to borrow money. A sudden glut of a country’s bonds may make it difficult for its treasury to get any new bond issues away, and will certainly reduce the price, thus putting up interest rates. If it doesn’t want to cut off the recovery before it has properly got going, therefore, it has to sell the bonds quite slowly. If it sells them too slowly, however, or waits too long, it is possible that the economy could start overheating and that inflation could already get a hold before the sell-off programme is complete, which would have an equally detrimental effect upon bond prices.
This is because bonds are redeemed at a fixed face value. During periods of inflation, as this fixed face value becomes worth progressively less, bond prices, therefore, quite naturally tend to fall. As inflation also tends to force up interest rates, bonds issued during periods of stagnation or recession, with low fixed dividends, also tend to lose value. What this means, therefore, is that, one way or another, the central bank is unlikely to get back all the money it injected into the economy when it first purchased the bonds. No matter how dexterous it is in managing the bond markets, some additional money will remain in the monetary base, and some level of inflation will result.
Another possible option, therefore, is for the treasury to redeem the bonds at face value, doing so, if necessary, even before they are due – assuming that there is provision for this. As few governments run surpluses – even when they are not running deficits – it unlikely, however, that many governments would be able to do this without additional borrowing. That is to say that they would have to issue new bonds in order to raise the money to buy back the old ones. The problem with this is that it would be very difficult for any government to do this if it were still having to borrow money to finance a deficit. In fact, it is for this reason, I believe, that, in making a form of QE available to Spain and Italy, the ECB has also made it a condition that these countries eliminate their deficits within an agreed timetable. During this period the ECB will buy an unlimited quantity of Spanish and Italian bonds from their commercial banks, thus providing these banks with greater liquidity to lend to the private sector and stimulate growth. Once this period is over, however, both countries have to be in a position where they no longer have structural imbalances in their economies – where they no longer have to borrow money simply for day to day expenditure – and are therefore in a position to borrow the money necessary to redeem their bonds from the ECB.
At this point, of course, you may ask whether this isn’t just as bad. Instead of borrowing money to pay pensions, these countries will now be borrowing money to pay back bankers in Frankfurt. I can certainly imagine friends in the Labour Party making some such comment. It is, however, to totally miss the point. For in borrowing money from their own rehabilitated commercial banks to redeem their bonds from the ECB, the countries involved would not now be adding to their national debts, merely repatriating part of these debts back into the normal banking system. More importantly, because they would not be borrowing to finance a structural deficit, once this repatriation was complete, they would end up with a balanced budget. Indeed, this proposal by the ECB contains the only QE exit strategy I have so far analysed, which, in the end, leaves the target country’s economy in tact and its finances sound: a fact which rather suggests that the Germans, with their collective memory of the Weimar Republic, are the only ones who have properly thought this through.
This contrasts quite markedly with the USA, for instance, where there are no plans to cut the fiscal deficit, which currently stands at $1.3 trillion per annum and is budgeted to rise slowly but steadily until 2019, when the total cumulative debt, presently $16 trillion, is projected to reach $25.9 trillion, or $100,000 for every man, woman and child in the country. Given that since 2008, US banks have experienced a similar reduction in their lending capacity to those in the UK, you will not be surprised to learn, therefore, that over the last three years, in order to support this level of borrowing, the Federal Reserve has already provided somewhere in the region of $2 trillion in quantitative easing, and that yesterday it announced that, from now on, it would be providing an additional $40 billion a month on an indefinite basis until the economy picks up.
This, however, could take some time. For $40 billion a month is less than 40% of US Treasury borrowing. This means that US banks and other financial institutions will still have to lend around $60 billion of their own money to the government each month, thus depriving the private sector of this money, and providing a drag on growth. For although public borrowing to pay salaries and pensions does not stop money from circulating, by reducing the amount banks have to lend for house purchases and business investment, it channels the money along routes that have less of a multiplying effect. While quantitative easing may continue to expand the monetary base, as long as the US government fails to reduce its deficit, therefore, the monetary multiplier, representing economic activity, will remain depressed.
How long the US economy, like the UK economy, is likely to stay in this state, I’m not sure. As I demonstrated in Table 1, the monetary base is only a very small percentage of the money supply. If the multiplier doesn’t change, one can go on increasing it for quite some time without it having much effect. As total US debt continues to increases, it is also likely that, regardless of the Fed’s intervention, its bond prices will come under pressure, and that US Treasury bond yields will rise, pushing up interest rates, which will also have a depressing effect on economic activity, keeping the multiplier low. Indeed, it is possible that the collapse of the US economy, when it finally occurs, will have nothing to do with the Fed’s QE programme, and that it will simply happen when bond markets start to feel, not only that the mountain of US debt will never be repaid, but that it can no longer be maintained. My guess, however, is that this will very probably be triggered when, even at low levels of economic activity, the expansion of the monetary base starts to have an effect on inflation. At this point, the Fed will have to discontinue its QE programme, thus leaving its banks to shoulder the burden of the deficit unsupported. As bond prices fall and yields rise, at some point the US Treasury will then not be able to sell all the $100 billion to $150 billion in bonds it needs to sell each month in order to the keep the government afloat, and the USA will simply turn into Greece, only bigger and with two to three orders of magnitude greater impact.
What this analysis indicates, therefore – unless anyone knows better – is that QE is only a sticking plaster. It is a short term measure that can be used, after a financial crash, to rebuild a country’s banking sector and refinance growth, while the government puts its economy in order. If the government fails to do this, however, not only is QE far less effective, it simply delays the day of reckoning and makes the eventual collapse even worse. The trouble is that while governments all around the developed world are now jumping on the QE bandwagon, seeing it as the solution to all their short term ills, very few are willing to impose the kind of hardship on their populations which correcting a structural imbalance requires.
In the USA, in fact, this has now become built into the political system. For while the constitutional division of power between the executive and legislature was meant to provide a series of checks and balances, it has now created a kind of impasse in which Republicans refuse to allow any tax increases while Democrats refuse to countenance any cuts in welfare. The result is an ever increasing deficit which no one can do anything about. Indeed, it is probable that the US economy is already beyond the point of no return, and that nothing anyone did now could prevent its inevitable collapse.
In the UK, however, there was a short period when the problem could have been met head on. For in 2010, when, following the financial crash, the current government was elected, there was a brief window in which the British public, shocked by what had happened, would have been willing to take the medicine. Had the new government announced real cuts in public expenditure at that point, they would therefore have been accepted. Knowing that before long, however, the architects of this new austerity would eventually come to be universally hated, and might never be elected again, the Conservative leadership simply bottled it. The budget they produced allowed for public expenditure to continue rising, while any trimmings they made to the previous government’s expenditure plans were back-ended to 2013-15, when they hoped renewed growth would make them virtually painless. As it is, continued government borrowing has stifled growth in the private sector and has put us in a very similar position to that of the US, in which quantitative easing is the only thing that keeps the wheels turning.
The real tragedy, however, is that very few people have any sense of this whatsoever. They believe the opposition when it tells them that the reason the government strategy is failing is that they tried to cut public expenditure too fast. As a result, the next government will almost certainly be a Labour government, which will try to stimulate growth by public expenditure, financed through borrowing, supported by QE. As this will continue to deprive our commercial banks of the money they need to finance the private sector, not only will this fail, it will simply make the problem worse when it finally becomes unsustainable.
The only good news is that this is probably all irrelevant. For when the US economy finally collapses – which I estimate will happen sometime around 2020 if not earlier – the entire global financial system will, of course, implode. It will make 1929 and 2008 look like minor hiccups. As a result it probably doesn’t matter what the UK government does. It’s Armageddon either way.
Me, I’m putting all my money – or what’s left of it – into gold!