As the recovery stutters in Europe and America many people (especially in the financial markets) are hoping Ben Bernanke will reflate the wheezing economy with a third round of quantitative easing (QE3). So far he has stopped short of promising this, perhaps because QE1 and QE2 were not very effective in boosting the real economy.
Indeed, a letter to the Financial Times (not in the UK print edition) argues today that more quantitative easing (expanding the money supply by buying financial assets) would be pointless or worse:
QE3 appears to fit the informal definition of insanity, where we repeat the same thing over again and expect a different result. But it also risks inflation rising out of the control of our central bankers.
I am inclined to agree with the writer. That said, QE is far from a complete failure. As this helpful Economist article reminds us, QE was not just meant to boost economic growth. What happens when the Federal Reserve or Bank of England buy a financial asset in the market is that the seller’s bank is paid by a credit to its reserve account with the central bank. Or to put it more simply, the central bank injects cash into commercial banks.
During the financial panic of 2008-9 this was a good thing to do because many banks had difficulty getting short-term funding, so the extra cash gave the banks some breathing space. Likewise, the signal that central banks would take extraordinary measures to prevent economic collapse helped to stop the panic.
But the situation today is different. Rather than the financial heart attack brought on by the collapse of Lehman Brothers, Western economies are now going through a sort of Chinese water torture: everyone expects more bad news but they don’t know whan it will come and what it will be. Understandably, confidence is evaporating.
In this situation quantitative easing has two big weaknesses. These are to do with what central bankers call the monetary policy transmission mechanism, which is the way changing the money supply influences the whole economy.
The first problem is that central banks don’t actually create most of the money we spend: high street banks do that by lending to people and companies. In theory (specifically, the Bernanke-Blinder model) an increase in central bank money will always result in rising prices and incomes. In practice, this relies on the multiplier effect of bank lending being constant. But if banks are worried about their funding or about the risk of losses, they may well choose to hoard their increased cash reserves rather than lend them. (Indeed, in the first three months of QE in the UK bank reserves rose at an annualised rate of 1968% [sic].)
Federal Reserve statistics suggest this problem is real. Between July 2010 and July 2011 the monetary base (currency and bank reserves) increased by 34.6% but M2 (the broadest American measure of money supply) grew by only 8.2%. Bank of England statistics show the same story: despite a historically low interest rate and the Bank’s own quantitative easing, growth in money supply (called M4 in the UK) is well below the level usual in a healthy economy.
Until the banking system is running smoothly again, trying to reflate the economy with QE is rather like trying to inflate an air mattress by blowing through a tube with holes in it – not much of your puff gets through. And the wobbles of European banks and the hoarding of capital by Bank of America suggest that the system is not running smoothly.
The second problem is in the financial markets. QE increases prices of financial assets, and this in turn is meant to boost the economy in several ways. First, buying bonds reduces long-term interest rates; this reduces the cost of borrowing on the corporate bond markets so should stimulate investment by companies. Second, since share prices also rise this should stimulate investment too, this time through Tobin’s Q. (As the market value of a company’s capital stock increases above its replacement cost it becomes profitable to invest more.) Third, the wealth effect of growing investment portfolios encourages their lucky owners to go shopping.
In practice, most of the money created by QE seems to be sloshing around inside the financial markets, as the high prices of government bonds and the rise and rise of gold indicate. And despite rising profits and masses of spare cash, companies are not investing. In fact, capital investment has fallen to record lows in the UK. If companies are unwilling to invest spare cash, then their cost of borrowing is frankly irrelevant. And any wealth effect from rising asset values will directly benefit only the already well-off (most people’s investments are either too small to matter or tied up in a pension fund). Suffice to say that the 30% jump in sales at Tiffany’s does not seem to have trickled down to the rest of the American economy yet.
The fundamental problem with quantitative easing as economic stimulus is that it relies on expanding credit, when banks are still counting the number of skeletons in their cupboards, and on stimulating investment, when companies see few opportunities to invest. If it didn’t work for Japan, why should it work for us?