QE Debate - The Case for the Defence
In case you haven’t seen it yet I highly recommend checking out Frances Coppola’s excellent new blog devoted to discussions of the effects of Quantitative Easing. Her recent thoughts on the subject are a must-read for anyone looking into the toxic consequences of the UK’s current policy mix.
Yet I want to go against the grain for a moment to look at the positive impact of QE and why, if used correctly, it is a powerful addition to the monetary policy tool-kit.
So let’s cast our minds back to September 2008. Lehman Brothers has just collapsed, the financial system has been thrown into chaos and the Great Moderation suddenly looks like a bad joke that no one understood. The key underpinning of an interconnected financial system – trust between institutions – has been shattered in one fell swoop.
Onto the stage step the central bankers. In March the following year the Bank of England slashed its benchmark interest rate to 0.5% and unveiled a stimulus package comprising a £200 billion asset purchase programme focussed predominantly on UK government debt.
In the Bank’s simple explainer the purpose of this scheme (later dubbed QE) was to “inject money directly into the economy” and “circumvent the banking system”. By inject money directly into the economy, they were mostly talking about the portfolio rebalance effect whereby private non-bank investors recycle the money they get for selling assets to the Bank into corporate bonds or shares driving up their price. However, they also saw transmission mechanisms of the policy through policy signalling effects, liquidity premia effects, confidence and bank lending.
In 2011 Deputy Governor Charlie Bean gave his assessment of the impact of the first round of QE purchases in which he claimed its impact on activity was something like 1.5-2 per cent of GDP and on inflation something like 1.5 per cent peak impact. Perhaps just as significantly, however, he suggested that “it’s reasonable to think [later rounds of purchases] will have largely equivalent effect”.
I have written at length about why I believe that the Bank was overoptimistic (to the point of naivety) about the impact of later rounds of asset purchases. Nevertheless, I do want to make a few points for the defence:
- Firstly, although a sovereign default by a large developed country seems unthinkable now, in the chaotic aftermath of Lehman’s collapse assessing risk became an extraordinarily complex task. Irrespective of the actual likelihood of a sovereign credit event, what central bank purchases did was remove solvency risk for a government that borrows in its own currency*.
- Secondly, as a consequence of removing default risk government debt became a “safe asset” at a time when the volume of private sector safe assets was collapsing. This is a key step in facilitating private sector lending (money creation), particularly in the shadow banking system that relies on safe assets as collateral. The swapping of assets for central bank reserves was also crucial in restarting interbank lending markets as it restored a level of trust in the balance sheets of financial institutions.
- Thirdly, by increasing the demand for sovereign debt (both directly and indirectly) QE pushed down government borrowing costs. This is, in my opinion, a necessary step in facilitating a Keynesian countercyclical fiscal stimulus programme for countries that are running primary deficits as it averts the necessity of cutting into a downturn. It does not mean, as MMTers would have it, that the government can simply spend as much as it wants on anything but it certainly allows for a targeted policy of national investment in projects with a high return.
That politicians in Britain, and to a lesser extent the US, have viewed QE as a get-out-of-jail-free card for a dysfunctional political system is not a fault of the policy itself. To my mind many of the toxic consequences we are now seeing are at least in part a reflection of the over-reliance on monetary policy to pull developed markets out of their current slump.
Yet it is not too late to take advantage of the positive aspects of asset purchases providing governments understand the irresponsibility of attempting fiscal tightening in a downturn.
*NB Structural problems in the Euro Area meant that in effect the periphery discovered only after the crisis struck that they were not borrowing in their own currency.