Quantitative Easing or nations buying their own debt: What are the implications of QE 2?

Yesterday saw another strong day for equity markets which continued a recent trend. We saw another triple digit rise for the American Dow Jones Index albeit only just with it up 100.81 to 10,525. The S&P 500 index which I mentioned in yesterdays article rose to 1115 which is up 5% since the lows of last Tuesday. There was also the beginning of news emerging as analysts used the European Stress Test data for their own purposes. For example there is a new criteria being set out of Basel which has been suggesting new capital ratios and criteria for worldwide banking. Now this is not yet in operation but if it was then 39 not 7 banks would have failed. The essential difference is that some 8% of Tier 1 capital is required and not 6%. After the last few years my faith in banking regulators is less than total but it is higher than my faith in euro zone officials.

Quantitative Easing

I was asked a question on this subject and replied to it on here over the weekend. There is some further news on this subject in terms of new research so I thought I would discuss this today. In terms of relevance we saw the Chairman of the Federal Reserve Ben Bernanke say this last week in his speech to Congress.

we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability
The emphasis is mine. Joining in with this new theme came the Minutes from the Monetary Policy Committee of the Bank of England.

The Committee considered arguments in favour of a modest easing in the stance of monetary policy.

Ordinarily we would take this to me an interest rate cut was likely but both countries have extraordinarily low interest rates already with the US operating at between 0 and 0.25% and the UK base rate being 0.5%. So more asset purchases were on the cards or at least being discussed at the last meetings of both central banks.

My View on how QE has worked with particular emphasis on the UK

As to buying your own bonds which both the UK and US have done recently there are two main issues. We both have to sell some of our government bonds abroad. That does not mean that we do not have domestic savers or pension funds that do buy them merely that we do not have enough. Indeed with the large expected deficits we both have then we are likely to be rather reliant on overseas purchases of our bonds over the next few years and we both have overseas holders of our existing bonds (around 30% in the UK). Think of it now from their perspective. They know that this is a risky experiment and they must to my mind have a lower view of us then before. So there are dangers here for their willingness to invest in us in the future. I thought that this would impact this year on bond yields but I have been proved wrong as spring turned to summer by the way that “flights to quality” effects have affected both US and UK bond yields favourably. So I feel that we will have to wait for the full impact of this until the world economy begins a more sustained recovery and risk,fear and contagion are no longer driving forces. Put more simply I think that it has been a fluke that Quantitative Easing has not been viewed more unfavourably as the political stability and safe haven status of the UK and US has outweighed “bond economics”.

Another way of thinking of this is saying why do you not buy your own mortgage? The problem then is getting people to trade with you and give you credit etc. Of course you may have to get them to stop laughing first at the idea…

Now if you look at the second issue which is the domestic economy. If we ignore the concept of sterilisation and look at pure QE then what is happening if you buy your own bonds? The first move is that your central bank is creating money and exchanging it for debt. So the money supply is expanded. There are many different theories on what the impact of this is but if you pump extra money into an economy there are two main possible effects a rise in output and/or a rise in prices. I personally feel that the links between pumping this sort of money into the economy and output are weak at best and that this has so far been demonstrated by how the US and UK economies have responded. However there have been signs of an impact on prices in the UK (and if you read my article on US inflation more there than you might think). To my mind there clearly have been effects on asset prices such as the stock market and in the UK on house prices and maybe in some commodity prices which are to my mind much higher than you might expect considering the fall in world output. So even at a time when you might think that expanding the money supply is least likely to raise inflation I would contend that it has done so, and I am using a wider definition of inflation here than just a consumer price index.

Now here is a question which I do not believe those in favour of buying your own bonds have ever properly answered. When things get better what is your strategy? 

I hope that this helps. There are issues here that do not have a definitive answer. The phrase “a dismal science” does apply to economics here, not necessarily that all of it is dismal but that you never actually get a definitive answer in the way that a scientific experiment might give you. You can never factor out one variable and isolate it as there are always other factors. For example if we take money supply you might think that this is easily calculated but once you get from base or high-powered money (which the central bank sets and therefore should know) it is often not so clear how you define things and then calculating it.This is rarely discussed but is true, I suspect it is rarely discussed because many of those who look at it do not understand it. So far with the lags in monetary policy the QE experiments in the UK and US have probably had about 2/3 rds of their effect so some is still unknown…

As to buying your own bonds I think part of the answer comes from thinking of it as a complete concept, as in if it is such a good idea why has it not been done before and why do we and the US not buy all of our own bonds? We need not bother then with such inconveniences as foreign investors and adverse change in interest rates, we could set whatever ones we liked. Here I think becomes the beginning of the rub to me as in it is a part of a fantasy that currently exists in the real world.

A Further Factor

One influence of a bond buying programme by a nation or QE is that the prices of its debt tend to rise or put another way the yields fall. The proponents of such a policy believe that this will lead to a more general fall in long-term interest rates which will benefit businesses if they issue new tranches of such debt. Also those taking out mortgages may be encouraged to take out longer-term fixed rate ones. If we look at the UK evidence the our ten-year government bond yield fell to around 3.1% leading observers to estimate a positive impact on long-term yields of around 0.75%. It was hoped that this would benefit an economy.

However in the UK banks increased their margins and also raised the amount of equity required to get a mortgage and the corporate sector did issue new longer-term debt but it remains a small part of the whole. So the benefit may have been low. Of course the government did gain as it issued a whole years debt (actually slightly over) to itself at low interest rates.

As time has gone by though we have seen a new situation as UK longer term gilt yields fell to nearly 3.3% in June/early July of this year. Whilst the stock of bonds bought is still in existence there has been no new buying for quite a few months. It makes me wonder if during the economic slowdown yields might have fallen anyway. Of course that there is an alternative scenario whereby existing investors were more than happy to see prices rise so that they could sell to the UK taxpayer at an expensive level.

A More Hopeful Alternative

It will hopefully be clear that I consider the QE experiment in the UK to have been a policy mistake and that some of the implications of the mistake are yet to come. However there is a better way. The Federal Reserve in America used it more which is to buy private-sector assets. The Bank of England had this option but choose to use it very sparingly and in fact it could still buy up to £50 billion of them if it financed it by the sale of Treasury Bills. So not quite pure QE but long-term assets would be bought.

This to my mind is much more likely to succeed in my view as you are directly buying private-sector assets and therefore are directly supporting  prices. The rise in prices will lead to a fall in yields which means further debt issuance will be cheaper and thereby encouraged. There is a clear route here to a benefit to the economy. Because such markets in the UK are small relative to the size of our economy then the size of such a policy would be kept contained.

An Even More Hopeful Alternative

Actually if we ever really faced an economic calamity such as a genuine prospect of a severe double-dip or a 1930s type scenario I would follow Keynes example. This would involve creating money at the central bank and giving it to people. As both the British and Americans are avid consumers and spenders I think the next link in the chain is clear. Sometimes simple really is best. It is something of an irony that Ben Bernanke has acquired the nickname of “Helicopter Ben” as that is precisely what he did not do.

New Research on QE

Vasco Curdia and Micheal Woodford at the NBER (National Bureau of Economic Research) have written a working paper on this subject and here is taste of their views.

We distinguish between “quantitative easing” in the strict sense and targeted asset purchases by a central bank, and argue that while the former is likely be ineffective at all times, the latter dimension of policy can be effective when financial markets are sufficiently disrupted. Neither is a perfect substitute for conventional interest-rate policy, but purchases of illiquid assets are particularly likely to improve welfare when the zero lower bound on the policy rate is reached.

I notice the “likely to be ineffective at all times” verdict on QE. No wonder the Bank of England keeps coming up with new explanations for it.

Questions

I have been asked a couple of questions on this subject. The first enquires as to what is a safe level of QE.That to my mind is easily answered the problems start at 1 and get higher as you increase. Now plainly in itself £1 or $1 would not have any measurable impact but with apologies to George Orwell all pounds are created equal….

with potentially “too much” money out there in the banking system from Q.E. but inflation not yet really hitting, what might be the mechanism and trigger for it to take hold? And when that happens is there anything a Central Bank could do about it at that stage?

Starting from the beginning do we have too much money? At the level of the monetary base or high-powered money then yes we do as central banks have poured money into these areas to try to jump-start economies. Those looking at monetary statistics would be looking at M1 or M0 measures here. However as we go into wider measures and also look at bank lending we have too little. So the real problem is a dislocation in the system. An analogy is a patient on a hospital trolley with a heart attack and the doctor pumping electricity into him/her but not getting much response.

To move forward to the final section then should this change it is likely to do so much too quickly for central banks to respond. In the medical analogy the patient will come alive and start breathing etc. instantaneously. Now if we replace the Doctor with a Central Banker what will he/she do? I believe we will get a huge sigh of relief followed quickly by the thought we had better hang on in responding, we do not want to be responsible to ending/curtailing an incipient recovery. In this gap inflation may well get into the system and the Central Bank will then be too late responding. There are lots of implications to this but for now I think it is best to remain with just one, central banks will respond too late and if you read their statements this is in fact a policy move. This to my mind is a serious criticism of the current crop of central bankers. Their job specification involves the control of inflation and yet many central banks currently would be grateful for it.  My view on this is that it is something of a betrayal and a  bit like a fireman turning out to be an arsonist.

I like to offer a solution. To my mind there is not one in conventional Central Banking action. The dislocation in money supply is between narrow and wide measures at this time and this is particularly wide in the US where shadowstats numbers for M3 are scary. My response would be to reform the banking sector. I know this is not a conventional response but to get things moving we need to get bank lending and hence the banking sector operating again. The saddest part of the lack of reform is that we are in danger of learning nothing at all from what happened in Japan in the 1990s. 

Conclusion

My question to the proponents of QE and QE2 is as follows. What is your endgame?

As a further thought I have something which is rather chilling so those of a nervous disposition may like to look away. If we go back in time then our current problems had other factors influencing them than the usual conventional analysis provides. So if you would be kind enough to suspend the usual “epoch breaking” analysis for a moment please consider this. Two rather ordinary factors were at play.

1. Interest rates surged inspite of official levels. In the UK,for example, three-month money stayed at 7% for quite some time. So one rather ordinary factor was simply interest rates being inappropriately set as in much too high for the circumstances. This would have had quite a contractionary effect and central banks were very slow to deal with this.

2. The oil price shot up reaching a peak in July 2008 of US $145. Now there is a lot of debate over why this happened but there are plainly two issues. One is that an increase in the oil price of this size would in itself have had quite a strong impact on world output. It also impacted at a time when the inappropriate interest rates in point 1 would have been hitting hard too.

So inappropriate interest rates and an inappropriate oil price. Does the fall in world output look so extraordinary now? You see if it doesn’t then it begs the question was the extraordinary response necessary? I am left with a rather chilling thought that it was for the banks (to carry on pretty much as they were as far as I can tell) but may not have been for the rest of us.

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5 thoughts on “Quantitative Easing or nations buying their own debt: What are the implications of QE 2?

  1. Surely QE was to support the continuation of govt spending (debt) and the recap of the banks which has been used as you suggest to continue speculation in the markets. However as commercial banks are not issuing debt and therefore not creating money, isn’t the net situation zero or even negative as far as the overall money supply is concerned?
    House prices in the UK have been supported by low base-rate linked mortgage deals but these are increasingly unwinding. Commodity prices are being supported by the half of the world that has never seen this recession, led by China stockpiling and buying up swathes of Africa.
    This has been predominantly a US/European recession and at its core is debt, private and sovereign. Allied to the increasing effect of globalisation and the squeezing of the middle classes. Whether it be by inflation or wage freezes/job losses, the ‘old world’ will have to lose 20/30% of its ‘wealth’ which has been ‘stolen’ from the future by increasing unsustainable debt. Of course the 1% who own the majority of the world’s wealth will just get richer.

  2. I think you’ve highlighted a number of important issues – namely, QE and its effects on money supply, the effects of commodity prices (particularly oil prices) on growth, and the way our central banks and governments have embarked on a panicked, indiscriminate bailout of the commercial banking sector.

    The QE mechanism in the UK helped bail out the Labour government in the run-up to a general election (nice one Mervyn). The Fed’s balance sheet expansion, which Bernanke was at pains to describe as ‘Credit Easing’ in contrast to the BOJ’s efforts in the 1990s, was largely a bailout of the GSEs Fannie Mae and Freddie Mac. In the latter case, this undoubtably did have the effect of reduce mortgage costs for households, but a cynic would say this was only to keep the banks solvent. The point being, as you have said, this sort of QE is not an effective way to stimulate the economy – it would be much better to throw the money out of helicopters as Bernanke jokingly suggested before he became Fed Chairman (or perhaps better, fund temporary tax amnesties). As you also say though, this may not have been necessary at all if the transmission mechanism from central bank base rate to market rate on loans had not broken down. This was also the reason that broader money measures such as M3 continued to contract despite the lowering of central bank rates and expansion of the monetary base.

    Commodity prices, and especially that of oil (on which basically all transport costs depend), also have a huge impact on economic activity. I don’t think it is too far-fetched to say that the commodity price spike that started around 2004-2005 was the catalyst that led to the 2006-2007 slowdown and property market bust. There is a strong argument that commodity price inflation is actually a deflationary force if it doesn’t feed through to wage rises (withdrawing equity from a house does not count as income in the long run!). If the advocates of peak oil are correct, we will keep running up against this brick wall, no matter how much money is printed. Keep your fingers crossed that the tight gas revolution will come riding to the rescue. In the meantime, look on the bright side – reduced demand has kicked this problem into the long grass for now, and has made life difficult for the unpleasant governments of some commodity-producing nations…

    On the final point, I think governments have been far too timid in dealing with the banking sector. They have missed a golden opportunity to do the following, in order of priority:-
    1. Create a more robust international financial regulatory framework. I guess the lead role could be taken by the BIS, with the agreement of G20 governments and central banks. A common framework for dealing with, in addition to capital adequacy, the orderly winding up and investigation of bankrupt international financial institutions would be a great boon. A small tax on bank assets (for banks with international operations) could have been used to create a fund for bailouts and the prosecution of fraud and professional negligence. In order to keep credit flowing, a general principal seems to be that a ‘bad bank’ should be split off from a failed financial institution so that it does not try to shrink its balance sheet in order to meet capital requirements.
    2. Reform of the credit rating agencies and the laws governing their activities. Along with the banks that created worthless CDOs etc., the credit rating agencies can take a lot of the blame for this financial crisis. Laws could have been drawn up to deal with the extent of liability, payment structure, independence of the assessor and professional misconduct. Again, perhaps the BIS could also oversee the regulation of the rating agencies (in consultation with IOSCO?) Some international body with teeth certainly should.
    3. Implementation of a Tobin tax to fund the IMF and establishment of an SDR bond market. The original idea behind the SDR was to make it the world reserve currency and take this burden away from the Dollar which, according to the Triffin dilemma, must otherwise become over-supplied leading to a Dollar currency crisis (given enough time, a pessimist is usually proven correct). The necessity for funds to clear up currency crises and sovereign debt disasters is starting to become apparent, and likely to become more so over the coming years.
    4. Implementation of counter-cyclical reserve requirements, coordinated by the BIS and government central banks. Had the banks built up larger reserves from say 2004 onwards (e.g. 10% Tier 1 by 2007) and were now required to hold smaller reserves (say 5% Tier 1), the pressure on them to shrink their balance sheets would be much reduced.

    Back in the real world, we have the Holy Trinity of Dodd-Frank, Basel III and the European Financial Stability Facility 😦

  3. Graeme B, I am trying hard to get my head round the implications of QE and commodity price increases on ‘inflation’ as targetted by the MPC.
    I agree that QE went to the ‘wrong’ people if growth in the economy was the aim, but I also agree it was in support of govt spending and the banks. I don’t think it has ‘leaked’ into the general economy and is not an ‘inflationary’ force. Also I agree that commodity price increases reduce demand and are deflationary if not resulting in wage increases. I would argue that increases to VAT are the same.
    I am then left with the uncomfortable feeling that increases in an annual price index ( CPI or RPI) brought about by these factors are ‘deflationary’, yet the rise in the index is used as a surrogate for ‘inflation’ and pressure is on the MPC to increase interest rates which adds to rather than relieve the ‘problem’ . I think this is what happened before the banking crisis when the MPC kept rates far too high for far too long and added to the subsequent depth of the downturn.
    The reverse situation must also be true, which worries all those who think rates are now too low for too long, and that must have been true around the turn of century, however I fail to see the ‘signs’ now, indeed everything seems to be pointing downwards in the USA/Europe.

    • JW, some of the QE money did leak back into the real economy in the UK, since it allowed the government to keep paying public sector wages that would otherwise have been cut. Also, the theory is that the sellers of the government bonds deposit the proceeds with commercial banks, thus expanding banks’ deposit bases (liabilities) and allowing them to make more loans (increase their assets). Since the BOE were over-paying for the bonds, they were also allowing the holders to make a small profit at the expense of everyone else. The two main problems with this are that a) the proceeds from selling the bonds can be used to purchase some other asset rather than left on deposit at a bank (e.g. equities, commodities or even more bonds!) and b) that this does not really address the main problem, which is the banks’ insolvency – allowing them to turn a quick little profit from flipping bonds won’t cancel out their potential losses on bad loans and worthless ABSs. Forcing down long bond yields also causes a headache for pension funds and insurers because it reduces the discount rate they can use to discount their liabilities. All in all, not a very good idea if you ask me.

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