Quantitative easing and the curious case of the leaky bucket

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Quantitative easing, a term first widely used in Japan in the 1990s, does not have an agreed precise definition. It describes a policy in which the central bank buys assets from the financial sector, and does not necessarily – as in conventional monetary policy – confine such activities to the management of the government’s own debt.

Though this policy had been pursued by Tokyo with little success, the US Federal Reserve, Bank of England and European Central Bank all adopted QE after the financial crisis of 2008. Amid all that has been written on this subject, there is very little about how it is supposed to work, or whether it has in fact worked.

When I was a student, I learnt that if there was a plentiful supply of liquidity to the banking system, there would be easy credit for businesses and households, which would encourage them to spend more. It was never clear that this mechanism worked well in recessions: nervous businesses and households might be reluctant to spend and invest, however much liquidity was available to them. The connection between lax monetary policy and inflation when the economy was overheated was much clearer than the connection between loose monetary policy and growth when the economy was depressed.

But that was then. Now there is far more liquidity in the system, most of it supporting the short-term trading of financial institutions. Or at least there is the appearance of liquidity: when confidence dried up towards the end of 2008, so did liquidity. The primary intention and effect of central bank interventions since 2008 has been to restore such liquidity. As a means of stimulating business investment and household spending through easier credit, this has been like pouring water into a leaking conduit in the hope that some will dribble through. Politicians and bankers argue about whether low business lending and consumer credit levels are the result of lack of supply or lack of demand; either way, the absence of consequential economic stimulus is the same.

In the modern financial economy, the main effect of QE is to boost asset prices, as market gyrations of recent weeks have clearly illustrated. But is the pursuit of higher asset prices an effective or desirable means of promoting economic growth? The distributional impact of the policy demands attention; the one certain consequence of boosting asset prices is that those with assets benefit relative to those without. Many people own houses – but, although in the UK, for example, we need more houses, we do not need another housing boom. The public also holds financial assets indirectly, largely through pension funds. But here there has been a paradoxical effect: because of the way pension funds are valued, QE has generally increased pension funds’ liabilities more than their assets.

A few technical papers from central banks try to estimate the overall macroeconomic effects of post-2008 monetary policies. But there is almost no direct evidence; these studies focus on the predicted effects of lower long-term interest rates within a particular economic model. The one policy certainty is that countries that claimed an early commitment to fiscal rectitude would encourage growth have not come through the crisis as well as those readier to adopt fiscal stimulus.

This relationship of monetary and fiscal policy reveals another paradox. Most opportunities for long-term investment are found in infrastructure, either in the public sector, or associated with or financed by the public sector. Yet far from treating the depressed state of western economies as an opportunity to make such investment, and taking advantage of opportunities to raise long-term finance at interest rates that are negative in real terms, austerity-minded governments have been cutting capital expenditure and their central banks have been aggressively buying long-term debt back from its private holders.

Why has so much attention been given to these monetary policies with no clear explanation of how they might be expected to work and little evidence of effectiveness? The very phrase “quantitative easing” seems designed to discourage non-technical discussion. But the real answer, I fear, is all too familiar: these policies may not benefit the non-financial economy much, but they are helpful to the financial services sector and those who work in it.

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