QE: The emperor's new monetary policy
Quantitative easing doesn't lower rates, generate credit growth or even create new money, argues Gwion Moore.
The Bank of England's (BoE) Monetary Policy Committee (MPC) has voted to extend quantitative easing (QE) by another £50bn (€63bn). The argued consequences, good or bad, of QE are many - that it is "money printing" that will stimulate credit growth, lower interest rates and improve confidence, leading to stronger growth and higher inflation.
To be sure, £50bn is a lot of money - we could finance another five Olympic games for that price. If the claims are to be believed, then the level of debate in the pension sector about QE would be justified. However, I will argue that the real danger with QE is not that it is artificially lowering interest rates or likely to lead to a whirlwind of inflation, but rather that it will do nothing at all, and pension schemes crafting their investment strategy around BoE policy are likely to be led astray.
The thing that first raised my suspicions about the effectiveness of QE was that there were so many arguments for how it would work to support the economy. Indeed, the BoE Q3 2011 quarterly report contains a widely reproduced diagram charting the many transmission mechanisms of QE. My thoughts are that one strong argument is more powerful than many weak ones and that the multiplication of arguments in favour of QE over time have in fact weakened rather than strengthened the case for its effectiveness. I will address three questions: Is QE money printing? Will it stimulate credit growth? Will it lower interest rates? My answer to all three of these is no, not really.
Firstly, 'money printing'. Since the nationalisation of the Bank of England in 1946, the UK government has, in principle, had complete control over its monetary policy. This means that, unlike in Greece or Germany, the UK government cannot involuntary run out of money, and that if the UK government wanted to spend money without issuing bonds it would be perfectly capable of doing so. The process of issuing bonds is to convert short-term government liabilities in the form of banking reserves into long-term liabilities in the form of gilts. QE reverses this process, converting long-term government debt back into reserves. So there is no net change in the amount of money owed to the private sector by the government, just a change in the average maturity of that debt, the balance between reserves and bonds.
From this perspective, 'money printing' is better attributed to the fiscal deficit, which does increase the government's liability to the private sector. A measure of the relative merits of the perspectives of QE as money printing versus fiscal deficit as money printing is to ask yourself which would have the largest impact on the economy - £50bn of QE, or five deficit-financed Olympic-sized infrastructure projects.
Secondly, credit growth. Under a model of the banking systems know as Fractional Reserve Banking, the amount of credit (loans) that can be produced by the banking system is limited by the reserves requirements imposed by regulators and the amount of reserves held within the banking system, which, as discussed in the previous paragraph, is in principle controlled by the BoE. So in theory, by switching government liabilities from bonds to reserves (QE), the BoE can increase the ability of the banking system to produce loans, which in turn will stimulate economic growth.
However, this theory has never been very well supported by empirical evidence. First, the process of banking deregulation means that most of the developed world effectively operates a fraction-less reserve banking system in which banks are not reserves-constrained, but capital-constrained in their lending abilities. And insofar as there is a causal relationship between reserves and loans, it appears to be the other way around: the banking system produces loans in response to the demands of the economy, and the central bank increases the amount of reserves to meet the demands of the banking system.
The economic terminology for these relationships is 'exogenously controlled money' (the BoE is in charge) versus 'endogenous money' (in which economic demand determines the production of credit). The theory of endogenous money lies at the foundation of Hyman Minsky's 'financial instability hypothesis', and it has been one of the financial crisis's minor ironies that a theory that has won such acclaim for explaining its origins has been so ignored when trying to find its solution.
Thirdly and finally, does QE lower interest rates? Simple supply and demand argument can often lead to erroneous conclusions if only half of the balance is considered. For example, since the onset of the financial crisis, the amount of gilts in issuance (excluding those bought by the BoE) has risen from about 30% of GDP to about 40% of GDP. Surely, this should mean interest rates should now be much higher than they were before the crisis because the supply is so much larger, but instead interest rates are at historical lows. One of the central insights from a school of economic thought called 'modern monetary theory' is that, for countries that control their own currency, like the UK, the process of taxing or borrowing money in order to spend it can easily be conceptually reversed. From this perspective, deficit spending creates the money that is used to fund the purchase of gilts, so there is never any question of there not being enough money to buy new issuances of gilts.
This has profound implications for the impact of supply and demand in the gilt markets. Essentially, the size of deficits or surpluses should not materially impact the level of interest rates, and instead interest rates are driven by growth and inflation expectations and risk premia. Anecdotal evidence of this can be seen in the historical behaviour of interest rate markets - the largest bond sell-off in modern history occurred in the US in 1994, when the US government was running a surplus, but when inflation was accelerating. Meanwhile, Japan, with a debt/GDP ratio circa 200%, has the lowest interest rates in the world commensurate with its low growth and inflation outlook.
So if QE is not money printing, is unlikely to spur credit growth and has probably not materially impacted the level of interest rates, then what does the BoE think it is doing? Meryvn King and the MPC are knowledgeable and experienced people, but like a doctor faced with a patient with an illness he doesn't understand, the temptation to handout sugar pills, if only in defence of professional mystique, can be enormous. The problem is that many pension schemes and their advisers have been taking the BoE assurances about the impact of QE at face value, changing their investment and contribution policy as a result. We should be rather more sceptical.
Gwion Moore recently left his position as head of investment strategy UK at MN. The views expressed are his own.