COST Action IS0902: Systemic Risks, Financial Crises and Credit
Questioning Policy Effectiveness: Quantitative Easing
They’re at it again. Last October the US Federal Open Market Committee announced it “is prepared to provide additional accommodation if needed”. This means ‘quantitative easing’, or QE. Indeed, under QE2, the US Federal Reserve committed to buying $600 billion of Treasuries between November 2010 and the end of this month. So far, the QE2 program positively disappointed and the markets have been buzzing with speculations about ‘QE3’. In these circumstances, it is news that in Tuesday’s speech on the U.S. economic outlook, Mr Bernanke did not mention QE3. But many expect he may still do.
The QE idea is simple. With deflationary fears building and the federal funds rate between zero and a quarter of a per cent, not much more can be done with the price of money. So why not try influencing the quantity directly? The Federal Reserve would buy financial assets off banks, and in paying the banks is thought to put money into the economy, boosting spending and (hopefully) avoiding deflation. During the latest QE experiment, in Britain from March 2009 to February 2010, Charlie Bean, Deputy Governor of the Bank of England, explained on the Bank of England web site that “quantitative easing aims to increase money spending”.
It will not work. Despite its popularity, QE is based on a misunderstanding. Banks are thought to multiply their central bank reserves into loans to the economy. In this causal scheme, expanding banks’ deposit with the central bank (their reserves) will lead to growth of the public’s deposits with banks. This ’fractional reserve banking’ theory seems to be supported by the fact that in normal times, bank loans and reserves tend to move together, so that the ratio is indeed fairly stable.
The problem is that the loan-reserves ratio is a number that can always be constructed ex post, but not therefore a causal determinant of bank lending. Increases in reserves are the result of increases in bank lending, not the other way round. Any bank short of reserves because it increased its bank lending will seek to buy reserves from another bank. If the banks in aggregate are short, the central bank will accommodate the demand. To start with increasing reserves is to reverse the sequence, which is not possible. QE is akin to pushing on a string.
QE is a metaphor for the central bank increasing the banks’ account balances with the Fed. However, what needs to happen in order to put money into the economy is that banks increase the public’s bank account balances - banks need to increase their lending, and the public must be willing to borrow more. Academic research has long recognized that money growth happens endogenously within the economy, between banks and the public - not exogenously, by policy interventions from outside. There is nothing to stop the central bank from multiplying reserves, but this by itself will not multiply lending.
And this is precisely what we observe.. In recent research*, we found that British loans and reserves moved together in the years prior to the 2009-2010 QE experiment.. But when British reserve balances quadrupled from £39.4 bn in February 2009 to £156.4 bn in February 2010, the total amount of outstanding loans remained flat (at £2,110 bn at the start of QE in March 2009 and £2,233 bn at its end). QE failed to increase lending in Britain in 2009-2010 just as it had failed in Japan in 2001-2006. Although this was clear from the figures already last March, the Bank of England admitted the failure only implicitly last week, when Mr Bean went on television to implore savers to spend more. This should not have been necessary, had QE worked and increased money spending as Mr Bean expected in 2009.
Instead, what we see is ‘Goodhart’s Law’ in action - the principle proposed by young Charles Goodhart in 1975 that ‘any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes’. QE proponents confuse correlation with causality. Loans and reserves tend to develop proportionally—until policymakers mistake this statistical regularity for causality, and purposely boost reserves. Then it is revealed that reserves do not and never did cause loans in a systematic fashion.
What are the lessons? Banks do not lend Central Bank money to the public, but their own money, by creating a liability on themselves. Money is not a thing to be pumped into the system from outside, in order to unclog the credit pipelines. Money consists of accounting relationships, and they come in different sorts that are not simply interchangeable. Reserve balances, for instance, are not money balances. Unless we want to have a realistic look at the accounting relationships that make up our financial system, we will remain clueless about effective monetary policies.
Dirk Bezemer is a fellow at the economics and business department of the University of Groningen in the Netherlands. Geoffrey Gardiner is a Former Manager in the Financial Services Division of the Barclays Group.
* ‘Innocent Frauds Meet Goodhart’s Law in Monetary Policy’, Levy Institute Working Paper.
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Replies to This Discussion
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Permalink Reply by Manuel Wäckerle on -
thank you very much Dirk for starting a discussion on QE with such a great post!
I have a corresponding question regarding this issue:
Isn't it even more problematic that the FED will introduce QE3 (expanding the reserves again) and at the same is holding the greatest extent of US debt now, instead of China? What about the currency and international trade in this respect? Consequences must be tremendous to the US economy or is there any fiscal way out?
best wishes,
manuel
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Permalink Reply by Dirk Bezemer on
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Hi Manuel,
QE2 was probably behind the commodity price spike but did little (nothing?) to increase transactions in the real economy of profit and wages. Indeed QE3 will be equally ineffective and equally adding to instability in commodity and (generally) asset markets.
However, the problem is not the US fiscal or debt or trade position. Any $ debts the US has it can service (in principle) by just creating the dollars. There is no need for fiscal measures in order to do that. And the US $ rate is set more by investor sentiments on the money markets than by QE. The amount of $ sloshing around the world is vastly larger than the 600 bn created in QE2. As long as demand for dollars remains strong e.g. because investors see the US as a safe heaven the exchange rate won't suffer.
This is different from the UK, where QE in 2009-2010 had a marked effet on the exchange rate.
It is also different from Euroland, which will not engage in QE because it believes debt is bad. That is also the reason Euroland - the ECB that is - will not take on the debts of governments, although historically that is the very raison d'etre of central banks. Euroland prefers to deflate its economies rather than deflate the financial sector.
The US debt (e.g. the treasuries held by China) is already so large they cannot repay it and we all know it. Repayment is not the purpose of US debt. The US emitting debt provides the world with the liquidity to conduct their transactions which, after all, are denominated in dollars. Remember, after Bretton Woods (post 1973, that is), we have a dollar-standard world financial system but without any constraint on dollar creation (under Bretton Woods, the constraint was parity to gold). So in order to supply the world econonomy with money ($), the US HAS to be in deficit and accumulate debt. That's the way it was set up.
Of course, ultimately this is a Ponzi game as it must, with mathematical certainty, end. But the problem is not QE or other single debt spree the US has gone on. The problem is systematic. It has worked, in a way, for nearly 40 years, but it won't for another 40. And it has cost us very dearly in terms of crises and productivity loss.
The least of the problems is debt held by the Fed - that is debt the Fed holds against itself. It can be written off with the stroke of a pen, without affecting anyone else's balance sheets.
best wishes,
Dirk
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Permalink Reply by Neil Lancastle on -
Dirk,
I agree broadly with your analysis, but not your conclusion that it can continue indefinitely. The US dollar has been declining as a reserve currency, particularly among emerging and developing countries. Obama has finally recognised that he needs to grow the economy out of recession. The recent credit downgrade will push up the cost of borrowing and weaken the dollar, exacerbating the trend.
What about Europe? Despite Eurozone GDP being almost as high as the US, the Euro has failed to make an impact as a reserve currency. Data from the IMF shows the Euro at about 15% of official reserves, compared to about 50% for the US dollar, yet the economies are a similar size. The central banks of developed countries are behind the curve in diversifying from the US dollar.
Neil
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Permalink Reply by Dirk Bezemer on
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Neil, thanks for engaging. Of course, in the real world nothin continues indefinetely. If others lose trust in the Dollar, that's the end. My point was that the US can always repay its debt, contrary to what the 'deficit terrorists' claim. The real question is - will others still want to accept it?
There is a simple reason why the Euro is not a major reserve currency: Euroland is in surplus. The country that emits reserves into the world economy does so by running a deficit. Euroland doesn't do that so cannot grow into being the major reserve supplier. Trade and finance are linked.
best wishes,
Dirk
Neil Lancastle said:Dirk,
I agree broadly with your analysis, but not your conclusion that it can continue indefinitely. The US dollar has been declining as a reserve currency, particularly among emerging and developing countries. Obama has finally recognised that he needs to grow the economy out of recession. The recent credit downgrade will push up the cost of borrowing and weaken the dollar, exacerbating the trend.
What about Europe? Despite Eurozone GDP being almost as high as the US, the Euro has failed to make an impact as a reserve currency. Data from the IMF shows the Euro at about 15% of official reserves, compared to about 50% for the US dollar, yet the economies are a similar size. The central banks of developed countries are behind the curve in diversifying from the US dollar.
Neil
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Permalink Reply by Neil Lancastle on
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Dirk,
Thanks for the reply. Yes, Euroland is in surplus but other central banks can still buy Euroland debt as a reserve holding. Central banks do not have to buy US Treasuries. They can let their currencies appreciate, rather than sterilise US trade receipts. They can divert surplus reserves into other currencies and asset classes through sovereign wealth funds.
Euroland, on average, has a debt to GDP ratio of 80% compared with 100% in the US. Yet Euroland has much higher tax rates, at about 40%, so in theory could afford higher public investment.
Neil
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Permalink Reply by Dirk Bezemer on
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What would the other central banks pay with, when they buy Euroland debt?
Dirk
Neil Lancastle said:Dirk,
Thanks for the reply. Yes, Euroland is in surplus but other central banks can still buy Euroland debt as a reserve holding. Central banks do not have to buy US Treasuries. They can let their currencies appreciate, rather than sterilise US trade receipts. They can divert surplus reserves into other currencies and asset classes through sovereign wealth funds.
Euroland, on average, has a debt to GDP ratio of 80% compared with 100% in the US. Yet Euroland has much higher tax rates, at about 40%, so in theory could afford higher public investment.
Neil
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Permalink Reply by Neil Lancastle on
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Hi Dirk,
That's a good question. If they sold US Treasuries to buy Euroland debt, then the US would reduce it's external liabilities and that would hurt developing and emerging markets who also hold US Treasuries. Since the Fed has signalled further buying of US Treasuries (QE3), an alternative might be for the Fed and ECB to agree a Euro-USD swap line. Then excess liquidity flows to Europe rather than create inflationary pressures in developing and emerging economies.
That requires Europe to accept greater fiscal union and a public-spending stimulus. In the long-run, both currencies weaken but the gains are public and not private.
Neil
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Permalink Reply by Dirk Bezemer on
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We were exploring what it means to have Euros as a reserve currency. My point was that one of the thing it means is that Euroland must run a deficit. Otherwise no one can acquire the Euros that are supposed to become the 'money of the world'.
To suggest that without the Eurozone emitting Euroes (=be in deficit), Eurodebt can still be sold aginast US liabilties is not an option when the Euro is a reserve currency. Why would the sellers of Euroland debt accept US treasuries any more than they would be willing to accept Norwegian treasuries? Why would Euope want excess US liquidity to flow into it unless the $ is stil a useful reserve currency?
The only reason they accept it now is because the $ is the global reserve currency. With the Euro replacing the $, that motive for holding US debt vanishes.
So we're back to square one: Euroland must run a deficit in roder to give the rest of the world the money to conduct global transactions with.
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Permalink Reply by Neil Lancastle on
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Hi Dirk,
I agree with you that Euroland could run a greater deficit. This would boost the economy and stimulate global demand. The same is true of public spending in many emerging and developing countries. I disagree that this requires a net surplus, though. There can be a net surplus if private sector inflows exceed public sector outflows, and most governments run a deficit.
But why should increasing global liquidity be via private banks in the US (and UK)? Stiglitz, and a few others, have criticised QE for 'creating havoc around the world' because the resulting capital flows are from developed to developing countries. If we took a post-Keynesian perspective, the Fed would buy US Treasury bills and sell SDRs. Those SDR IOUs would be perfectly acceptable collateral for global US banks.
If the Fed offer a swap line to other central banks, the result is not unlike that post-Keynesian ideal. The composition of the swap basket is determined by central banks that want to sell US Treasury bills. Increasing global liquidity becomes a public good, not a private one, and countries can choose to partake or not depending whether they want a fiscal stimulus. The US can pursue domestic macroeconomic policies without fear of contagion, and the central banks (eg: China) get to swap US T bills for more stable SDRs/currency baskets without private sector arbitrage.
Am I just being a utopian post-Keynesian? I would welcome your comments.
Neil
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Permalink Reply by Dirk Bezemer on
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I meant a TRADE deficit not a budget deficit - sorry to be so imprecise. Euroland running a trade deficit means Euros are emitted into the rest of the world (RoW) as it buys goods from Euroland. Running a budget deficit would stimulate Euroland bit would still leave the question of how those Euros get into the hands of others - not, if RoW buys more rather than less from a budget-stimulated Euroland.
This need for RoW purchasing power in your own currency was precisely the reason the US came up with the Marshall Plan. It lent dollars to Europe and recycled them back into the US by exporting, rebuilding Europe and capturing Europe's markets in the process. With European markets matured, the process was repeated globally. The reversal was in the 1970 when America went off gold, turned net importer and lost the need to recycle what it could now freely create.
Please explain your idea. Why would the Fed buy Tbills which it (well, the Treasury) can emit at no cost? Why would banks hold SDRs - how do we know they are less risky or higher returns than bills?
Neil Lancastle said:Hi Dirk,
I agree with you that Euroland could run a greater deficit. This would boost the economy and stimulate global demand. The same is true of public spending in many emerging and developing countries. I disagree that this requires a net surplus, though. There can be a net surplus if private sector inflows exceed public sector outflows, and most governments run a deficit.
But why should increasing global liquidity be via private banks in the US (and UK)? Stiglitz, and a few others, have criticised QE for 'creating havoc around the world' because the resulting capital flows are from developed to developing countries. If we took a post-Keynesian perspective, the Fed would buy US Treasury bills and sell SDRs. Those SDR IOUs would be perfectly acceptable collateral for global US banks.
If the Fed offer a swap line to other central banks, the result is not unlike that post-Keynesian ideal. The composition of the swap basket is determined by central banks that want to sell US Treasury bills. Increasing global liquidity becomes a public good, not a private one, and countries can choose to partake or not depending whether they want a fiscal stimulus. The US can pursue domestic macroeconomic policies without fear of contagion, and the central banks (eg: China) get to swap US T bills for more stable SDRs/currency baskets without private sector arbitrage.
Am I just being a utopian post-Keynesian? I would welcome your comments.
Neil
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Permalink Reply by Neil Lancastle on
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Hi Dirk,
The incentive for central banks is that they can co-ordinate monetary policy globally.
If the Fed emits currency baskets in return for T Bills, it has T Bill reserves that it can use for domestic monetary easing.
Other countries have two incentives to participate. They might seek monetary expansion, such as Europe adding Euros to the basket. Or they might seek monetary contraction, such as China adding US dollars to the basket. So each basket would be different, and domestic central banks would underwrite their part of the basket (not the Fed).
Keynes was adamant that SDRs should not be publicly traded, but you can assume a shadow market would be created and why shouldn't a currency basket be better collateral, with several central banks behind it? Most central banks accept other forms of collateral these days, so why not accept private debt that matches your assets?
It is utopian, not least because central banks would no longer be able to take unilateral action. It was interesting yesterday, though, that China said they would buy European debt, the ECB wanted T Bills that China has in surplus, yet co-ordinated action was between Europe, the UK and US. How is that stabilising?
Best,
Neil
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Permalink Reply by Neil Lancastle on
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Hi Dirk,
You are right, it seems flawed. The US (or any country wanting to loosen monetary policy) would need to underwite the SDRs they issue. There is no incentive for a weak currency to do that. Like you, I am troubled by the notion of QE3: it props up the banks but at what cost?
Neil
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