Quantitative easing has done its bit
TWO weeks ago, the European Central Bank announced a big increase in quantitative easing. The Bank of England and the US Fed, of course, have stopped QE but the effects of previous programmes continue in the system. As many have urged, it is high time to take stock. During and after the financial crisis of 2007-09, QE made a huge contribution to stabilising the financial markets, helping to bring about economic recovery.
But once recovery had been secured, what more QE achieved is questionable. And there have been some undesirable consequences. So, as with everything else in economics, the verdict is a matter of balance - of deciding when the minuses outweigh the pluses.Under QE, the central bank buys financial assets in the markets (usually government bonds) with money that it issues itself, thereby increasing both sides of its balance-sheet. In practice, hardly any extra notes are printed. Rather, the extra money is created electronically.But since deposits at the central bank are interchangeable with notes, to describe this as "printing money" is acceptable shorthand. This policy sounds extraordinary, and perhaps even foolhardy.
But it has featured in standard economics textbooks for generations (under the name Open Market Operations). Moreover, it was advocated not only by John Maynard Keynes, but also by Milton Friedman. Mind you, there are limits to what it can achieve, and it is not for all seasons.But every so often the monetary system breaks down in a spectacular fashion. When that happens, the real sources of prosperity - hard work, investment and technological progress - are as nothing against the tsunami of monetary collapse. That's when printing money comes in.
In the Great Depression in the US in the 1930s, output fell by 30 per cent and unemployment soared to 25 per cent. The money supply contracted by 25 per cent.Although different schools of thought argue about the precise cause, all agree that the monetary contraction played a huge role. At the time, the US Federal Reserve did little to stop this process. Indeed, it probably exacerbated it.
By contrast, after 2008-09, what could have been a re-run of the Great Depression was stopped in its tracks by much lower interest rates and QE.
The Great Recession's fall in output was minor compared to the 1930s: only 4 per cent to 5 per cent.Some critics accept that without the intervention of the central banks there would have been an economic collapse, but they argue this would have been a good thing. A system purged of bad practices and bad institutions would have been healthier when the economy recovered.
Yet it wasn't obvious that the collapse of the 1930s provided a beneficial purge. In Germany, it led to the rise of Hitler. And in the US, the misery of the soup kitchens was only overcome towards the end of the decade once war production raised aggregate demand.Other critics argue that the recovery created by QE is only temporary and that the system will either succumb to a burst of hyper-inflation or fall into a new crisis under the impact of the financial distortions created by QE. But much higher inflation is not the inevitable consequence of all this money creation.
The policy can be put into reverse, as the central banks can offload the bonds they have bought. Equally, they can impose reserve requirements on the banks to absorb excess cash and they can raise interest rates.The example of Zimbabwe, which printed boatloads of money and succumbed to hyper-inflation, is not a case of QE gone wrong. It was the result of government incompetence in being unable to raise sufficient taxes to cover expenditure on a gross scale and resorting to money printing to cover the gap.In fact, when the monetary crisis is over and yet the monetary system remains severely impaired, it is questionable whether buying government bonds, which are themselves liquid and supposedly of unimpeachable credit quality, with liquid deposits at the central bank will do very much at all.
It may just be irrelevant. In principle, of course, it may help one country by depreciating its exchange rate. But even that channel didn't appear to work for the ECB. And, of course, currency depreciation is not a solution for everyone.As to the distortions created by QE, they are certainly there. There is currently a quasi-bubble in government bonds.