In the US, the Fed has just commenced another round of quantitative easing. This is despite the absence of any evidence to suggest that previous implementations of the policy – in Japan, the UK or the US – have had any significant impact on demand, output and employment. At the same time, some critics of quantitative easing claim that the policy will be inflationary. But this claim also defies both theoretical considerations and the empirical evidence. The policy is not inflationary, just impotent.
The Fed’s decision to persist with the policy probably says more about the neo-liberal distaste for discretionary fiscal policy than any confidence that QE2 will be more successful than its predecessor.
An earlier discussion of quantitative easing can be found here. The policy involves the Fed purchasing longer term bonds and paying for them by crediting the reserve accounts of the commercial banks.
Since quantitative easing simply swaps one type of asset for another, it does not alter the net financial assets of the non-government sector in any significant way. It merely alters their composition. There is no significant boost to the purchasing power of the non-government sector as a whole. The sector has less bonds but more cash (bank reserves). Strictly speaking, the sector has relinquished higher interest earning bonds for lower interest earning reserves (reducing purchasing power), but sold them at a price somewhat higher as a result of the Fed’s action (increasing purchasing power). Overall, there may be some minor purchasing power effect, but only a very small one, and the direction of the effect is unclear.
There is little reason to believe that this alteration in the composition of the non-government sector’s net financial assets will encourage greater spending in the real economy. Prior to the quantitative easing, individual holders of the bonds were perfectly at liberty to exchange their bonds for cash to make expenditures if they had so desired. They didn’t want to spend on real goods and services, so had no reason to convert to cash. Under quantitative easing, they became willing to convert to cash, but it was not because they wanted to spend but because the Fed had pushed up the price of longer term bonds, making some non-government sector participants willing to alter the composition of their savings, but not necessarily the level of their savings.
For quantitative easing to have a positive impact on aggregate demand, and hence potentially cause inflation if and when the economy’s productive capacity is reached, the policy would need to induce a change in the saving behavior of the non-government sector. Assuming this is the intention of the policy, the Fed might conceivably be relying on one or other of the following mechanisms:
(i) The expansion of reserves inducing greater lending and a multiplied increase in bank deposits (this is actually a false hope and not one that modern central bankers appear to believe in but worth dispelling because the flawed idea remains ubiquitous in textbooks);
(ii) A reduction of longer term interest rates stimulating aggregate demand through a positive impact on private productive investment;
(iii) Perceived wealth effects stimulating aggregate demand.
Mechanism (i) is the fictitious ‘money multiplier’ effect, which rests on the false premise that banks need sufficient reserves prior to lending. By this reasoning, the expansion of bank reserves associated with quantitative easing supposedly gives commercial banks more capacity to extend loans.
But this is not how banking in the current system works. Banks do not require prior reserves in order to make loans. They require credit-worthy borrowers (and sufficient capital). They need to see that the prospective borrower has a realistic prospect of repaying the loan. If the bank considers the borrower a good risk, it will extend the loan by crediting a bank account. In this way, the loan creates a new deposit: loans create deposits, not the other way round. If at the end of the day the bank is short of reserves, it simply borrows them from another bank with excess reserves, or, if the banking system as a whole is in deficit (for example, because tax payments exceeded government expenditure over the period), the bank borrows the necessary reserves from the Fed. For a simple explanation of this point, see this post.
In assessing loan applications, the bank (assuming sufficient capitalization) will focus on the credit-worthiness of the loan applicant. If the prospective borrower is a firm, the firm’s intended productive investment will need to appear sufficiently profitable to earn for the firm more than the interest owed on the loan. If the prospective borrower is a household (most commonly someone wanting to take out a mortgage on a home), the household will need to demonstrate to the satisfaction of the bank its capacity to earn sufficient income, primarily through employment, to repay the loan.
What matters in assessing the loan application is the credit-worthiness of the prospective borrower in the estimation of the bank. The bank’s assessment is influenced by the general economic situation. Lending requirements have tightened because general economic prospects are poor. Banks can’t be sure of household members retaining their jobs or finding new jobs and can’t be confident of future demand conditions in firms’ product markets.
Now, in aggregate, quantitative easing does nothing to alter the credit-worthiness of borrowers. As was mentioned at the outset, it causes no (or very little) alteration in the net financial assets of the non-government sector. The non-government sector has relinquished some bonds (a decrease in net financial assets) in exchange for bank reserves (an increase in net financial assets). The purchasing power and capacity to service debt of the non-government sector has, in aggregate, remained more or less unchanged.
Further, the sellers of the bonds were, by definition, bondholders, and the bonds came from that part of their income designated for saving, not spending. So they have switched their form of saving from bonds to cash to the extent that they participated in the Fed’s operation. Unless these people now decide that they want to save less and spend more, there will be no effect on the broader money supply. All that happens is that the reserves of the commercial banks mount. There is no impetus for the extra reserves to be lent out for productive purposes. They will just sit in the banks’ accounts with the Fed. And this is what has been happening.
As long as the net financial assets of the non-government sector remain unchanged, the only hope for a stimulus to aggregate demand is through an alteration in the saving (and spending) plans of the non-government sector. If this sector suddenly decided it wanted to spend more and save less, there would be more demand. But there is a reason the non-government sector is saving so much. The sector over-extended itself in the lead up to the crisis, becoming highly indebted under the false perception that real estate and Wall Street bubbles represented a real increase in wealth rather than fictitious value. Once these bubbles burst, people lost a lot of nominal wealth but were still stuck with their debt. This is why the non-government sector needs to net save. As a matter of accounting, the government must run deficits if this net saving is to occur.
So there is no reason to expect an expansion of bank reserves to induce an increase in private lending and a multiplied expansion of the broader money supply. But, just for the sake of argument, it may be instructive to suppose – contrary to operational reality, logic, and empirical evidence – that the expansion of reserves did somehow result in more loans and a multiplied expansion of the broader money supply, and consider whether this would be inflationary. The answer is that it would not be inflationary unless and until the debt-financed expenditures tested the supply-limits of the economy. Any demand – whether government, private or external – can cause inflation if the economy is pressing up against its supply limits. But when there is high unemployment and excess capacity, competition compels firms to respond to increased demand through expansion of output and employment at current prices. Otherwise the firm will miss out on potential sales and lose market share. If we are frightened of the inflationary effect of an expansion of loans to fund domestic private expenditure, then by the same logic we should be frightened of an expansion of export demand. If the level of economic activity was such that an increase in demand will be inflationary, then an increase in any form of demand will be inflationary. But this is not at all a danger when there is mass unemployment and excess capacity. And if and when it became a danger, due to a strong and sustained rise in demand that tested the supply limits of the economy, the Fed – since we have assumed in this paragraph for sake of argument that this tremendous boom has grown out of the Fed’s strategy of quantitative easing – would merely need to reverse its operation by selling back longer term bonds in exchange for bank reserves. By the same logic, this contraction in reserves would induce a multiplied contraction in private lending and broader money.
But that last paragraph was just for the sake of argument and its premise is actually a complete fiction. The expansion of reserves achieved through quantitative easing has no such positive impact on private lending and aggregate demand, and therefore poses no inflation risk, even potentially as an indirect boost to aggregate demand.
Private Investment and Interest Rates
Another hope of the Fed may be that reducing longer term interest rates will stimulate private investment and aggregate demand. Such an effect relies on a highly unreliable transmission mechanism. First, other components of aggregate demand may be dampened even if private investment is stimulated, leaving the overall effects on aggregate demand uncertain. Most notably, lower long-term interest rates reduce the interest income of savers who will reduce consumption in accordance with their saving plans. Second, the supposed inverse relationship between private investment and longer term interest rates ignores the revenue side. Although lower interest rates reduce the cost of borrowing, weak demand conditions in product markets depress revenue and profit expectations. Third, the alleged inverse relationship between private investment and longer term interest rates has been shown not to hold on logical grounds. This is a chief lesson of the capital debates.
There are some signs that mainstream policymakers increasingly understand the unreliability or invalidity of effects (i) and (ii). With this in mind, some people think the Fed is pinning its hopes on a third effect.
The Fed may be hoping that another Wall Street bubble will create a (fictitious) wealth effect that might stimulate demand. That is, if the non-government sector, in aggregate, feels wealthier in response to another Wall Street bubble, it may be lulled into taking on more debt in order to spend more and kickstart the real economy. There is little evidence that the quantitative easing to date has produced a wealth effect. Even if it could, it would be a foolish use of policy, because any boost to demand achieved in this way would be unsustainable due to the heavy indebtedness of the non-government.
The bottom line is that the private sector cannot sustainably lead the economy out of a balance-sheet recession. If policymakers want the private sector to drive recovery, they need to arrange for an orderly cancellation and/or significant write down of private debts. This would reduce the need for non-government net saving and free up income for private expenditures.
If, on the other hand, policymakers want to prevent creditors from taking losses, as appears to be the case, then there is only one viable solution: strong and sustained fiscal stimulus targeted directly at the real economy.
Monetary policy is ineffective in a balance-sheet recession. Banks will not extend loans to poor credit risks.
Fiscal policy targeted at job creation is more effective. Large and sustained budget deficits aimed at employment creation result in higher income and enable non-government net saving to repair balance sheets alongside stronger demand conditions. Once balance sheets are in better shape, the non-government sector will be in a position to drive economic activity, and banks will be more willing to lend.