Misplaced Faith in Quantitative Easing

A major component of the policy response to the economic crisis in the United States, Japan and Britain has been ‘quantitative easing’. The policy is having very little impact on the real sectors of the economies in question, which should not be surprising given the weakness of the policy’s theoretical underpinnings. But neither is the policy likely to cause excessive inflation, as some of its critics erroneously claim.

The policy of quantitative easing

Quantitative easing involves the central bank buying longer-term financial assets and paying for them by crediting banks’ reserve accounts. This action in itself leaves net financial assets unchanged, but alters their composition, which affects yields and returns.

One effect of the policy is to create an influx of bank reserves. Another effect is to reduce longer term interest rates. By buying longer-term financial assets, the central bank causes the prices of these assets to rise relative to shorter-term asset prices, which brings down longer-term interest rates.

Supporters of quantitative easing believe that the policy will boost lending and private investment. Some critics of the policy fear that it will be hyperinflationary.

Quantitative easing was actually first introduced in Japan almost a decade ago as the economy struggled to recover from the Asian crisis of the late 1990s, so the policy approach has some history prior to the current crisis. The experience of Japan suggests that the policy is neither likely to be stimulatory nor inflationary.

Bill Mitchell provides an in-depth discussion of the Japanese experience:

In the late 1990s, Paul Krugman joined a number of academic economists in urging the Bank of Japan to introduce large-scale quantitative easing to kick start the economy. The Bank, reluctantly, heeded their advice and in 2001 they increased bank reserves from ¥5 trillion to ¥30 trillion. This action had very little impact – real economic activity and asset prices continued their downward spiral and inflation headed below the zero line.

Many economists had also claimed that the huge increase in bank reserves would be inflationary. They were also wrong. …

In this 1998 article on Japan’s trap, Krugman claimed that Japan was “in the dreaded ‘liquidity trap’, in which monetary policy becomes ineffective because you can’t push interest rates below zero”. …

He said that when the nominal interest rate is at zero and therefore stimulatory interest rate adjustments can no longer be made, the real rate of interest that is required to “match saving and investment may well be negative”. …

Krugman [said] that the nation [needed] a dose of expected inflation so that the real interest rate [would become] negative (and flexible).

[H]e was completely wrong in this diagnosis. The only thing that got Japan moving again in the early part of this Century was a dramatic expansion of fiscal policy.

Mitchell’s complete argument can be found here.

The ineffectiveness of quantitative easing

Hopes of quantitative easing being effective appear to be based, in large part, on ‘money multiplier’ reasoning as well as an overly optimistic assessment of the interest-sensitivity of private investment.

According to the traditional money-multiplier model, if the central bank increases bank reserves, this will lead to more lending and a multiplied increase in deposits. If banks are not lending, the reasoning goes, it must be because banks have insufficient reserves.

The main problem with this theory is that banks do not require reserves prior to lending. If there is demand for loans from good credit risks, the banks will extend loans (credit the bank accounts of borrowers). Loans create deposits. Borrowers can subsequently use the loans to consume or productively invest, adding to production and income. If necessary, banks can always acquire reserves at the end of the process, either from other banks or the central bank. The cost of acquiring reserves will be factored into banks’ estimates of loan profitability, but bank lending is not limited by the quantity of reserves.

The reason banks are unwilling to lend during a crisis is that there is insufficient demand for loans from credit-worthy borrowers (in the assessment of the banks). Increasing bank reserves will not do anything to alter this problem. Lending is demand, risk and capital constrained, not reserve constrained.

The hope that lower interest rates will induce higher private investment is not supported by the evidence. The theoretical claim relies on the notion of a well-behaved ‘demand for capital’ function, which was shown to be invalid in the capital debates. Empirical evidence for the claim is also lacking.

Misplaced fears of hyperinflation

While the arguments in favor of quantitative easing do not appear to be convincing, the inflationary fears of some critics are even less so. The fears derive from the ‘quantity theory of money’. This theory is based on a particular interpretation of an accounting identity known as the ‘quantity equation’:


In this identity, M is the quantity of money (defined in this context as currency plus demand deposits), V is the income velocity of money (the number of times a unit of money, on average, circulates in the accounting period), P is the general price level (price index) for the economy as a whole and Y is real output. The identity simply says that the amount of nominal output sold (PY) must equal the quantity of money times the average number of times a unit of money is used in transactions over the period (MV). For example, if the general price level is 1, real output sold is 100 and a unit of money is used in an average of 5 transactions each period, the quantity of money must be 20.

The relationship is true by definition, but in itself says nothing about how the different variables affect each other or what determines each variable. The quantity theory of money relies on particular assumptions: (1) the quantity of money is assumed to be exogenously controlled by the central bank; (2) the velocity of money is assumed to be constant; (3) real output Y is assumed to be ‘fixed’ at the full-employment level in the long run; (4) causation is assumed to run from left to right (i.e. changes in MV are assumed to cause changes in PY).

Given these four assumptions, the theory suggests that if the central bank increases the quantity of money M, the only effect in the long run will be to increase the general price level P. In other words, a monetary expansion causes inflation in the long run, with no effect on real output, which will supposedly gravitate to the full-employment level irrespective of government policy.

The assumptions are unfounded. First, the central bank is incapable of strictly controlling the broader money supply. This is because the broader money supply (currency plus deposits) depends partly on private bank lending, which has an effect on deposits that is largely independent of the central bank’s policy actions. All the central bank can do is control the short-term interest rate (and other interest rates if it wishes) and let the quantity of money vary. This was made very clear in the early 1980s when central banks temporarily tried to put this monetarist theory into practice by controlling the money supply. The attempts failed abysmally and the approach was quickly abandoned in favor of interest-rate targeting.

Second, the velocity of money is not constant. It varies over the economic cycle and can move inversely to the quantity of money. An increase in M may coincide with a reduction in V, leaving MV unchanged. At the onset of the crisis, the velocity of money collapsed. It has remained low, though variable, due to the weakness in economic activity.

Third, the notion that market economies automatically tend to full employment is unsupportable, on both theoretical and empirical grounds. The traditional neoclassical argument (developed prior to Keynes’ General Theory and later work by neoclassical general equilibrium theorists) was that unemployment will be eliminated in the long run through adjustments in wages, interest rates and other prices. The steps of the argument were that: (a) unemployment puts downward pressure on real wages; (b) this results in higher demand for labor and an increase in aggregate employment; (c) the increase in employment results in higher output; and (d) demand adjusts to this higher level of output through price and interest-rate adjustments.

Step (c) of this argument is reasonable. Step (a) is also plausible, although to hold it requires prices not to be falling relative to money wages under conditions of weak demand. However, steps (b) and (d) are based on fallacies of composition (aggregation problems). It is not valid to suppose the existence of a general inverse relationship between real wages and aggregate employment, or between real interest rates and total private investment. Employment and private investment are dependent on conditions in product markets. Lower wages, for instance, have effects on product demands, which then react back on employment. In general, the effects of wage and interest-rate changes at the aggregate level are indeterminate.

Since no automatic tendency to full employment has been established in either theory or practice, it is illegitimate to suppose real output to be ‘fixed’ at the full employment level in the long run. Therefore, if MV increases on the left-hand side of the quantity equation, the corresponding increase in PY on the right-hand side will not necessarily be due to an increase in the price level P. It could instead be due to an increase in real output Y. In fact, whenever there is unemployment and underemployment, higher spending is likely to result in an expansion of output, not a mere increase in prices. There is competitive pressure on firms to respond to increased demand in this way to protect market share. For this purpose, they tend to operate with a planned degree of excess capacity, which enables them to respond to fluctuations in demand without necessarily altering prices.

Fourth, causation does not necessarily run from money to prices (i.e. from MV to PY). It is probably the reverse. Nominal output PY reflects the level of economic activity, which influences the demand for loans from credit-worthy borrowers. Banks then extend loans accordingly, altering the amount of deposits and the quantity of money M.

To sum up, in the identity MV = PY, quantity theorists suppose M to be directly controllable by the central bank (which it isn’t), Y to be at the full-employment level (which it usually isn’t), V to be constant (which it isn’t), and causality to run from money to prices (which it probably doesn’t).

Claims of quantitative easing being hyperinflationary are therefore unfounded. The policy does not result in an expansion of loans, and so cannot cause spending that tests the supply limits of the economy. Even if it could succeed in boosting lending and expenditure, the primary effect under conditions of high unemployment and underutilization of productive capacity would be an increase in real output to meet the greater demand. Price effects, if any, would be secondary.