05 March 2009

Say Hello to Quantitative Easing (long but worthwhile)

..or "printing money" as it's called in the media, which is not completely accurate, but close.

Today the Bank of England lowered interest rates to 0.5% - almost the practical minimum (a negative interest rate doesn't make a lot of sense, although as commercial banks don't normally lend at base rate but something above base rate (quite a lot above base rate at the present time), I guess you could have a negative base rate but maintain a positive interest rate for lenders in the real economy.)

But the interest rate cuts seem to be doing very little to reflate the UK economy (although they are drastically reducing the amount of savings in the UK, which raises the question - where are all these withdrawn savings going? Under mattresses) so the B of E is going to use quantitative easing (hereafter known as QE) to expand money supply directly.

What the B of E will do is to buy up bonds (probably some mixture of corporate and government bonds) with money it has created out of thin air. This expands the amount of money in the economy whilst reducing the supply of bonds. The idea behind QE is that the addition to the money supply makes banks more likely to lend money.

Will this work? It depends crucially on whether the factor limiting bank lending at the moment is a lack of availability of funds to lend. I would argue that it isn't - they have already had billions of pounds of bailout money injected to lend with. The main factor inhibiting bank lending is that banks think they will make a loss on any funds lent out because the economic situation is looking so grim. QE is not going to change that. So it's not going to reflate the economy.

Having said that, QE may have a role to play in preventing a very bad situation getting even worse. That's because it should prevent deflation (i.e. general falls in the price level) by expanding the money supply. Deflation is bad news because it makes consumers less willing to spend - because things are likely to be cheaper in future, so you might as well save your money now (even if you've got it under a mattress!) and buy later. This removes more demand from the economy and can depress the economy still further.

QE directly increases the money supply and so should increase the price level. This is not a cast-iron relationship but the basic 'quantity theory of money' is an accounting identity which states:

M x V = P x Q

where M is the money supply, V is the rate at which money changes hands in the economy (on average), P is the price level, and Q is the real volume of transactions (e.g. real output).

Now, QE clearly increases the money supply. So will it increase P? It depends on Q and V. Assume that Q - real output - at least isn't lowered by QE more than it would otherwise be falling. In that case everything depends on V. If banks just sit on the extra money created by QE that could decrease V and offset the increase in M, leaving P unchanged. But a full offset is unlikely. Therefore, increased M should feed through to P.

However, as the monetarists discovered in the 1980s, there is a catch. The previous paragraph assumes that M can be clearly and uniquely identified as a quantity, which just isn't the case. M isn't just notes and coins in circulation. Equally important in M, if not more so, is 'wide' money - what used to be called "M3" and "M5" in the days of monetarism in the 1980s - which includes the supply of credit and various liquid assets (indeed, 'credit creation' is really 'wide money creation'). The 'credit crunch' has massively reduced the supply of 'wide money'. So QE will only have an impact on 'wide M' (as opposed to 'narrow M') if it gets the banks lending again - which, as I indicated earlier, doesn't seem that likely to me. Having said that, the direct impact of increasing narrow M should be enough to avoid deflation in itself if pursued vigorously enough.

(An interesting side issue here is that the impact of deflation on spending only occurs because money can be held as cash, which by definition has a zero nominal change in value over time. If cash was abolished and the government decreed that we had to have our money in various types of bank account, the interest rate on which could go negative, then the incentive to hoard money in deflationary periods would disappear.)

So the overall verdict is that QE looks a bit dodgy. What's the alternative? Well, the basic problem is that banks don't want to lend. So take 'em over and MAKE them lend! It's all about restoring confidence - at (metaphorical) gunpoint if necessary. But the govt doesn't have the willpower to nationalise large chunks of the financial sector - so we're left with the current mess. Expect little or no impact on the real economy from QE - meanwhile, zombie banks continue to drag us all down with them...

1 comment:

giroscoper said...

An article in yesterday's Telegraph features various analysts from Fathom Consulting and Capital Economics expressing much the same concerns as in my post.