Guest Post: What’s Wrong With Quantitative Easing?
Submitted by David Howden via the Ludwig von Mises Institute of Canada,
Since the crisis erupted in 2008, the new buzzwords in central banking have been “quantitative easing”. The Federal Reserve embarked on a series of them, with the most recent one colloquially termed QE? to denote the open-ended nature of its latest venture. The venerable Bank of England has been a guilty belligerent. The Europeans under the sway of the ECB, itself created in the shadows of inflation-fighting German Bundesbankers, has increased its foray into this new untested policy with every new Euro-crisis. Japan, where the term was originally coined earlier in the 2000s, has been the guiltiest party and its new era of “Abenomics” promises to continue with this innovation.
Quantitative Easing, despite a fancy name, is not a complicated process. While some use it as an analogy for printing money, this is a little disingenuous.
The vast majority of monetary policies by a central bank are aimed at increasing the money supply. This can either be done by increasing the currency in circulation (i.e., printing money), or by creating electronic book-keeping entries. The latter is the primary result of the quantitative easings of the past five years, and has resulted in the large increases in reserves that many have commented on elsewhere.
From the central bank’s point of view, it doesn’t matter much if the increase in the money supply is in the form of electronic reserve or currency in circulation. It accounts for each in the same way – as a liability on its balance sheet.
The real action with quantitative easing is on the asset side of the central bank’s balance sheet. As we can see below, the central banks of the U.S.A., U.K., and Eurozone have all exploded since 2008, and especially over the past year.
Central banks increase the money supply by purchasing an asset from a financial institution. The payment for this asset increases the amount of money in circulation (either by directly increasing the currency in circulation, or by creating a larger reserve balance for the bank that sold the central bank the asset in question). The more assets the central bank buys, the more the money supply will increase by.
Many commentators have warned that the growth in “central bank balance sheets” over the past five years is worrisome. By this they mean that central banks purchasing more assets is somehow potentially destabilizing.
The fact of the matter is, QE policies are really not so different from how central banks functioned back in the “old-normal” days of the earlier 2000s. They still just bought an asset and paid for it by increasing the money supply.
One critical difference is that in order to increase the money supply by as much as they did, the central banks of the world had to change the scope of assets they were willing to buy. In the United States, for example, the Fed commenced purchasing lower quality federal agency debt (Freddie Mac and Fannie Mae bonds), and then eventually also mortgage-backed securities.
Herein lays the rub. By expanding its range of acceptable assets, the Fed created a market for these assets that did not exist. As a result it maintained their prices above which the market deemed necessary to clear – an essential occurrence in market economies.
Consider what would have happened if the Fed had not purchased Freddie Mac, Fannie Mae and mortgage-backed securities throughout the crisis. The prices on these assets would have fallen, as would the profitability of dealing in them. As a consequence, housing prices would have decreased to clear the excess inventory while the financial sector would have shrunk in size as it lost profitability from one of its previously high-flying components – mortgage debt.
To partake in a counterfactual, the usual man on the street would have seen housing prices fall to reasonable levels so that he could afford to buy a home again (Toronto, Vancouver and Montreal homeowners take note). The much bemoaned “too big to fail” financial sector would have been brought down a notch to a size that was consistent with what consumers want.
Instead, by expanding its asset purchases through quantitative easing policies, the effects we see are unreasonable prices among some financial assets, and a housing sector unable to sell its unsold inventory.
Much as this outcome seems completely ridiculous, it is no different than the outcome we always had under central banking. Instead of propping up the financial sector, however, central banks supported the government.
“Regular” monetary policy always purchased government bonds as the offsetting transaction in monetary policy. With a large, ready and willing buyer of government bonds, interest rates on these securities fell below what they would otherwise be, and gave the government a free lunch. With lower interest rates, governments could spend more than they otherwise would and incur more debt to pay for the services they provided.
Today we have a situation where government debt is worrisome. It didn’t come from nowhere, and a large part came into being because central banks previously proved to be hungry customers to buy it.
When commentators point out that the quantitative easing policies of central banks today are harming the average Joe and enriching some preferred bankers’ pockets, they would do well to keep it in perspective. This is what central banks the world over have been doing for centuries. The only difference is that it used to be governments that were aided, and the over-indebted problems we see today are a direct result of such policies in the past.
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