Duncan’s Economic Blog

Quantitative Easing II – Why I’m worried

Posted in Uncategorized by duncanseconomicblog on September 30, 2010

In both the UK and the US, monetary policy makers tip-toeing towards a second round of quantitative easing, already dubbed QE2.

In as much as George Osborne has a “plan B” for the UK, this is it – continue to cut spending and hope that Merv and the MPC will take up the slack by printing more cash to stimulate demand.

I am deeply concerned by this strategy.

In April last year, as QE 1 began I wrote a long post setting out my views on the money, credit and the likely impact of the policy, a policy that really was a leap in the dark.

I was half right. QE did have relatively little effect on the actual real economy. 

I suspect, given my views on credit, that the bank lending channel is one of the more important ways that monetary policy effects the economy. I also suspect that the bank lending channel is currently blocked. If I am right, QE will see an extra £75bn pumped into the economy (as gilts are taken out and cash put in through central bank purchases) and, probably, a £75bn rise in the money supply. The worry is that this will have little effect on the actual economy.

However I was also complacent.

So, should we try QE? Of course. Either it works and provides a stimulus that prevents, or lessens, a slide into deflation or it doesn’t and nothing happens. Either way it does not cause hyper inflation as some seem to suggest.

I entirely (a big failure) neglected to consider the effects on asset prices. In my defence I was working as a fund manager at the time – I had watched the near implosion of the global financial system from a ringside seat and was all too aware of what has happening in the economy, in the banking system and in the wider markets. I convinced myself that against such a backdrop, surely a bout of money printing wouldn’t lead to an asset price boom? Surely fund managers wouldn’t committ money to equity markets whilst the real ecoomy remained on life support? Surely banks, in  midst of a the burstng of a real estate bubble, won’t start lending against still over-valued property again?

I was wrong.

By the October of 2009 I was concerned

For all the talk of green shoots, we still have rising unemployment and collapsing investment levels. What little ‘growth’ we are seeing is  the result of companies rebuilding inventories (which will be temporary in the absence of private sector final demand) and government spending.

And yet despite this, asset prices are rising. House prices are up 3 months in a row. The FTSE 100 has rallied a massive 46% since March.

Now as someone who works in fund management, maybe I should just keep quiet and be thankful. Rising asset prices are good for my clients and good for me.

But I do have to question what is causing this?  Irrational exuberance on the likely strength of any recovery?  A side effect of quantitative easing? Future inflation worries? An excess of global liquidity, which is simply being used to purchase assets rather than help the real economy?

The economy needs to be rebalanced. But not in way that favours holders of assets over the real economy. This is raising serious questions about the manner in QE is pursued, something I shall return to in a further post this week.

I returned to the topic with another post in which I advocated using QE to finance a new National Investment Corporation.

Let’s be clear about what’s happening here. The original intention of QE was to increase the amount of money circulating in the economy and bank lending. This isn’t really working (with the important caveat that things would probably be even worse without QE). So now QE is aiming to prop up the economy via the mechanism of raising asset prices.

This allows corporates to issue bonds cheaper (in effect borrowing money whilst side stepping the banks). It also allows companies to re-capitalise themselves by issuing fresh equity cheaper. Both of these effects are helpful.

But a deliberate central bank policy to raise asset prices also poses questions. What are the distributional effects of this policy? Again let’s be clear, the policy of the Bank is to raise the raise the price of assets – this necessarily favours the wealthy over the poor and increases inequality.

For how long can asset prices be artificially supported? Do we risk a new bubble?

Economically how does this policy help the economy re-balance, how does it help small and medium sized businesses that can’t access the equity or corporate bond markets?

I’m a long term supporter of  policy of low interests to encourage investment. (See this very long post if especially intersted).

But I didn’t quite grasp back in April last year was quite how powerful finance capital could be. This is a them I have since turned to several times. Beginning here and more throughly set out here

A deliberate policy of low interest rates, aiming to increase the volume of financial capital and fund the ‘green stimulus’ that we desperately need, is achievable. But simply giving money to finance capitalists – essentially the current policy of quantitative easing – will achieve nothing more than supporting asset prices. What is called for is Keynes’s ‘somewhat comprehensive socialisation of investment’, with the ultimate goal of the ‘euthanasia of the rentier’. A social democratic economy requires that finance is challenged directly.

And this is why I’m worried – we are about to do it all over again – hand over billions of pounds to finance capital and keep out fingers crossed that some of it leaks into the real economy.

I’ve got a long essay in Renewal on this topic (here, but not free online – you should all read Renewal though, it’s excellent). I’ll finish with an extract from it:

A Tale of Two Economies

Perhaps the most vivid example of the decoupling of physical and financial capital identified by Keynes can be found in the period from March 2009 until March 2010, the year of quantitative easing. The Bank of England’s decision to essentially print £200 billion of electronic money and inject it directly into the financial system by buying government bonds from banks.

            During that year lending by UK banks, themselves the recipients of much of the £200 billion, to financial companies rose by £81.0 billion whilst lending to non-financial firms contracted by £21.4 billion pounds, whilst the financial sector found itself with ample liquidity, the real economy was starved of credit.

The results were striking. Unemployment, by the International Labour Organisation definition, rose from 7.3 per cent to 7.7 per cent – an extra 200,000 people out of work. Business investment, the primary driver of future prosperity, fell by 7.7 per cent. Industrial production recovered by a modest 0.6 per cent. The real economy struggled forward in March 2009 – March 2010 with sluggish growth, falling investment and rising unemployment.

In the financial sector things were very different. The FTSE 100 index of leading shares rose by a staggering 44.7 per cent. House prices (as measured by Halifax) rose by 5.5 per cent. Bonuses returned, with an estimated payout of £6 billion to staff, up from £4 billion in 2008.

Although a temporary tax was charged on bank payrolls (raising £2.5 billion pounds) little attempt was made to ensure that the £200 billion of ‘new money’, created by the State, found its way into the real economy. Gordon Brown announced the creation of a new National Investment Corporation in his 2009 conference speech although nothing of substance emerged from this. Even nominally state-controlled RBS continued to make excessive payouts to staff in the ‘Global Markets’ division. In short little attempt was made to challenge the power of finance capital, despite the mess it had made of the economy and the near universal public distaste for bankers evident throughout 2008-2010.


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17 Responses

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  1. Luis Enrique said, on September 30, 2010 at 2:02 pm

    If the money ends up getting spent on shares, whoever originally owned those shares gets the money… where does the money go? Assets cannot soak up cash, because every purchase is matched by sale.

    I think you are essentially questioning whether an increase in the monetary base will lead to an increase in the money supply and, at least as 1st year macro has it, unless the money gets stuffed in mattresses, the only way that can happen is for banks to increase their cash reserves. So is that what you are predicting? I’m not sure where all the stuff about financial capital comes in.

    Banks and investors want to hold assets. QE takes some assets off the table and increase the quantity of cash looking for a home, which I guess inevitably pushes up other asset prices, but as it does so it’ll reduce expected returns on them and make the returns from doing things like lending to businesses look relatively more attractive won’t it? That is, once accumulating cash in reserves stops being the most attractive use.

    have you read Nick Rowe of Worthwhile Canadian Fame on QE? he has interesting ideas about the bank buying risky assets… can’t find right link at the mo.
    NB if you think QE stopped things being worse than they would otherwise have been, I don’t see why you don’t say QE worked.

    • duncanseconomicblog said, on September 30, 2010 at 2:10 pm

      Hi Luis,

      As a first point, I think standard macro theory has very little to say about the bank lending channel of monetary policy and it was this channel that QE was originally aiming to use.

      It’s also interesting that by Autumn last year policy makers (at the BOE) were discussing QE as a policy of increasing asset prices.

      “If the money ends up getting spent on shares, whoever originally owned those shares gets the money… where does the money go? Assets cannot soak up cash, because every purchase is matched by sale.”

      But new money can push up asset prices by increasing demand without increasing supply.

      “I think you are essentially questioning whether an increase in the monetary base will lead to an increase in the money supply and, at least as 1st year macro has it, unless the money gets stuffed in mattresses, the only way that can happen is for banks to increase their cash reserves. So is that what you are predicting? I’m not sure where all the stuff about financial capital comes in. “

      Basically yes – the finance capital comes in when you look at what happened to bank lending in March 2009 to 2010, look what the banks choose to do with it.

      “Banks and investors want to hold assets. QE takes some assets off the table and increase the quantity of cash looking for a home, which I guess inevitably pushes up other asset prices, but as it does so it’ll reduce expected returns on them and make the returns from doing things like lending to businesses look relatively more attractive won’t it? That is, once accumulating cash in reserves stops being the most attractive use.”

      Again, yes. But two points – it can take an awful long time for cash reserves to stop being the most attractive and… the effects on he wider economy (in terms of increased inequality from rising asset prices) have to be considered.

      “if you think QE stopped things being worse than they would otherwise have been, I don’t see why you don’t say QE worked.”

      I think it could have worked a lot better if coupled with tougher financial reform.

      Would be interested to read Rowe.

  2. Luis Enrique said, on September 30, 2010 at 2:41 pm

    Thanks Duncan.

    Possibly talking at cross purposes – I thought you were saying that pushing up asset prices stopped money getting into the real economy, as if assets soaked up cash. As we agree, QE pushes up asset prices… but that doesn’t entail the foregoing.

    “it can take an awful long time for cash reserves to stop being the most attractive” … maybe so, but that’s an argument for QE not against it, because QE fills up those reserves much more quickly than sitting there collecting on loans but not making new ones (which is what i thought we wanted to avoid).

    on the bank lending channel:

    http://d-squareddigest.blogspot.com/2010/02/probably-most-important-thing-you-wont.html

    • duncanseconomicblog said, on September 30, 2010 at 4:19 pm

      Excellent link!

      Would you support using QE created money for direct investment in the economy? (Posen is edging towards this I think).

      • Luis Enrique said, on September 30, 2010 at 5:24 pm

        this is where I feel my understanding of economics is too shaky to offer much more than a “I don’t know”.

        you’re talking about, I think, QE financed fiscal policy (I presume the government would – directly or via state owned bank – be the instrument of this investment). Now I’ve read some people wondering why we don’t help ourselves to a bit of QE financed government expenditure (here: http://www.voxeu.org/index.php?q=node/5449 )
        but the worry at the back of my mind when it comes to financing investment is over how to drain the money out of the economy again when it becomes necessary. QE is a one-off (or series of discrete) hits, whereas are you talking about sustained flows for QE financed investment?

        Setting aside worries about how good the government would be at directing investment (I give those worries a non-zero but not necessarily a ‘deal breaker’ weight) I’m not sure whether there are any additional problems that might arise from financing investment via QE. Would be interested to read anything you might find on these questions.

        Perhaps because government finances are all one big pot, if we decide to monetize some government debt, investment if financed out of the big pot, it doesn’t even make much sense to say “this is finance by QE”? So once QE has been and gone, might the govt leave itself saddled with an ongoing finance commitment?

        NB one of the things Nick Rowe talks about is QE buying risky assets of the sort where if things turn out bad, the central bank just wears the lost and the money is not drained out the economy, and if things turn out good, the CB sells the assets thereby removing the money once it’s done its work. I think.

        • Alex said, on October 5, 2010 at 9:34 am

          Do we need to look at different channels for getting the QE into the circular flow? As well as a big-project NIC, could we perhaps do something with credit unions or similar?

          • duncanseconomicblog said, on October 5, 2010 at 11:24 am

            If there was an easy way, or even a slightly difficult way!, to get the money into credit unions, I’d be very interested.

    • vimothy said, on October 5, 2010 at 11:22 am

      Like the author of that blog post says, this is all very cut and dried and (should be) obvious. But I’m confused–if you accept it, how can you also expect QE to “work”?

      • duncanseconomicblog said, on October 5, 2010 at 11:25 am

        Vimothy,
        I accept that raising asset prices (esp bonds and equities) can help the real economy.

        I just think there are far better ways to achieve this outcome.

        • vimothy said, on October 5, 2010 at 12:17 pm

          Sorry, Duncan–it’s not clear from the way wordpress has displayed my comment, but i was trying to respond to Luis. In particular, I disagree that increasing the volume of excess reserves will increase bank lending. It doesn’t matter what 1st year macro says. Banks do not lend out reserves and they do not make lendng decisions based on the banking sector’s aggregate reserve position. Otherwise, why aren’t we still targeting the monetary aggregates? The reason we are not is that we tried it and it doesn’t work. Reserves are settlement balances. The government will always ensure that there are enough aggregate reserves such that the payments system can function smoothly, given its base rate target. They are not relevant for anything else. The real target of QE was always the wealth channel.

          • vimothy said, on October 5, 2010 at 12:22 pm

            If you want to increase lending then you need to inject capital into the banking system, not payment and settlement balances (i.e. “cash”). If you want to inject money into the economy, then you need to spend directly into the economy, not deposit settlement balances in the banking sector, where they sit, unneeded and unused.

          • Luis Enrique said, on October 7, 2010 at 10:28 am

            I’m confused.

            I think I agree with the “bank lending channel critique” that you can’t push lending by increasing reserves. But I’m not entirely sure amounts to saying that there’s nothing QE can do to shift the supply of credit.

            Why aren’t the banks lending so much? Is it solely because loan demand and quality of would-be borrowers is low, or has supply shifted too?

            Do you (vimothy) give no credence to the story that banks aren’t lending because they are trying to accumulate cash or any supply orientated explanation?

            Perhaps my confusion stems from not really understanding/knowing whether banks are trying to accumulate cash reserves (which is money owned by depositors – a liability from bank’s p.o.v) or whether they are trying to increase their equity cushion – i.e. retain more profits. (I’m not even sure I’ve described this correctly, so if you know the more accurate terms, please translate…).

            After all, even if you buy the story that banks can lend at will don’t lend out of deposits (i.e. you don’t buy the 1st year macro story) does that amount to saying there’s never a situation in which banks are “trying to build up cash reserves”? If it does happen that banks go through periods of trying to build up cash reserves, doesn’t that have any implications for the supply of loans and the effectiveness of QE?

            Or, if it’s all about trying to rebuild equity, doesn’t QE do anything with respect to that?

  3. dannyboy said, on September 30, 2010 at 4:45 pm

    isn’t the whole point that other non financial assets have higher carrying costs than government bonds?

    what is needed is a way to get those sat on large piles of cash to use it to increase their consumption. The point is if they just re-invest it it can’t possibly help anybody.

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  5. Tyler said, on October 7, 2010 at 5:58 am

    QE was partly done to lower interest rates, but also partly done to fund the Labour government’s massive deficit through a crisis and just before a general election.

    The lending to the private sector QE was supposed to spur was never going to happen – banks are still obliged to hold a similar amount of Tier 1 capital, and with their balance sheets under pressure any positive effect QE was going to have on them went more towards repair than renew.

  6. Luis Enrique said, on October 7, 2010 at 12:22 pm

    here’s a related post … bank lending turning the corner in the US?

    http://www.creditwritedowns.com/2010/10/is-bank-lending-on-the-cusp-of-increasing-in-the-us.html

    what this tells us about QE in the UK, I don’t know.

  7. […] less convinced by Cable’s calls for more QE (without radical reform) and don’t see the logic at all of Osborne’s reported desire to cut the 50p […]


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