Duncan’s Economic Blog

Quantitative Easing Failing?

Posted in Uncategorized by duncanseconomicblog on September 2, 2009

A few months back, in a post that became something of a magnum opus I wrote that:

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.

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.

I’m starting to fear that I am correct. Despite an enlarged QE programme yesterday’s monetary data release from the BOE made for grim reading.

Figures from the Bank of England show that outstanding loans to companies and individuals declined at a record pace in July, in a worrying sign for the prospects of economic recovery. Moreover, private non-financial corporations – which form the backbone of the nation’s economy – paid down £8.4bn of debt during the month. That represented a 1.7 per cent overall drop in their bank credit and the largest decline since records began in 1997

Households showed no more propensity to spend; net lending to individuals fell by £600m to just over £1,450bn, the first net repayment of consumer loans since records started in 1993. The weak level of lending came as loans secured against property and consumer credit both declined by record amounts.

As the FT notes:

A brighter message emerged from a key measure of the money supply, seen as a gauge of the success of the Bank’s efforts to boost supply through so-called quantitative easing.

The underlying M4 money supply, which includes notes, coins and deposits at banks but excludes volatile deposits from within some parts of the financial sector, grew by 0.6 per cent in July, and at an annualised 5.3 per cent pace over the three months to July, data from the Bank showed on Tuesday. That is a faster growth rate than earlier this year.

 To which I’m inclined to say… so what? Back in April I wrote that:

I’d argue further that money supply in and of itself is not the crucial variable – the crucial variable is credit, i.e. lending. It is lending that drives economic activity not money. Economists have focused on money for a long time. For decades this was reasonable. As most credit came from banks, money growth was a decent proxy for credit growth. As deposits (money) grew, and the liability side of the banks’ balance sheets expanded, credit also grew (the asset side of the banks’ balance sheets).

This cozy relationship though may no longer hold. The growth of ‘other credit providers’ – specialist mortgage lenders, credit card companies, car finance, store cards, the shadow banking system, etc – might have caused this relationship to break down. So money supply might soar with little impact on inflation or activity. Or banks might want to reduce their loan to deposit ratio from 130% to 100% (or even 90%) – again money supply (deposits) could soar with no growth in lending and hence little impact on activity. Mechanical monetarism doesn’t work.

This is what we are now seeing. QE is succeeding in driving the money supply higher but having little impact on credit. And it’s credit that is the vital variable.

With the banking system still broken, the transmission mechanism of monetary policy is still impaired. Fiscal policy must come to the fore.


8 Responses

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  1. John Ross said, on September 2, 2009 at 9:17 am

    Good analysis and good last sentence but it raises the issue of what should be the content of the fiscal policy?
    I assume that a priority to tax cuts is not meant – as that would be no guarantee of increased demand as I am fairly sure the current blog would agree with.
    If it is an issue of maintaining government spending should this be on consumption or investment? It is evidently necessary to maintain consumption demand including by fiscal measures but UK investment is in a state of freefall – the largest decline since records began. A similar pattern is occurring in the US. The decline in investment is much worse than the consumption fall.
    The evident need is for the state to step in with major investment programmes – in the UK that means particularly in housing and transport where the declines are biggest. But that would run counter to the dogma that the state must always be subordinate to the private sector and not ‘compete’ with it. Therefore, unless that dogma is broken from investment is likely to continue sharply declining. Fiscal action aimed only at sustaining or raising consumption would not deal with this issue of very sharply falling investment.
    Therefore what would is this blog’s author’s comments on the outline content of the required fiscal policy?

    • duncanseconomicblog said, on September 2, 2009 at 10:02 am

      For me two factors are crucial – (i) what gets the most ‘bang for the buck’ and (ii) what is the most useful in the long term?

      In both cases is investment scores well. As you’ve argued before investment is the key to long term growth. In the short run though, it also scores well.

      In the US the multiplier of different fiscal policy alternatives has been estimated as follows:

      Tax Cuts

      Nonrefundable Lump-Sum Tax Rebate 1.02
      Refundable Lump-Sum Tax Rebate 1.26

      Temporary Tax Cuts

      Payroll Tax Holiday 1.29
      Across the Board Tax Cut 1.03
      Accelerated Depreciation 0.27

      Permanent Tax Cuts

      Extend Alternative Minimum Tax Patch 0.48
      Make Bush Income Tax Cuts Permanent 0.29
      Make Dividend and Capital Gains Tax Cuts Permanent 0.37
      Cut Corporate Tax Rate 0.30

      Spending Increases

      Extend Unemployment Insurance Benefits 1.64
      Temporarily Increase Food Stamps 1.73
      Issue General Aid to State Governments 1.36
      Increase Infrastructure Spending 1.59

      Given this I stick to what I advocated before the last budget:

      In other words, actual spending on ‘stuff’ is generally a more effective way at stimulating the economy then simply giving people money. The Bush tax rebate of last year pretty much failed despite the praise it picked up from the right here. This is not to say we shouldn’t have any tax cut/benefit increases, but they should not be the majority of the package. I’d argue to go one third tax cuts/benefit increases broadly aimed at those most likely to spend, i.e. those that save the least. So raise pensions, raise IB, raise JSA, raise tax credits.

      In addition consider raising the personal allowance for all income tax payers. Even if this money is saved that is still, to an extent, helpful. If all of this money was saved or used to pay down personal debt then it would be a simple transfer of debt in the economy away from households and onto the public balance sheet. The public balance sheet will mean less credit risk and hence lower interest payments.

      I’d also argue that tax cuts aimed at businesses have not generally succeeded in the past. The level of corporation tax does not make a difference if you are not making profits.

      But two thirds of any package should take the form of direct government infrastructure spending, aimed at keeping people in work. Preventing unemployment rising should be the explicit aim of the budget. Only by slowing down the rate of job losses will we slow down the rate of economic decline. Someone more stable in their employment prospects is more likely to keep spending.

      So let’s build some stuff. Schools and hospitals, more social housing, transport infrastructure – anything. I hear there is a prison shortage, right let’s build some more. I would like to see Alistair Darling ask every local authority in the country to come out with a lost of ‘shovel ready’ projects on which work can begin within weeks.

      I do agree that we need to be more aggressive in arguing for an expanded role for the State.

  2. dannyboy said, on September 2, 2009 at 10:10 am

    Duncan, what about charging a fee on excess bank reserves like they do in sweden (-0.25%)? There seems to be a rumour that Mervyn King is hinting about following the swedish lead.

    • duncanseconomicblog said, on September 2, 2009 at 10:24 am


      It’s certainly worth looking at.

      What I really wish though is that UKFI (our holding company that essentially owns Lloyds and RBS) would start acting like an owner.

      In the end though monetary policy won’t work until the banking system is functioning again. And that won’t happen until legacy asets are properly cleared up. I now worry we are in a situation whereby every quarter will see yet more write downs of bad assets. A Japanese style situation where credit is broken for a decade or more.

      Force them to take the write downs now and nationalise any with insufficent capital to cover it. Swedish (early 90s) style.

  3. dannyboy said, on September 2, 2009 at 11:00 am

    Duncan, while I’m in agreement with the above, i do wonder what you mean by ‘when the banking system is functioning again’? It’s going to be a long time before that happens and then this (from the FT a while back):

    “The International Monetary Fund estimates that among the Group of 20 nations whose leaders meet in London today, the industrialised members will have increased their national debts by an average equivalent to nearly 25 per cent of gross domestic product between 2007 and 2014. That is a heavy burden. But, to 2050, the cost of this crisis will be no more than 5 per cent of the financial impact they face from the ageing of their citizenry. As the IMF says, “in spite of the large fiscal costs of the crisis, the major threat to long-term fiscal solvency is still represented, at least in advanced countries, by unfavourable demographic trends””

    Leaving aside the issues of how weak ongoing consumer demand is going to be once both consumer credit and short term consumption stimulus are removed (behind which wage arbitrage continues to lurk) the demographics of the next 20-30 years plus the pension black hole call into question both whether bank led/private demand led money supply expansion is a reasonable expectation for the future under _any_ circumstances, and whether fiscal demand can realistically substitue for private demand given all of the above -but perhaps you take a neo-chartalist view on the latter?

    • duncanseconomicblog said, on September 2, 2009 at 11:14 am


      I agree it could be a long time before we fix the system – especially as we appear to lack the political will to force through write downs.

      I agree on the demographic timebomb in the West – the development of Japan (and then Germany) will have to be closely watched for clues as to how best to respond.

      Also on the longer term I have occassional worries about peak oil.

      I’m not quite a neo-chartalist but I do have a lot of time for monetary circuit theories and Steve Keen’s work.

  4. dannyboy said, on September 2, 2009 at 11:33 am

    Yes, it will be interesting to see what the japanese do, especially now with the DPJ in charge. They must be nearing the endgame of attempting to prop up the status quo with monetary and fiscal boondoggles. I do question how much of japans failure to re-inflate was due to bad policy and how much is simply due to demographics.

    On the demographic front, the UN does predict does it not, that world aggregate population growth would be negative by 2025 (early scenario) or by 2050 (medium scenario). I think a baby bust is a likely outcome over the next 10 years so the early scenario seems plausible.

    I can’t see how an economy can be kept inflated by demand led bank lending when the population is falling, and the populations of potential export markets are also falling. I think we need to be working towards a solution that will support output under protracted contractionary conditions. Debate about this last point seems entirely absent from economic discourse on both left and right.

  5. […] It may mean, as Duncan argued, that it may be failing. […]

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