QE, the expectations fairy and other bedtime stories
There are perhaps more myths about QE than almost any other monetary policy instrument. Here are five of the most pernicious QE myths:
Myth 1: QE raises inflation. Despite the considerable evidence that it does nothing of the kind, people still persistently believe that it does – that “eventually” inflation will come. This is because of the widespread misrepresentation of QE as “printing money”. Numerous people have painstakingly explained what QE is and how it works, but inflationistas aren’t listening. To them, QE is printing money, and everyone knows that printing money causes inflation. (That isn’t necessarily true either, but as I said, they aren’t listening). An alternative view proposes that because QE props asset prices, eventually the increase in asset values would feed through into an increase in the money supply as asset holders take profits and spend the proceeds, increasing inflation. This is perhaps more reasonable, but again there is little evidence to support this.
Myth 2: QE stimulates the economy by forcing banks to lend. This is based on the idea that if you throw money at banks they will lend. But banks only lend if the risk versus return profile is in their favour. At the moment banks don’t want to lend, because their balance sheets are a mess. QE increases reserves, but it does little to repair bank balance sheets. No amount of excess reserves will force damaged banks with weak balance sheets to lend.
Myth 3: QE stimulates the economy by persuading corporates to invest. This is similar to Myth 2. It is based on the idea that if you make borrowing ridiculously cheap for corporates (i.e. throw money at them) they will invest. But corporates only borrow to invest if the risk versus return profile is in their favour. At the moment they don’t want to invest, because the economic outlook is very uncertain and profitable investment opportunities look few. They are very happy to borrow to refinance debt or to buy back equity – but that doesn’t help employment or incomes. I should make it clear, too, that this only applies to larger corporates that have access to the capital markets. Small and medium-size businesses are much more dependent on bank lending, and they are living in a financial desert – see Myth 2.
Myth 4: QE encourages households to increase spending. This is by means of the “wealth effect”, whereby people who have assets that are increasing in value feel wealthier so spend more. Why the esteemed economists in charge of central banks seem incapable of understanding that having illiquid assets (such as houses) that are increasing in value doesn’t make people who are income-dependent spend more is beyond me. Furthermore, NO amount of propping up asset prices will compensate for downward pressure on wages due to poor economic performance, or for benefit cuts and tax rises from austere fiscal policy. Nor will it compensate for reduction in the real incomes of people living on income from savings – which is certainly an effect of low interest rates and possibly also of QE. When ordinary people find their incomes being squeezed they cut spending, even if their houses are increasing in value. When ordinary people find their savings for their old age being eroded by low interest rates they save more, not less. Why these esteemed economists, not to mention the politicians designing fiscal policy, don’t understand this is a mystery. Maybe they are all so wealthy that income-dependence is a foreign concept to them.
Myth 5: QE debases the currency. Whether this is seen as a positive effect depends on your viewpoint: devaluing the currency is supposed to help exports, but hard-money enthusiasts are appalled at the very idea of debasing the currency – they regard it as theft (I saw an article recently that described QE as the modern equivalent of coin-clipping). Actually there is very little evidence that QE has significant effects on the value of the currency – indeed as it doesn’t raise inflation it is highly unlikely that it debases the currency. Though as a recent article at VOX pointed out, when a large part of a country’s GDP is made up of global industry, devaluing the currency has little effect on exports, because exports are dependent on imports. The idea that devaluing the currency always helps exports is another of those economic myths, it seems.
When the transmission mechanisms of bank lending and corporate investment are not working properly, QE does not reach the wider economy in any particularly helpful way, as I’ve explained elsewhere. But people – especially economists and politicians – believe that somehow it does, or it will, eventually. The Expectations Fairy will wave her magic wand and all these things will come to be.
When central banks do QE, inflation expectations rise: this is shown by higher bond yields at the start of QE programmes, usually coupled with a rise in the price of gold. As the programme continues and inflation fails to appear, expectations moderate, bond yields fall back and the price of gold collapses. We have seen this effect most recently in Japan: high inflation expectations at the start of the Bank of Japan’s current QE programme have now fallen back to where they were in early April, the currency has recovered its value and asset prices have fallen. Not one QE programme has ever generated significant inflation. Not one. In fact no central bank in history has ever succeeded in deliberately creating inflation. And yet every time there is QE, inflation expectations rise. It’s magical thinking.
Those who believe that QE achieves its effects through raising inflation point to index-linked bond spreads (which are a measure of inflation EXPECTATIONS) as evidence that QE works. But expectations and reality are not the same thing. Just because markets EXPECT inflation doesn’t mean it is going to happen. Frankly, since the reason markets expect inflation is based on a misunderstanding of QE and its effects, it would be amazing if expectations did turn into reality.
Inflation expectations from active QE are illogical enough. But now we are seeing even greater illogicality. The Fed starts to talk about tapering off QE. And TIPS yields rise – considerably. So it seems that talking about NOT doing QE also raises inflation expectations. There seems to be some kind of belief that when the Fed stops doing QE all the excess reserves will leak out into the economy and cause inflation. Why, for goodness’ sake? The banks are in no better shape than they were before (and reserves aren’t “lent out” anyway). Yes, there could be a huge credit bubble – but as we saw in the mid-2000s, that can happen just as easily when there aren’t excess reserves. And as corporates are not much more positive than they were before, and household incomes are no higher than they were before, and unemployment is still uncomfortably high, where on earth is this credit bubble and inflation going to come from? It’s more magical thinking.
There is zero chance of domestically-generated inflation while wages are falling, contractionary fiscal policy is depressing real incomes, banks are not lending and corporates are failing to invest. Externally-driven inflation is possible, and we are of course seeing inflation in asset prices as a consequence of QE. But the core trend is disinflation in developed countries – I hesitate to say “deflation”, since inflation is still above zero, but core inflation is on a downwards trend in nearly all developed countries. Some people think that the UK is an exception, but I disagree with this: UK CPI is currently distorted by rises in student fees and by above-inflation price rises in privatised utilities that could and should have been prevented by government. Strip out those, and the UK’s core inflation rate is heading for the floor like everyone else’s.
Belief in inflation caused by QE is therefore irrational. So is belief in inflation caused by NOT doing QE. In fact belief in ANY of the myths I describe above is irrational. But markets are responding to central bank signalling on the basis of those myths. More importantly, governments are constructing fiscal policy on the basis of those myths. And this is poisonous.
When banks aren’t lending and corporates aren’t borrowing to invest, QE does not affect the wider economy in any very helpful way: its effects if anything are contractionary, because of the hit to aggregate demand for some groups caused by the depression of interest rates on savings. But politicians construct fiscal policy in the belief that it does. Therefore – in their view – fiscal policy can be directly contractionary, because it will be offset by expansionary monetary policy. The UK’s Chancellor has pursued an austere fiscal programme for the last three years, cutting both out-of-work and in-work benefits, raising taxes and – most unhelpful of all – cutting capital investment to the bone. He has done so (and continues to do so, despite concerns expressed by a number of institutions including the IMF) in the expectation that the Bank of England’s loose monetary policy, including its large QE programme and other initiatives such as extended-term repo and Funding for Lending, will protect the economy from the contractionary effects of fiscal austerity. The Expectations Fairy will wave her magic wand and Gideon will get the economic recovery he desires despite his considerable efforts to prevent it……
Sadly the reality is different. QE and its relatives do not protect the wider economy from the effects of fiscal austerity. There has been a considerable hit to aggregate demand in the UK, firstly due to recession (which as the Institute for Fiscal Studies (IFS) notes has caused significant falls in nominal wages), and secondly due to ill-considered fiscal policy. I have to ask whether, in the absence of supposedly supportive monetary policy, the Chancellor might have adopted a more relaxed approach to fiscal consolidation.
The political situation in the US is different: there, fiscal tightening has occurred more because of political gridlock than deliberate policy. But the effects are much the same. And it is a real pity. The US was doing well: it was the one country that appeared to be getting the balance of monetary and fiscal policy about right – helped by a disintermediated banking system, which improves monetary policy transmission – and it was starting to recover. But then the payroll tax cuts were allowed to expire…and now there is the sequester….It remains to be seen whether the US’s nascent recovery will survive this idiocy. Given the downwards path of US inflation and its stubbornly high unemployment, I am not hopeful.
The most idiotic policies of all have to be in Europe. Though they aren’t doing QE. They are relying on everyone else’s QE to stimulate the Eurozone economy, while screwing down aggregate demand all over the place. I’m not about to advocate QE in the Eurozone – the banking system is severely damaged, so I strongly suspect it would be either ineffective or actually contractionary. But fiscal austerity is doing immense and possibly permanent damage to some Eurozone countries. A better way of revitalising the Eurozone periphery really has to be found.
And then there is Abenomics…..I don’t pretend to understand Japan, but it seems to me that to have any chance of success, monetary and fiscal policy must complement each other. All monetary stimulus is likely to do in a moribund and savings-dominant economy is blow up asset bubbles, which then of course burst spectacularly….. Not that I am necessarily suggesting fiscal stimulus either. The Japanese problems run deeper. Structural fiscal and social reforms are needed – but whether there is the political will to make such changes remains to be seen.
Central bank heads around the world have expressed concern about over-reliance on monetary policy alone to fix economic ills. Mervyn King commented that “there’s a limit to what monetary policy can hope to achieve”, a view echoed by Shirakawa, the former head of the Bank of Japan, in a speech in 2012. Bernanke, in his testimony to Congress’s Joint Economic Committee in October 2011, observed that “Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy.” And the ECB’s Draghi, in an interview with the Financial Times in December 2011, bluntly remarked that “Monetary policy cannot do everything”.
But Shirakawa has already been replaced with Kuroda, who has embarked on a massive QE programme: the Bank of England’s Mervyn King is about to be replaced by Mark Carney, who is known to favour forward guidance (which amounts to greater reliance on the Expectations Fairy): and Bernanke’s term as Fed chief will be up soon, though his replacement has yet to be named. And meanwhile governments in the US, UK and Europe continue their catastrophic fiscal consolidations while praying every day to the Expectations Fairy, who seems to have replaced the Confidence Fairy as the principal policy goddess.
Paul Johnson, Director of the IFS, complained in a recent presentation that the problem with recovery from the 2008 recession is that, unlike the deep recessions of the 1930s and 1980s, there is no clear vision. I disagree with this: I think there is a vision, but it is based upon mistaken economic ideas and is therefore doomed to fail. The 1930s recovery was led by massive housebuilding programmes, and the 1980s recovery by radical supply-side reforms. In contrast, the main feature of the years since 2008, after a brief period of fiscal stimulus early on, is fiscal consolidation coupled with what the UK’s Chancellor terms “monetary activism”. The last five years have seen what the FT describes as the “largest economic experiment in history”. And the results are stagnant economies, falling real incomes, increasing insecurity and uncertainty for the majority of people (especially the young), and a catastrophic drop in both private and public sector investment in many developed countries. The “vision” is an illusion. That is why there is no lasting recovery.
The Expectations Fairy is no more real than the Confidence Fairy, the Inflation Monster or the Bond Vigilantes. It is time for all of them to be consigned to the realm of mythology, and for monetary and fiscal policy to be grounded firmly in reality and redirected towards achieving the best quality of life for ordinary people.
Inflation, deflation and QE – Coppola Comment
There’s a problem with the transmission – Coppola Comment
Why do large movements in exchange rates have small effects on international prices? – Amiti, Itskhoki & Konings (Vox)
Stock markets and money creation – Euronomist Blog
Unwinding Quantitative Easing – Grenville (Vox)
Bernanke kills Fed credibility and the Confidence Fairy in one shot – Naked Capitalism
Slaying the inflation monster – Coppola Comment
Britain has never been through a recession like this before – Paul Johnson, IFS