In October 2016 I was asked to give a talk on “What’s Wrong with QE?” to an anti-fractional-reserve-banking organization called Positive Money. I have split my findings on what’s wrong with QE into two sections: fundamental flaws with the theory behind QE, and practical problems with implementing QE.
 
Flaws with the theory behind QE
 
There are a multitude of flaws with the theory behind QE. Three important ones are that QE provides diminishing marginal utility, it decreases a country’s exchange rate, and it assumes that confidence in the program is unfaltering.
 
1. Why does QE provide diminishing marginal utility?
 
David Rosenberg, Chief Economist and Strategist at Gulskin Sheff, summarized why QE provides diminishing marginal utility in the U.S.. All of the arguments cited below apply to virtually any central bank that utilizes QE as a means of economic recovery.
 

1. Credit growth remains anemic despite massive rounds of QE. My reasoning behind this is that perhaps, at the initial stages of QE, those investors who were hesitant to borrow were galvanized by the low interest rates into borrowing; with more and more rounds of QE, fewer and fewer people borrowed as they had already done so in the past. At this stage, where the sheer volume of investors is no longer high enough to allow banks to make a profit, the extremely low interest rate dissuades banks from lending entirely; interest rates would have to be higher to compensate for diminishing volume of borrowers to allow banks to make a profit.
2. The “wealth effect” people feel with an influx of money is only permanent if the influx of money itself is permanent. With the UK, talks about winding down the QE program largely dissuaded investment. Thus, increased mentions about winding QE down was met with diminishing utility with QE - people felt poorer and poorer the more winding down was mentioned.

 
2. What is the relationship between QE and exchange rates?
 

1. A change in the yield due to the increased supply of money in an economy results in a depreciation of the exchange rate to maintain the yield. This is summarized in the chart below.

It is important to note that none of these figures is factually accurate. These figures were simply imputed to simplify the explanation of the relationship between the exchange rate and the yield. In fact, by definition, the interest rate during QE is much closer to 0% than it is to 1%. Having the interest rate at 1% means this is expansionary monetary policy. Still, we consider 1% to be the interest rate during QE for ease of explanation.
 
Assume that, before the QE program is implemented, a U.S. investor wants to invest $1 in U.K. government bonds. This process takes a few steps.

1. In Year 0, he exchanges $1 for £1.
2. He invests £1 in government bonds
3. In Year 1, he has £1.02
4. Assuming the exchange rate hasn’t fluctuated, he exchanges £1.02 for $1.02. Thus, his yield is 2% - he has earned 2% over the course of the year.

 
Now, assume that after the QE program is implemented, a U.S. investor wants to invest $1 in U.K. government bonds. For this to happen, he must expect the same yield; otherwise, he will not bother investing. During QE in the U.K., the interest rate has decreased to 1%. To maintain a 2% yield, the interest rate must increase by about 1%. This is why:
 
Assume the interest rate has changed by x%. The investor ultimately wants to make £1.02 from a £1 investment, i.e. a 2% yield. However, the interest rate in the U.K. is only 1%, i.e. the investor will only get $1.01 in Year 1 if he puts in $1 in Year 0. The extra $0.01 must then be made because of an exchange rate change.
 
In other words, $1.01 must now be worth £1.02 to maintain the same yield, i.e. $1.01=£1.02, or $1=£1.01.
 
Why is this a problem? After all, wouldn’t this increase exports and decrease imports, thus improving trade balance? Yes; however, other economies are likely to start a currency war to make their own exports competitive again.
 
In fact, the other problem with different exchange rates globally is that it allows for something called carry trade, a phenomenon in which an investor will borrow money from a country with a low exchange rate and invest in a country with a high exchange rate, pocketing the difference for himself.
 
3. Why is it wrong to assume that confidence in the program is unfaltering?
 
Confidence in the markets differ as different stages of QE are implemented. This one is rather self-explanatory. Depending on how international investors interpret statements made by central banks, it may lead to capital flight or rapid capital influx.
 
Practical problems with implementing QE
 

1. QE encourages risky investment. Investing in government bonds itself don’t provide a high enough yield. Investors are forced to turn to riskier investments if they want to enjoy higher returns. Ultimately, it starts to sound like a situation that’s very similar to a pre-financial crisis situation: bad investments and risky behavior begets a financial crash.
2. Banks find it hard to make any type of profit given the extremely low interest rates, and are somewhat dissuaded from lending. This defeats the purpose of QE entirely, where the aim is to encourage banks to lend by influxing the banks with printed cash.
3. At some stage, central banks might have to start buying other assets such as corporate bonds and even equity shares. This leads to a severe distortion in financial prices and distorts the playing field.
4. Asset prices increase as a result of QE for two main reasons: First, the increase in money supply for individuals must be put into something. Assets are usually a good bet due to their relative stability. Second, the low prices of assets means that people are encouraged to hold them for longer - after all, why not buy a house if the interest rate is practically 0%?

 
If not QE, then what?
 
Before discussing alternate monetary policy measures, it’s important to revisit the question, “what’s wrong with QE?”. One interpretation might be that this question is genuinely asking about the failures behind QE, some of which have been noted down already. The other interpretation of the question is a more challenging one - “what, exactly, is it that’s wrong with QE?”. Both questions are equally as important. While it is important to recognize the drawbacks of QE, it is equally as important to keep in mind that QE was the saving grace in many economies, especially the U.S.. Just because it poses problems like diminishing marginal utility now, does not mean that the same problems existed at the beginning of the program. Most economists are in consensus that QE is necessary for struggling developed economies. Without it, their economies would be suffering far past what we could imagine.

What alternatives do we have to QE? There are many, but the one most worth mentioning is helicopter money, in which there is increased collaboration between a government and a central bank to target money supply very directly. More about helicopter money will be posted soon.

Synopsis: A look at Japan’s economy and a discussion about how best to improve it

​Click here to read the original article.

Discussion:

This article discusses the ways in which Japan could improve its economic situation, chiefly through fiscal and monetary policy.

Krugman highlights aspects of the Japanese economy that are encouraging: “Output per working-age adult has grown faster than in the United States since around 2000, and at this point the 25-year growth rates look similar”, and “… Japan is closer to potential output than we are”. Nevertheless, Japan is struggling to escape from deflation. Why has Abenomics not worked as well as people hoped?
​
The main ideas in his article are best portrayed through a flow chart:

1. According to Krugman, the two biggest issues are Japan’s over-reliance on fiscal expansion (which leads to a high debt-to-GDP ratio) and its chronic deflation. Fiscal consolidation may be called for to balance the debt-to-GDP ratio and to reduce Japan’s reliance on fiscal expansion, but Japan has no way of offsetting the effects of fiscal consolidation through QE; after all, the interest rates are already as low as can be.

2. It follows that one of the only solutions is to raise inflation such that real interest rates fall. This way, QE can happen alongside fiscal retrenchment. Krugman adds as a side note that raising inflation would also reduce the value of debt.

Krugman describes how Japan may be facing a negative Wicksellian rate (explained under ‘key terms’) as a permanent condition. He points out that even if the Bank of Japan were to promise greater QE, it is ultimately consumer expectations of future inflation that will determine inflation (more about this will be explained under ‘context’).

Krugman’s solution is to combine monetary policy with a burst in fiscal stimulus. The fiscal stimulus will raise the inflation, and the increase in inflation leaves room for more QE. Only when more QE is enacted can fiscal consolidation occur, which would cut down the debt-to-GDP ratio.
The question, then, is how high should inflation be? While the answer does not have a certain numerical value currently (i.e. it has to be high enough to allow QE to occur), it is clear that Japan’s 2% inflation is not enough.

Krugman emphasizes the problem of fiscal consolidation alone: it may cause an economy slump, in which case Abenomics may be beyond redemption. He says that the only measure left is for Abe to engage in aggressive austerity and QE together to increase inflation.
​
Key terms:

1. Wicksellian rate (a.k.a. natural rate of interest): Kurt Wicksell was a leading Swedish economist who was best known for his idea of the natural rate of interest. The theory suggests that there is a long-run natural rate of interest, and if the current rate of interest is higher than said natural rate, there will be deflation, and if the current rate is lower than the natural rate, there will be inflation. When the current interest rate equals the natural rate of interest, there is equilibrium in the commodity market and price levels are stable. To read more about this (and how it pertains to modern-day economics), click here.

Context:

1. To understand this article, it is important to understand what Abenomics is. Abenomics is a portmanteau of the words economics and Abe – Shinzo Abe being the Prime Minister of Japan. His plan is to fire three ‘arrows’ to stimulate economic recovery. The first arrow is expansionary monetary policy in the form of QE, the second is fiscal stimulus, and the third is structural reforms, mainly through strengthening the Japanese army.

While these three arrows seem like feasible ways to revive the economy, Japan is still faced with lacklustre inflation, and many attribute this to the fact that Abe is not aggressive and hawkish in any of his three tactics, or arrows. Paul Krugman discusses what Abenomics’ next steps are.

2. How does future inflation determine inflation today? Consider this situation: a consumer in an economy wants to buy a new phone. She believes that inflation will increase in the future, i.e. the price of the phone will be higher in the future than it is currently. For this reason, she buys the phone today. Many consumers in the economy also believe that future prices will be greater than current prices, and buy the goods and services today instead of waiting for the price to increase. The aggregate demand in an economy suddenly increases, and producers increase the price of the goods and services in an economy as a response. This increase in prices of goods and services is, in fact, inflation. Deflation works in a similar way. In this way, inflation (or the lack thereof) is a self-fulfilling prophecy.
​
3. In my opinion, there are a few problems with Krugman’s proposed solution. The first is that despite years of fiscal expansion by the Bank of Japan (BoJ), deflation still persists. Even aggressive fiscal expansion, which is what Krugman suggests, has its problems. Firstly, there is no telling when the aggressive expansion will result in a sufficient level of inflation; it could take much longer than the BoJ can afford, and it will exacerbate the debt-to-GDP ratio greatly. Secondly, even when the BoJ deems the inflation level in Japan as healthy enough to allow fiscal retrenchment to happen, they have to be wary of consumer expectations. Either the BoJ will have to execute fiscal consolidation so slowly that it now faces high inflation and a high debt-to-GDP ratio, or it will have to carry out fiscal consolidation quickly enough to avoid inflation from becoming a worry. The problem with the latter is that consumer, investor and producer confidence in the market is shaky enough as it is; fiscal consolidation may scare them enough to revert the economy back into the original state of deflation where people are hesitant about consumption, production and investment.

Synopsis: What problems the EU will face with QE, when it will happen, and how it might come about.

Click here to read the original article.

Discussion:

This article discusses the likelihood of QE in the Eurozone, the necessity of QE, the problems it could face and the manner in which it would happen.

The Eurozone has faced persistent lowflation (which, for the countries in the periphery, means actual deflation). Hence, there has been a push from many countries for QE – “creating money to buy fiscal assets”.  The ECB faces strong opposition from Germany, whose nightmares about hyperinflation eclipse the need for QE to put a stop to sliding inflation.

Both core and headline inflation are slipping lower and lower – substantially lower than the ECB’s 2% target. The all in oil prices itself is a welcome relief for many countries, where the decrease in oil prices reduces their own costs of production. However, if the lower costs of production make people expect deflation (or even lower inflation), deflation will happen, true to its self-fulfilling nature.

Lowflation is equally as harmful as deflation, where the latter means an increase in the real value of debt (debt is in nominal terms), and the former means prices rising slower than what the government expected when they first borrowed money.

As the ECB can no longer decrease the interest rates (it is currently at 0.05%), they must try to expand their own balance sheet by buying sovereign bonds. They plan on expanding it by 1tn euros, although when this will happen is unknown.

Past attempts at increasing their balance sheet and pumping money into their economy was as not fruitful as the ECB had hoped – only 212bn euros of the 400bn euros was borrowed by banks from 2011-2012. One potential reason for this is that banks were not willing to borrow money during a stagnant economy.

Because Germany has its own reservations about the ECB’s buying sovereign bonds, the ECB is also buying covered bonds and asset0backed securities, neither of which is big enough to absorb the whole of the QE needed.

The ECB also has the option of borrowing corporate bonds, but even that market is not substantial.

The ECB, therefore, must buy public debt.

Whenever the ECB may enact QE, the program is unlikely to surpass 500mn euros, which may or may not be sufficient to aid the economy.

Context:

This post about the ECB and QE by Ambrosse Evans-Pritchard discusses similar things, and hence, is worth reading. Both articles reach a similar conclusion that the scale of QE the ECB plans to do is insufficient.

Synopsis: The effects of and solutions to deflation.

Click here to read the original article.

Discussion:

This article discusses the effects of and the lack of potential solutions to the current worldwide deflation.

Christopher Sims, a Nobel laureate who specialises in causality in macroeconomics (quoted in this article) warns that QE by itself has little effect on monetary patterns, and thus, on inflation. He says that the only reason Anglo-Saxon QE worked at all is because the central banks (BoE and the Fed) “talks a better game” (which, in its essence, is qualitative easing) than the ECB.

The effects of deflation are:

1) Pre-emptive retrenching, given consumer expectations for prices to decrease.

2) Decreased investments and increased savings from businesses who expect a hit.

Overall, the two points above mean that there will be less money circulating the economy. Notice how those two points show that an expectation of deflation causes deflation – these two reasons are the main reasons why deflation is a self-fulfilling prophecy.

Whether QE works to increase deflation can be seen by observing Japan, whose large-scale bond-buying programme is meant to encourage inflation.

Key words:

1) Money indicators: money indicators measure the amount of money in an economy. Different definitions of money supply include cash, or cash and deposits, or checks.

These definitions, according to Investopedia, are:
a) M0: Hard cash and coins
b) M1: M0 + checking accounts, traveller's checks, demand deposits
c) M2: M1 + savings accounts, time deposits (less than $100,000), money market funds

2) Primary surplus: This is where government income – government expenditure > 0 but the interest on the loan has not been paid back yet. For another blog post that discusses the primary surplus, click here.

Context:

What is Sims referring to when he says that the Fed “talks a better game” than the ECB? This is the idea of qualitative easing (more can be read about this here), where the Fed assured the economy that it will do its best to decrease unemployment and increase inflation, i.e. they said that they would carry QE through to the end. I disagree that the ECB doesn’t “talk a good game”. In fact, in 2012, Draghi said that the ECB will “do whatever it takes” to improve the economy. In 2012, many people believed that the periphery Eurozone countries would split from the EU. As a result, borrowing rates for the PIGS countries increased, and confidence in the euro was lost. Draghi responded by saying that the ECB would do "whatever it takes" to save the euro. Because of this, the faith in the Euro was restored and the borrowing rates for the periphery countries dropped. Click here to read the official statement made by Draghi.

Synopsis:  The ECB and how it avoids QE.

Click here to read the original article.

Discussion:

This article discusses the fact that the ECB is taking negligible steps towards helping the Eurozone economy in terms of monetary policy.

The ECB is facing major opposition from Germany, which fears that the launch of large-scale and proper QE might result in uncontrollable hyperinflation – a repeat of pre-World War 2 German economy.

As opposed to the QE that was used by the Fed and is being used by the BoJ, the ECB is instead enacting ‘penance’ measures – more to put up a show rather than to improve the economy, according to Pritchard.

Mr. Mario Draghi, the head of the ECB, has hinted at a EUR 1tn spend. As much as it sounds similar to QE, it is not, for two major reasons:

1) Central banks that enact QE take the risk on their own balance sheet; this is to say, whatever happens to the value of the sovereign bonds they purchase, they deal with it. Instead of doing so, they are offering LTROs (explained in the article) to banks in exchange for collateral.

2) The ECB is spending nowhere near the EUR 1tn promise – rather, its spending amounts to about EUR 450bn, perhaps lower. This equates to roughly EUR 17.5bn a month (and this spending will not start until the end of the year), 10 times less than the spending by the Bank of Japan.

Many economists also say that the lowered interest rates will have a negligible effect on the overall market at this point, i.e. conventional expansionary monetary policy just does not work for the Eurozone as of now.

Key terms:

1) Deleveraging: Where banks lower the amount lent to the public so that banks can keep up with the capital adequacy ratio.

2) Capital adequacy ratios: To protect bank depositors, governments have come up with this concept. The idea is that a bank must have a certain amount of capital in its bank, so that if the bank incurs losses and cannot pay depositors back, the banks can use some of its own capital to cover the losses. Usually, when capital adequacy ratios are discussed, the Basel rules are mentioned as well. These rules (Basel I, Basel II and Basel III) dictate the amount of capital needed in the banks. The more, the better for the depositors.

Context:

One thing worth discussing is the sixteenth paragraph: “Nor is it clear… said Mr. Roberts from RBS”. The statement being made here is that unless the ECB takes on bad bonds, there is no point in bothering with QE in the EU. The problem with this statement is that no economy that has practiced or is practicing QE (Japan, USA and UK) has taken on bad bonds; they have only ever taken sovereign (government) bonds. Government bonds are steady and trustworthy, and very reliable bonds to purchase. For a long time, the government and the central bank of a country have been split, where it is the government’s job to take on bad loans and liquidate frozen banks. The central bank has two objectives: to maintain steady and reasonable inflation, and to reduce unemployment. If an economy were to be taking on “bad stuff”, as Mr. Roberts from RBS (quoted in that paragraph) says, it would be only from the part of the individual governments, not the ECB.

Synopsis: Qualitative easing and its effects on quantitative easing.

Click here to read the original article

Discussion:
This article discusses the reasons behind the success of QE, stating that, in theory, QE (buying long-term treasury bonds) shouldn’t have any effects, as it only shifts government debt from cash to treasury.  However, this shift is what made QE1 successful; investors preferred the cash.  In QE2 and QE3, when financial markets were mostly back to normal, what made the difference is the confidence the Fed injected back in the market.  The public and markets felt comforted by the fact that the Fed would do whatever it takes to ameliorate the economy.  This injection of economic confidence is a lesson the Bank of Japan and the ECB should learn in their own efforts to make QE successful.

This article was specifically chosen to show the effect of qualitative easing, which is essentially a bank’s use of forward-looking statements to reassure the market and provide stimulus. This is a prime example of the fact that sometimes, economics hinges on not only theory, but also on the psychological aspect of humans.

Synopsis: How long will it take for the Fed to raise the interest rates after the end of QE?

Click here to read the original article

Discussion:
This article talks about the U.S. Federal Reserve’s (Fed’s) next steps after the end of its bond-buying program. Quantitative easing (QE) is ending in October, and this begs the question of when interest rates will increase. The Federal Open Market Committee (FOMC) had said that this will happen in “considerable time”, which can be perceived to mean between April and June, i.e. six months after QE stops. However, speculation has it that Yellen was speaking “dovishly”, and that it may not increase after a “considerable time”; interest rates will rise after the six-month window.

Why is the Fed speaking so dovishly? What is “considerable time”? The use of this phrase is a part of the Fed’s attempt at qualitative easing, i.e. the use of forward-looking statements about interest rates to reassure the market and to provide a stimulus. To read another article and commentary on qualitative easing and its impacts on the U.S. market, click here.

The Fed has always spoken dovishly so as to allow itself some “wiggle room”, as the article calls it. Resultantly, is not one to renege on its words, so if they do want to withdraw the “considerable time statement” it will have to be done around December so as not to shake consumer confidence.

Context:
There are three steps to ending QE, and the Fed is on the second step.

1. Tapering (bringing down the level of new bond purchases)
2. Maintaining the stock of bonds on the Fed balance sheet
3. Letting the bonds mature and the stocks run down

Key words:
Dovish – to speak with a tone that implies that no immediate action will be taken.
Hawkish – the antonym of dovish, to speak with a decisive tone