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: The abysmal state of the Italian economy and how it can recover.

Click here to read the original article

Discussion:
This article discusses the dismal state of the Eurozone, focusing on Italy, and stresses the importance of QE as a means of recovery.

Many economies are doing abysmally, such as France, Germany and Italy, all of whoom had great hopes of recovery. As GDP in Italy slows down to 0.1% and debt rises, the debt/GDP ratio rises to 145%.

The high debt/GDP ratio worry many, and the writer, Ambrose Evans-Pritchard, calls upon Mario Draghi (the head of the ECB) to start QE in a serious way, as opposed to the timid plans that are being discussed by the ECB.

Italy is now practicing contractionary fiscal policy to lessen its high debt.

Zolt Darvas, quoted in the article, rom the Bruegel think tank in Brussels, warns that relying on additional lending by ECB will do minimal good. Instead, QE, in the form of asset purchases, is needed to stimulate the economy.

Whether or not Italy’s current prime minister, Matteo Renzi, will “meekly” participate in further austerity and fiscal cuts, one thing is clear: only if the ECB begins QE in a meaningful way will the Italian economy be saved.

Key words:
1. Primary budget surplus (paragraph 10): This is where the Italian government is in surplus when the government pays back the principal borrowed, but not the interest. Once the Italian government pays the interest back to its lenders, it is facing a deficit. The solution to this is austerity measures, which allows them to stop borrowing but maintain some reasonable level of government revenue through the collection of taxes. A good analogy is found here.
2. Debt trap (paragraph 12): A debt trap is where a country borrows to pay back interest. For example, if Italy borrowed 10 billion euros with 2% interest rate per annum (not real figures), and Italy pays back the 10 billion euros at the end of the year but not the 200 million euros interest, it will borrow more money to pay back the interest. The new loan will come with its own interest rate, which Italy must pay back by borrowing from somewhere else. Ultimately, Italy will spiral into uncontrollable debt.
3. Anglo-Saxon QE (paragraph 15): U.K. and U.S. QE
4. Austerity measures: This is contractionary fiscal policy, which means an increase in tax rates and a decrease in government spending. This is usually used to reduce the debt level in a country.

Context:
1. Internal vs. external devaluation: Neither of these terms is explicitly said in the article, but both ideas are mentioned. External devaluation is when an economy’s currency is devalued, which will encourage exports and hopefully increase production in the economy. Italy, being a part of the EU cannot devalue its currency as it does not have its own currency to control. Hence, exports cannot be encouraged through external devaluation. What Italy can do is devalue its economy internally. In paragraph 17, Evans-Pritchard writes, “If Italy slashes wages and deflates the economy to further regain lost competitiveness…” This is internal devaluation. By slashing wages, there will be less for Italian citizens to spend. Because of this, the price of commodities will drop. This drop in price of commodities might encourage other countries to import goods from Italy. It is a risky game, because it increases unemployment. Hence, internal devaluation is always a second-resort option; most economies prefer external devaluation.
2. Debt/GDP ratio: this is the ratio between debt and GDP. No economy ever looks at debt on its own, because it must be in relation to its economy. Imagine Country A with $100 debt and Country B with $200 debt. While it seems like Country A is doing better, this might not always be the case. Country A has only made $10 GDP, while Country B has made $100. So, Country A’s debt is ten times the amount of its GDP but Country B’s is only twice. On this scale, Country B is doing much better. This is why debt is always taken as a ratio of GDP.

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