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: With all the different directions that different economies are dealing with their QE, what are the repercussions?

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Discussion:
This article discusses the repercussions of the lack of synchronization between the Federal Reserve’s and the Bank of Japan's monetary actions. While the Fed has ended its bond-buying practices, the BoJ has just intensified it. Consequently, the yen fell sharply against the dollar, which will hopefully increase exports and production in Japan, battling its long-lasting deflation. However, this means that other exporters might have to lower prices in other countries to compete in the global markets. The writer thinks that this might cause worldwide deflation. The author then talks about how the stagnant state of inflation in the US (which has not yet capitulated to the worldwide deflation that the writer fears) has caused the gold price to drop. The U.S. and Japan’s central banks’ diverging monetary decisions are causing a rift in the global markets.

I will be summarizing the points made in this article in a flow chart in the next post, as well as problems I am seeing while applying this article to the actual situation in Japan.

Synopsis: What is the effect of a strengthening U.S. dollar on different stakeholders?

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Discussion:

This article discusses the effects of a strengthening U.S. dollar on various stakeholders. The U.S. economy is currently improving amidst generally weakening economies, such as Germany and France. For another article discussing different impacts on the U.S. dollar (and more specifically, the differences in monetary policy between different economies) on different stakeholders, click here.

Impact on:
1.       Investors: With the economic strength of the U.S. and a weaker world economy, investors are attracted to U.S. markets, where they can finally reap large benefits from a “carry trade” strategy.
The incentive to invest in bonds and stock in America is intensified for investors by America’s economic performance, regardless of the interest rates America offers.
2.       American citizens: Positives for America include an influx of money to fund governments, an increase in purchasing power and a decrease in import prices.
Negatives include less competitive exports, devaluation of overseas profits, and an eventual decrease in GDP.
3.       Other QE-leading economies (i.e. Japan and Europe): Exports are now cheaper, and consequently, more attractive, fuelling production and avoiding deflation. This is especially good for Japan who has been struggling with deflation for decades.
4.       Emerging markets: Capital will flow out of these emerging markets and into the U.S., which will exacerbate their governments’ ever-growing debt problem, especially as they have borrowed in dollars (this is to say that if they have borrowed in dollars, and the price of the dollar goes up, their debt increases as well).
5.       World government: Economies might have to resort to protectionism (in the long, long run), such as America, because the export sector of America will suffer if there is stubbornly high dollar.

Key Words:
1.       Trade-weighted basis: this term is found in the first paragraph of the article. What does it mean? If a currency is calculated on a trade-weighted basis, it means that the currency is valued based on the amount of its currency that is being bought and sold for goods and services.
2.       Carry trade: Carry trade is borrowing from economies with low interest rates and investing in ones with high interest rates, which, in this case, the U.S. In another article, it discusses how carry-trade was nearly impossible for a long while because all interest rates were very similar, i.e. pretty much 0%. The risk with carry-trade is that fluctuations between currencies might be so great that carry traders might find that when they convert their earnings back to their home currency, the value is suddenly so little. On the other hand, it could be very high! For this reason, many people refer to carry trade as “picking up pennies in front of a road roller” – the risk is very high.

Synopsis: Qualitative easing and its effects on quantitative easing.

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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: Should the U.S. invest in infrastructure now?

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Discussion:
This article argues that the U.S. government must take the opportunity now to increase public investment, before this fiscal climate changes.  The writer argues that the fear of increasing taxes to fund such projects is unfounded, as is the fear of slipping further into debt.  He or she cites examples of a boost in GDP due to such projects, covering and surpassing the debt caused.  In fact, it is with slow-growing economies that borrowing and funding is most profitable, due to low interest rates and minimal competition for loans.  It is for these reasons that the writer argues that the U.S. should invest in public goods – the economic climate is just right.  The only problem is what to invest in: while most economies can easily pinpoint deteriorating infrastructure, those projects may be a waste of time and money.

Key words:
Natural monopoly – This is where the lowest price can only be achieved if the market has a monopoly. The article gives three examples of natural monopolies:
“telephone network, electricity grid or sewer system.” The article goes on to explaining why it is best to have a natural monopoly – “fixed costs… are typically high and operating costs relatively low”.
Crowding in – This is the opposite of the crowding out effect, and is where government spending on public projects boosts the demand for a good, and so, increases the private investment in it.

For more on infrastructure and investment, read “Government Spending Booms Not So Great for Long-Term Growth” and “Bridges to Somewhere"

Discussion:
This article updates us on the economic health of the U.S. after the end of QE. While the author presents us with some encouraging statistics, such as an increase in employment and diminishing underemployment, other statistics are not as promising, such as a decrease in the labor force participation rate (LEPR) and stagnant wages.  My guess is that the discouraging statistics will turn around in time, e.g. these statistics are the result of time lag.

D.K. also contrasts the generally positive economic outlook of the U.S with that of the EU, where expansionary monetary policy may be needed. Mario Draghi, the president of the European Central Bank (ECB) is facing opposition from Germany, whose fear that expansionary monetary policy will result in hyperinflation stems from its past bad experiences with hyperinflation. It is worth referring to “Dwindling U.S. Inflation Casts Shadow”, which discusses the fact that, as opposed to hyperinflation taking place, there is minimal inflation at all.

Pay attention to the statement in the fourth paragraph that says, “… unemployment reaches a level where employers have to start paying more to find workers”. The nature of having to pay more is one of the steps in the Phillips curve, which suggests a link between unemployment and inflation, chiefly that as unemployment is lowered, inflation increases. This relationship is shown below (figures not based on real data).

We can notice now that, even though unemployment has lowered, inflation is not budging. Where did the Phillips curve go wrong?

We will discuss this in later blog posts.

Key words:
Unemployment – This is when those who are actively looking for work cannot find an
Underemployment – Where a worker can find a job, but it does not maximize his capacity. Examples would include those who are only able to find a part-time job, or perhaps an economist with a Ph.D. working as a bus driver.
Hyperinflation – This is when the rate of inflation accelerates, sometimes out of control. One of the most famous examples is in Germany from 1921-1924.
PMI – This is the Purchasing Managers Index and measures the economic health of the manufacturing sector.
LFPR – The labor force participation rate is the ratio between the labor force (those who have a job or are actively looking for one) and the whole working age population. So, those who retire prematurely, for example, are no longer part of the labor force, but are instead part of the rest of the working-age population.

One important analysis point about the LFPR is to do with the rate of unemployment. Let’s say the unemployment rate drops. Does that mean that more people are finding jobs? Perhaps. But it could also mean that people have given up looking for jobs and, in a sense, have retired prematurely. So, the unemployment rate has dropped, but so has the LFPR. The point to remember is that a lower unemployment rate does not equate to a better economic situation.

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

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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