Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 7 March 2023

Why Quantitative Easing should always be with us


Quantitative Easing (QE) is not a well loved policy instrument in many quarters. What I want to argue in this post is that this unpopularity is in many cases misplaced, and also why QE will and should always be with us as long as central banks remain independent. To understand why, we need to talk about how fiscal policy (changes in government spending or taxes) is financed, and what happened at the start of the Covid pandemic.

Macroeconomic textbooks are full of discussion and analysis contrasting bond financed and money financed fiscal policy. With a bond financed fiscal expansion the extra spending (or tax cuts) are matched by higher borrowing, while a money financed fiscal expansion is paid for by creating more money. But in the real world governments do not debate whether to finance the deficit by issuing bonds or creating money. That is because money creation has been delegated to their independent central bank.

Central banks in turn typically determine short term interest rates to achieve inflation targets. But a money financed fiscal expansion is still possible, if a fiscal expansion is accompanied by Quantitative Easing (QE). This is what happened in the UK during the pandemic. Furlough was paid for by increasing government borrowing, but the Bank of England bought a very similar quantity of government debt by creating bank reserves (electronic money). So if you treat the central bank as part of the consolidated public sector (as you should here, because central bank profits and losses go to the government), furlough was largely paid for by creating money. It was similar to a classic money financed fiscal expansion. [1]

If QE is very similar to textbook money creation, why was it initially treated as something new, and why has it become so unpopular in some quarters? Before the Global Financial Crisis (GFC) most mainstream economists signed up to the idea that macroeconomic stabilisation (and therefore control of inflation) should be exclusively done by independent central banks varying interest rates. In such a world, there would be no need for fiscal stimulus during recessions, because lower interest rates would do the job more quickly and efficiently. Any money creation done by the central bank would just be a bi-product of its interest rate setting process.

In effect, independent inflation targeting central banks removed the option of governments choosing to finance their deficits by creating money rather than by borrowing. But that was fine, because there was no reason for governments to want to finance fiscal policy by creating money rather than borrowing as long as the central bank was able to control demand and inflation by varying short term interest rates.

That idea broke down during the GFC, because interest rates fell so low they hit a level (roughly zero) that central banks were reluctant to go below. QE was adopted by both the UK and US as an alternative way to stimulate the economy. Money creation was back on the menu. Unfortunately, this also helps explain some of its unpopularity. When fiscal stimulus in 2009 turned to austerity in 2010 in most major economies, too many people who should have known better suggested this wouldn’t matter because QE could do the job interest rates could no longer do.

There is a simple reason why this was not, and will never be, true. Fiscal stimulus has a much more reliable impact on aggregate demand than QE. It is now generally recognised by most academic economists that fiscal consolidation in 2010, at the start of the recovery from the biggest recession since WWII, was a major mistake. But this mistake didn’t happen because of QE. It happened in part because some, including many senior central bankers, oversold what QE was able to achieve.

Quantitative Easing is also unpopular because it’s associated in many people’s minds with increasing wealth inequality. Once again, I think QE is being unfairly judged. What causes asset prices to rise is low long term interest rates. The decline in long term interest rates since the 1980s is in large part outside the control of policy makers. Long term rates are influenced by central banks varying short term rates, but they do this to keep inflation on target and aggregate demand reasonably strong. The contribution of QE to the level of asset prices is marginal compared to other factors, including the impact of the central bank’s interest rate decisions. Of course low interest rates also mean the income received from financial assets is lower, so what the wealthy gain on the wealth side they lose on the income side.

The wealth effect of very low interest rates is also not inherent to interest rate stabilisation, but is instead a reflection of bad fiscal policy. Good fiscal policy should ensure that interest rates never need to fall to zero, except in extreme circumstances where fiscal policy has not had time to have an impact on the economy. The fact that we had interest rates at their lower bound for so long after the GFC reflects the 2010 austerity mistake in the UK, US and the Eurozone.

There is a serious issue involved in reversing QE, which I have looked at in a recent post. Central banks are understandably reluctant to sell the large quantities of government debt they hold quickly (and use it to reduce reserves), which means money creation is slow to be reversed. As central banks pay interest on these reserves, when interest rates are high and rising as they are today the public sector ends up transferring funds to the private banks holding the reserves. But as my post points out, this is not a necessary consequence of QE, and can be fixed in more than one way.

Last, but definitely least, there is an argument some make that the expansion of QE during the pandemic helped cause today's high inflation. This is in my view largely nonsense, and relies on either inflated views of the importance of central bank money creation (a form of monetarism), or incorrect views on what determines bank lending. If pandemic QE hadn't happened we would still have had higher energy prices and the invasion of Ukraine. More generally, given what happened after the GFC, it was important that policy ensured a strong and quick recovery from the pandemic, which is why I still think Biden's fiscal stimulus in 2020/21 was the right thing to do. As I note above, good fiscal policy should always ensure interest rates are well above their lower bound.

While QE is not the evil that some make out, a legitimate question is whether it has any positive virtues. Why do you need an unreliable replacement for cutting interest rates when interest rates hit their lower bound if fiscal expansion is always superior? To answer that we need to go back to the last time a money financed fiscal expansion occurred, which was the pandemic. What the onset of the pandemic showed is that bond markets (the markets for government debt) can be fickle. As the pandemic broke they initially refused to buy government debt (not just in the UK but elsewhere), so without QE the government would have been forced to repeat the mistake of 2010 and cut spending or raise taxes.

This is why the QE option always has to be there, and why QE will always be part of the policy toolkit. When a fiscal expansion is vital but the government cannot sell its debt, there has to be the option of a money financed fiscal expansion.

We can make the same point another way. One of the excuses for 2010 austerity was precisely that without it the bond markets might panic. QE was the key reason why that argument was false, as I outlined in one of my first blog posts. When bond financed fiscal expansion is not possible because of fickle bond markets, yet fiscal expansion is necessary for the health of the economy, money financed fiscal expansion has to be an option. QE is what makes that option possible. It is very ironic that while central banks mis-sold QE as an alternative to fiscal expansion, in reality QE was all you needed to blow the main argument against fiscal expansion out of the water. [2]

So in my view the bad press QE gets is largely unwarranted. It is true that QE is a pretty unreliable stimulus tool in itself, and it should never be a substitute for fiscal expansion during recessions. However QE is an important policy instrument that allows those fiscal expansions when the economy needs it, interest rates are so low they cannot provide it, yet bond markets will not buy government debt. This combination of circumstances is unlikely to happen very often, but even when it doesn't happen the existence of QE knocks down claims that it might.

[1] In a textbook money financed fiscal expansion, the government saves having to pay the current interest rate on the government bonds it would otherwise have had to sell. With QE, the consolidated public sector (government+central bank) saves having to pay the interest on the bonds the central bank happens to buy. Another difference in detail is that furlough was more like fiscal support rather than fiscal expansion.

[2] Is there a problem because governments do fiscal expansions, but central banks do QE? There shouldn’t be, because in recessions caused by deficient demand central banks will want long term interest rates to be low, and if the bond market is reluctant to buy government debt long term interest rates will rise, so the central bank will buy that government debt.

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