Why Quantitative Easing is qualitatively important but quantitatively not so important

 

I have written a couple of posts recently where Quantitative Easing (QE) has played an important role. Here, for example, is a post about why QE could end up putting a large hole in the public finances, and how this could be avoided. I also wrote recently about how QE shows us that the government can easily finance its deficits by creating money rather than selling debt, if it chose to do so. This second post illustrates why QE is qualitatively important.

One of the first posts I wrote over a decade ago involved a similar theme. QE showed us why a key idea behind austerity, that we had to reduce the government’s deficit despite being in a recession because the bond market might suddenly decide not to buy UK government debt, was nonsense. QE was a Bank of England policy of buying UK government debt to keep longer term interest rates low, so in any bond market strike the Bank would simply step in with QE. After that happened during the pandemic, I could say I told you so. At a slightly more mundane level, QE helps tell us why it is dumb to continue to teach students about the ‘money multiplier’.

However, while the existence of QE is important in many ways, just how important it has been in quantitative terms is much more questionable. Ever since QE was widely introduced by the major central banks after the Global Financial Crisis, it has occasionally attracted rather outlandish claims about how much it was doing. Some of this came from a predictable source. Those who couldn’t quite believe that the equation MV=PT was nothing more than a meaningless identity claimed post-pandemic inflation was down to additional QE during the pandemic. But a more interesting example is from the New Statesman’s Will Dunn (whose stuff I normally like). Its title is “The QE Theory of Everything” and the subtitle “How the $30 trillion quantitative easing experiment reshaped our world – from Brexit to the dominance of Big Tech” reflects the article’s claim that QE was quantitatively very important.

The problem is that, in the macroeconomic scheme of things, QE is really not that important. It is almost a footnote in any account of the response to the Global Financial Crisis (GFC) and the 2010 austerity period. Evidence suggests it has a modest effect in reducing long term interest rates, and therefore increasing output, but no one is quite sure why it is having that effect and how predictable or repeatable that effect is. As I noted before, central bank estimates of how effective it was tend to be much higher than academic estimates, and while central bank economists have an incentive to exaggerate its impact, it’s not clear why academics should want to do the opposite.

So how can QE have reshaped our world? There is nothing qualitatively wrong in Dunn’s piece. As he says, QE involves the central bank creating huge amounts of money to buy large quantities of government debt with the aim of reducing long term interest rates. Of course the central bank sets short term rates, but by 2009 rates had fallen to almost zero and central banks in the UK and US felt they couldn’t go any lower, so their focus changed to getting longer term interest rates (which were above zero) lower.

As I explained in this recent post, long term interest rates are heavily influenced by current and expected short term interest rates (through arbitrage). The idea of QE was to force them even lower, by using the traction of supply and demand. As I explained in that recent post, it is arbitrage rather than supply and demand that mainly determines interest rates on government debt, but in extreme circumstances supply and demand can matter, as we saw after the Truss fiscal event when UK pension funds wanted to sell debt and no one wanted to buy.

So central banks use QE to try and bend the arbitrage that links interest rates on government debt to expected short term interest rates by buying huge amounts of debt and thereby making it scarce. With less government debt around, buyers are prepared to accept an even lower interest rate.

The reason for doing this was the hope that by lowering long term interest rates firms would be encouraged to invest more. But another effect is to raise asset prices: the less return you can get by buying paper assets (government debt), the more the return you get from investing in real assets (equity, houses) is worth, so the price of real assets goes up. Inevitably the wealthy become wealthier.

So QE undoubtedly raised the wealth of the wealthy to some extent. But what is also true is that the value of wealth was mainly raised by central banks having to reduce short term rates to almost zero, and keep them there for a very long time. If QE had never happened, house prices and equity markets would still have soared, and wealth inequality would have increased dramatically. For this reason, QE was never the prime cause of the cake belonging to the wealthy rising but rather just the icing on top.

The importance of low interest rates rather than QE in explaining rising wealth inequality shows that what the wealthy gain in a higher valuation of wealth they lose in terms of income from that wealth. It is misleading to recognise one without recognising the other. This can work both ways. MMTers are always telling me how high interest rates favour the wealthy, because they tend to focus on the income effect and not the valuation effect.

Why did short term interest rates hit almost zero? Because we had the biggest recession since WWII. Why did short term interest rates stay at almost zero for so long? Because in all the major countries except China from 2010 we had a fiscal policy known as austerity. It was austerity that kept short interest rates so low for so long, and therefore it was austerity that was the main driver of low long term interest rates and rising wealth inequality.

Laying the blame at the door of austerity rather than QE is important for political reasons. Austerity was a policy carried out by elected governments, while QE is a more ‘technocratic’ policy enacted by unelected central banks. It would indeed be a serious charge to ascribe widespread ills to a policy enacted by unelected central bankers that was never voted for. Indeed the governments that ignored basic macroeconomics and majority academic opinion to push through spending cuts at the depth of the recession would love the idea that it was central bankers fault all along. Which is why it is important to understand that it was austerity, enacted by governments, that is mainly responsible.

A more subtle argument would be to concede that QE played a minor role in increasing wealth inequality, but instead suggest that its existence allowed politicians to enact austerity because central bankers said they still had the power to influence the economy through QE. As someone who is pretty critical of central banker’s silence on the impact of austerity (and some even for encouraging it), I would have no problem making that argument, except for the fact that I don’t honestly think it stands up. In the US austerity happened because Republicans won control of Congress, and they just wanted to cut public spending (defense aside). In the Eurozone austerity happened because politicians, particularly German politicians, wanted it. In the UK Cameron was criticising Labour’s moves to fiscal expansion in 2008/9 largely oblivious to interest rates hitting the lower bound.

So I think ascribing most of the increase in wealth inequality that has happened since the GFC to QE is both factually wrong and lets the politicians who enacted austerity off the hook.

It also matters because of what is called Quantitative Tightening (QT), which is just the unwinding of QE. If you inflate the impact of QE, then its reversal also ought to have large effects. Accordingly Dunn writes “But Truss and Kwarteng were also doomed to fail by the Bank of England, which also planned to sell very large amounts of gilts, at exactly the same time.” By the same logic any Labour Chancellor that wanted to borrow more to invest could have similar problems because the Bank of England could be selling off their government debt at the same time, flooding the market.

Fortunately, the evidence suggests otherwise. A recent study showed that the reversal of QE undertaken by central banks so far has had very little impact on long term interest rates. This is partly because QE wasn’t that powerful to begin with, but also because the QT is being done much more incrementally than the original QE. So I think it is wrong to suggest that QT played any part in what happened to the Truss fiscal event, and it is also wrong to suggest that QT will have any material effect on a future Labour government’s ability to borrow to invest.

Quantitative Easing is interesting and important in many ways, but it hasn’t reshaped our world.