Satyajit Das: They are all at it – but side effects of QE may turn out to be highly toxic

Midweek View: Inflation cuts the value of debt. It also induces consumer spending, as people accelerate purchases
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The Independent Online

The Bank of England is doing it again. The US Federal Reserve may do it again. The Bank of Japan has been doing it for a long time. Even the Europeans are now doing it, secretly. It is quantitative easing (QE), sometimes parsed as "printing money".

With interest rates low, central banks are changing the quantity of money by buying government bonds, injecting cash into the banking system. In theory, QE lowers borrowing costs and creates liquidity, hopefully stimulating demand and inflation.

But lower rates and increasing the supply of money, of themselves, may not boost economic activity.

Crippled by high levels of debt, low house prices, uncertain employment prospects and stagnant income, household are reducing, not increasing, borrowing.

For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment.

QE has primarily boosted asset values, subsidised banks, weakened the

currency and helped the Government finance its deficit.

Lower interest rates and central bank buying help boost the value of

financial securities. It increases the attractiveness of financial assets producing higher income, such as dividend-paying stocks or corporate debt.

The effect of QE on real economic activity through higher asset prices is based on the wealth effect, whereby people are likely to spend or borrow more when their investments are worth more.

QE provides discreet subsidies to banks in the short run. Lower rates reduce the cost of deposits, which can then be reinvested in low-risk government bonds at a substantial profit. But QE ultimately pushes down yield on bonds reducing returns, decreasing the net interest margin and profits earned by banks.

QE weakens the currency, improving export competitiveness. It reduces the value of a country's debt which can be paid back in devalued paper money.

But it does not work if everyone tries to do it simultaneously. In the relative game of currencies, every nation cannot have the cheapest money.

The ability of QE to generate rising prices relies on the economist Milton Friedman's observation that "inflation is always and everywhere a monetary phenomenon".

Inflation cuts the value of debt. It also induces consumer spending, as people accelerate purchases, anticipating higher prices in the future. But QE's ability to create inflation is doubtful, at least in the short run.

Unfortunately, the transmission mechanism, the banking system, is broken. The velocity of money or the rate of circulation has slowed, offsetting the effect of QE.

The lack of demand due to weak consumption, lacklustre investment and now government austerity, and excess productive capacity in many industries also means low inflation.

Most developed economies have an "output gap", with total demand well below the economy's potential to produce goods.

QE also creates problems for emerging markets and commodity prices. Low interest rates and falling currency values have encouraged investors to increase investments in emerging markets, offering better returns and more encouraging growth prospects. Much of the capital flows into emerging markets are short term. A rapid withdrawal of this money could be highly destabilising, as evidenced by the Asian crisis of 1997/1998.

As most commodities are priced and traded in US dollars, the lower value of the currency causes commodity price rises. In addition, low interest rates encourage speculation in and stockpiling of commodities.

Higher commodity prices and strong capital flows fuel inflation in emerging markets. Given that emerging markets have been a key driver of the tepid comeback of economic activity globally, this risks truncating the recovery.

The side effects of QE may prove highly toxic, in part because of the risk

of retaliation from affected parties. Emerging market countries are openly talking about "currency wars". Some have already introduced controls against short-term capital flows. Such measures could affect the prospects of global economy recovery.

QE resembles fetishes, objects believed to have supernatural powers.

Despite evidence to the contrary, these financial fetishes are predicated on the belief that the theories and models are correct, policymakers know what they are doing and the actions will be effective.

Satyajit Das is author of 'Extreme Money: The Masters of the Universe and the Cult of Risk'