Stephen King: Experiments that could blow us up
Monday 23 March 2009
It is bad enough explaining to people what quantitative easing is, let alone what it actually does. Part of the problem lies with the different approaches adopted by central banks on either side of the Atlantic. The Bank of England deliberately intends to increase the supply of money, whereas the Federal Reserve has, so far, made no such commitment. Both central banks are, though, supposedly engaged in quantitative easing.
Meanwhile, commentators are absolutely divided over the benefits and costs of quantitative easing. Some believe that, at best, it might reduce the threat of deflation and, if we're lucky, pave the way towards an economic recovery. Others regard quantitative easing as the Devil's work. On this interpretation, it won't be long before deflationary fears are replaced by hyperinflationary reality, leaving Messrs Bernanke and King burning in monetary hell.
So how should we make sense of what's going on? The different approaches from the various central banks say more about what quantitative easing isn't, rather than what it is. In recent times, central banks have adjusted monetary policy through setting a target for the overnight interest rate. By doing so, policymakers hope to have an indirect influence more broadly on the costs of borrowing and rewards for saving by affecting interest rates on longer- dated government debt, mortgages, credit cards and corporate debt.
This approach is no longer working. Overnight rates are near enough to zero to leave central banks without their usual monetary ammunition. Meanwhile, the gap between the interest rates at which governments borrow and rates more generally is currently very wide, highlighting the massive risk aversion associated with the financial crisis.
The Bank of England's response has been to start creating money from nothing. It has taken the very simple view that the creation of additional money will make other assets look more attractive. The Bank will buy existing gilts from pension funds and other institutions at inflated prices. The money received by those institutions will then, hopefully, be invested in riskier assets which should, in turn, lower the cost of raising funds for companies and households. The idea, then, is to get money directly into the economy without relying on a banking system which, for now, is moribund.
The Fed's response, at least until now, differs in one key sense. Rather than creating more money, the Fed has so far been happy to borrow existing money and use it for the purposes of boosting the economy.
Imagine, for example, that banks are extraordinarily risk averse and only want to hold very liquid assets. Believing that the US government is never likely to default, the banks happily invest in short-dated government paper called Treasury Bills while limiting their lending to companies and households. Recognising this preference, the Treasury issues more of these T-Bills. The funds raised are then given to the Fed to purchase a range of assets which banks have turned their noses up at. These include, most obviously, mortgage-backed securities, credit card debt and commercial paper. This way, the Fed allows credit to spread through the economy more widely.
Last week, the Federal Reserve also announced it would be buying Treasuries (longer-dated government paper). Unlike the Bank of England, though, the Fed hasn't spelt out precisely how it intends to fund these purchases. It might simply ask the Treasury to issue more T-bills, which implies the Fed is borrowing from the Treasury at short-term interest rates to lend back to the Treasury at long-term interest rates (a similar policy was adopted 50 years ago when, via "operation twist", the US authorities attempted to lower long-term interest rates in the hope of spurring capital spending). Alternatively, it might decide to follow the Bank of England's example by creating new money with which to purchase Treasuries. Either way, the intention is to keep long-term rates as low as possible. Following last week's announcement, the 10-year Treasury yield dropped from over 3 per cent to just 2.5 per cent.
Whether quantitative easing is funded through printing money or by mopping up and then lending out existing money which would otherwise sit idly within the banking system, the approach rests on the idea that the banking system itself is unable to pump money around the economy. Either you take money away from the banking system to give to others (the Fed's Robin Hood approach) or, instead, you leave the existing money within the banking system and create some more to give to others (the Bank of England's alchemist approach). The Fed's approach – so far at least – redistributes existing money while the Bank's approach creates new money.
I suspect those who worry about hyperinflation think the Bank's approach is a lot more dangerous than the Fed's. They'd be wrong. Excess inflation can be created either by printing more money (an increase in the money supply) or by making sure the existing stock of money is spent more frequently (an increase in the velocity of money). Either way, there should be upward pressure on output and prices. When, though, an economy is operating well below its full employment potential, it is more likely that quantitative easing, under any guise, will have an impact on output alone and not prices.
The US economy, for example, has already experienced both a huge increase in unemployment and an extraordinary drop in capacity utilisation which, in manufacturing, is now at a new post-war low. Getting money to slosh around the economy more readily should, in these circumstances, help to lift activity and spirits without threatening inflation. Indeed, with activity so depressed at the moment, the important thing is not to worry about inflation but, instead, to ward off the danger of deflation. Now that interest rates so low and debt levels so high, deflation is, surely, the biggest single economic threat facing our nations. Already, an absence of company pricing power is leading to collapsing profits and surging unemployment. Worse may be to come.
Nevertheless, despite my guarded enthusiasm for quantitative easing in its various guises, I recognise that we have reached one of those extraordinary milestones in our monetary arrangements. If central banks are now buying Treasuries and gilts, they no longer look quite so independent. As they seek to bypass the banking system, their influence over capital markets is rising, for good or bad. And, in the international sphere, the endgame is still a long way off. The dollar took a major tumble last week as investor nervousness over the US currency's safe-haven status began to increase. The Swiss authorities have intervened heavily to prevent their franc from becoming the safe-haven currency of choice. And emerging market central banks are increasingly fretting over their holdings of dollar assets in a world where the Federal Reserve is thinking about turning on the printing press.
Heightened international monetary tension is, generally speaking, not a good thing for economic progress. The collapse of the gold standard in the 1930s led to a series of unco-ordinated and possibly damaging shifts in exchange rate regimes, all accompanied by deflation. The collapse of Bretton Woods at the beginning of the 1970s equally led to major exchange rate volatility but, then, the key problem was inflation. The deflation versus hyperinflation debate will go on for months but, in the meantime, the more our central bankers carry out their localised experiments, the more likely we are to see the return of extreme currency volatility.
Stephen King is managing director of economics at HSBC
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