And so it comes to pass: the perceived failure of quantitative easing to deliver economic growth has led to calls for even more quantitative easing. The puzzled public are caught between the mounting shrieks of ‘if at first you don’t succeed… but this time with conviction’ on the one hand, and ‘only a fool makes the same mistake twice…’ on the other.
I don’t intend to settle this debate – declaring it ‘right’ or ‘wrong’ oversimplifies what is a complex issue. But there are some important points that are worth emphasising.
Firstly, let’s confront terminology. QE is not exotic or new – it is just printing money. Even if it has the best intentions to not let it escalate into hyperinflation, the Bank of England buying assets on the secondary market is essentially a gradation of the policy that Mugabe’s government has unleashed in Zimbabwe. One arm of government is buying up the debt of the other. We can pretend that those two arms are separate, but that illusion is becoming harder to maintain by the day.
Finding the right solution to the current economic challenges depends on correctly identifying the actual problem. Consider the issue of bank bailouts. The original reason for having a lender of last resort was to provide emergency liquidity during a bank ‘panic’ and to help unwind unsound banks so that they wouldn’t pose a systemic risk. As time has passed since the first round of QE1 we have realised that it wasn’t merely a short-term liquidity problem, but a fundamental one of solvency. This cannot be cured with a quick gush from the monetary spigot, and direct bailouts merely obscure the distinction between liquidity and solvency problems further.
It’s also the case that monetarists are right to mock scaremongering about hyperinflation. When QE1 was launched in March 2009 I warned that we were in for another bout of inflation, and I confess that this has yet to materialise. Yes, the CPI is above target (3.1%), but not to the extent that I (and others) feared. Having said this, we should avoid making the same mistake we did in the build up to the financial crisis by focusing solely on the CPI as our inflation measure. The RPI is at 4.6%, and the PPI for input prices is 9.5%. We should also remember that inflation could manifest itself in asset price bubbles, for example in the gilt market or emerging markets. So although QE might be ‘working’ a little ‘better’ than we realise, we are still waiting for the forecasted inflation to truly bite.
Indeed, those who believe that low interest rates and a fast growing monetary base imply expansionary monetary policy make the same mistake that economists made during the Great Depression. Then, as now, they were actually signs of an inept central bank failing to offset a fall in the broader money supply.
This suggests that monetarists have a case when they argue that QE hasn’t been enough. The fact that gilts have such low yields suggest that markets believe that deflation is the more likely evil (for now), and indeed it is bizarre for central banks to try to inflate their way out of trouble whilst keeping inflation expectations anchored.
Central banks have created a tightrope with hyperinflation on one side and a deflationary spiral on the other, and by attempting to convince markets that they are alert to these threats they can increase the chances of both. Their concerns over inflation mean that they keep inflation expectations low. This increases the chance of deflation.
The excess liquidity that QE creates will find its way into the real economy at some point – possibly after the economy has already begun to recover naturally – and this is why having an exit strategy is so important. Again, the more confidence markets have in the efficacy of such a strategy, the harder it is for QE to ‘work’, but doubts remain as to whether this can be navigated. Some argue that it’s simple to hike up interest paid on reserves, or possibly even confiscate such reserves when banks begin lending again. However, this overestimates the Bank of England’s ability to anticipate events.
Some are concerned by the incentives that bank officials and policy makers face, and question whether they possess the practical skill set and motivation to do a better job of managing the bust than they did with the boom.
The main problem, though, is a knowledge problem – that no central agency possesses the knowledge required to ‘know’ how much money should be in circulation. There is a plausible free market argument to say that under certain institutional conditions (such as competitive banks and no moral hazard), increases in the money supply to offset changes in the demand for money would avoid adjustments having to take place through the notoriously ‘sticky’ real economy. In the same way that inflation creates real effects, so does a monetary deflation, and these effects are neither desirable nor necessary. However, whether this theoretical possibility can be acted upon is another matter. Even if central bankers had the benevolence to try to replicate markets, they most certainly do not possess the omniscience. Expecting such economists to comment on the ‘appropriate’ level of monetary expansion misunderstands the whole point. It is merely wishful thinking to expect central bankers to stabilise MV without returning to the conditions of the original boom – and setting the stage for another bust.
Indeed, attempts to do so exacerbate the paralysis of the economy. Policies like QE increase regime uncertainty and generate systemic instability. They have the potential to make matters worse, and ignore the fact that you cannot buy confidence. The Bank for International Settlements – one of the few organisations that foresaw large elements of the financial crisis – warns about the upside risk of continued low interest rates. Systemic misallocation of capital (including human capital) remains. Excessive risk-taking remains. Over-leveraged balance sheets remain. Volatile capital flows remain. We know that we still don’t know the amount of toxic debt in the economy, so not only are the conditions that led to the crisis still at work, but they are growing as time passes.
For free market economists, there is a positive programme for laissez-faire. Firstly, economic recovery will only come when we begin to rebuild the capital stock through investment. And rather than recapitalise the banks through taxpayer bailouts, it can be done through an increase in voluntary savings. Secondly, the recession itself is a sign that markets are adjusting, and that entrepreneurs are engaging in the recalculation that is required to understand which plans were unprofitable and where capital should be reallocated. Allowing relative prices to adjust as quickly as possible, reducing labour market rigidities, and improving labour mobility will all help with this. These policies are independent of the social safety nets that prevent such adjustments degenerating into long-term unemployment and stagnation, and no one would argue that the recoveries are painless. But it is better to confront the realities of life to allow a recovery to take place than attempt to maintain the economy in a permanent frozen state.
To be sure, such policies will not return us to the euphoria of 2008, but they will generate a platform for genuine and sustainable economic growth. There is an alternative to more QE.