13th November 2009 by Shaun Richards
Essentially central banks have two main methods of operation. The first is that they have the power to set interest rates (strictly the overnight interest rate) and the second is where they can simply create money. The first method of operation by the Bank of England is reasonably well understood. If it feels inflation approximately two years ahead will be above its target rate then it raises interest rates and if it feels it will be below then it cuts them.
The second power to create money is less well understood. The Bank of England could at the simplest level just print more banknotes. It has this power but in normal times does not explicitly use it to influence the economy. However having cut its base rate to only 0.5% the Bank of England realised that its main weapon of manipulating interest rates was nearly used up. It could do little more with it.
Putting more money in the economy is the alternative option and this is what Quantitative Easing (QE) is . Should you do this then the general principle is that more money in the economy creates more liquidity (often called excess money balances) which people then tend to spend. Thus the real economy benefits as consumers spend more than they otherwise would. So in a situation where the economy is suffering from insufficient demand such a policy can help to increase demand. It all sounds so simple and in theoretical terms it is.
The next question is how do you do it in practice? John Maynard Keynes came up with the idea of burying the money in coal mines. The idea behind this was that people would have to work to get the money and would in a way consider it to be a type of wage. So they would then spend it. One can see that creating this money might quickly influence the real economy. In more modern times economists speculated that it might be better to drop money from helicopters so that people could collect it and spend it. If you dropped the money on a main shopping street such as Oxford Street it might get spent rather fast! In case you had ever wondered how the current Chairman of the Federal Reserve Bank in America got the nickname “Helicopter Ben” I hope it is now clearer.
What has the Bank of England actually done? According to its website it has so far created £178,291 million of new money,so it cannot be accused of a lack of enthusiasm for the task. So far so good you might think. However the next number is troubling to me because of the above amount £176,175 million has been spent on UK Gilts (UK government debt). The mechanism by which this money creation expands demand in the economy is much less clear than the examples above. There may well be individuals who receive money and then go on to spend it but the vast majority of this money will have gone to UK and foreign institutions such as banks, pension funds and sovereign wealth funds. It requires further links in the chain for this to help demand in the UK economy.
One method by which such a policy might help is by lowering long-term interest rates. This in theoretical terms might help companies to borrow at cheaper interest rates for example or house buyers to get cheaper fixed rate mortgages. However long-term interest rates are already quite low. Twenty or so years ago as a young man working in the UK gilt market I remember the 20 year gilt yield being 15%. Today it is in the region 4.2/4.3% and in fact the UK gilt market goes out to 2060 at similar rates. This may well be too low rather than too high so it is an odd method of policy operation in my view. Of course one could argue that this policy makes long-term interest rates lower than they would otherwise be rather than actually reducing them but the effect is similar.
I have heard some economists argue that QE is a good idea as it is a zero sum game. Sadly for their logic there are other counterparty’s such as foreign institutions benefitting from the policy if they choose to sell their gilt holdings. If you follow the logic that gilt interest rates are low then we may be doing them a favour by allowing them to sell at such price levels in such quantity. But it is definitely not a zero sum game.
So far there has been very little evidence of QE working in the UK. There are claims from the Bank of England that it is but there is very little evidence to back it up. This leads to the question where has the money gone? Well in the main the institutions receiving the money operate in asset markets. It is no coincidence in my view that equity markets have rallied over this period, in fact most asset markets have risen. One might argue that a higher stock market will support the economy by allowing firms to refinance themselves via right issues and there has been some evidence of this. But this is quite an indirect mechanism and might take quite some time to have its full effect.
So for the sums committed it might be reasonable to suggest that the results are at best partial. I think that the Bank of England initially deserved praise for taking decisive action in a crisis but since then it has had an opportunity to reflect at more leisure and modify its course of action and in my view it has not. Indeed there are issues still to be resolved as if it has led to a rise in equity markets then it is possible QE has led to an asset price bubble. The role of central banks is to stop or deflate bubbles not to create them. Also I have heard no coherent policy on how this policy is going to be reversed. I intend to return to this issue in later posts.
All opinions on this blog are my own and the figures quoted come from the Bank of England website