Why Quantitative Easing should always be with us

Quantitative Easing
(QE) is not a well loved policy instrument in many quarters. What I
want to argue in this post is that this unpopularity is in many cases
misplaced, and also why QE will and should always be with us as long
as central banks remain independent. To understand why, we need to
talk about how fiscal policy (changes in government spending or
taxes) is financed, and what happened at the start of the Covid
pandemic.

Macroeconomic
textbooks are full of discussion and analysis contrasting bond
financed and money financed fiscal policy. With a bond financed
fiscal expansion the extra spending (or tax cuts) are matched by
higher borrowing, while a money financed fiscal expansion is paid for
by creating more money. But in the real world governments do not
debate whether to finance the deficit by issuing bonds or creating
money. That is because money creation has been delegated to their
independent central bank.

Central banks in
turn typically determine short term interest rates to achieve
inflation targets. But a money financed fiscal expansion is still
possible, if a fiscal expansion is accompanied by Quantitative Easing
(QE). This is what happened in the UK during the pandemic. Furlough
was paid for by increasing government borrowing, but the Bank of
England bought a
very similar quantity of government debt by creating
bank reserves (electronic money). So if you treat the central bank as
part of the consolidated public sector (as you should here, because
central bank profits and losses go to the government), furlough was
largely paid for by creating money. It was similar to a classic money
financed fiscal expansion. [1]

If QE is very
similar to textbook money creation, why was it initially treated as
something new, and why has it become so unpopular in some quarters?
Before the Global Financial Crisis (GFC) most mainstream economists
signed up to the idea that macroeconomic stabilisation (and therefore
control of inflation) should be exclusively done by independent
central banks varying interest rates. In such a world, there would be
no need for fiscal stimulus during recessions, because lower interest
rates would do the job more quickly and efficiently. Any money
creation done by the central bank would just be a bi-product of its
interest rate setting process.

In effect,
independent inflation targeting central banks removed
the option of governments choosing to finance their
deficits by creating money rather than by borrowing. But that
was fine, because there was no reason for governments
to want to finance fiscal policy by creating money rather than
borrowing as long as the central bank was able to control demand and inflation
by varying short term interest rates.

That idea broke down
during the GFC, because interest rates fell so low they hit a level
(roughly zero) that central banks were reluctant to go below. QE was
adopted by both the UK and US as an alternative way to stimulate the
economy. Money creation was back on the menu. Unfortunately, this
also helps explain some of its unpopularity. When fiscal stimulus in
2009 turned to austerity in 2010 in most major economies, too many
people who should have known better suggested this wouldn’t matter
because QE could do the job interest rates could no longer do.

There is a simple
reason why this was not, and will never be, true. Fiscal stimulus has
a much more reliable impact on aggregate demand than QE. It is now
generally recognised by most academic economists that fiscal
consolidation in 2010, at the start of the recovery from the biggest
recession since WWII, was a major mistake. But this mistake didn’t
happen because of QE. It happened in part because some, including
many senior central bankers, oversold what QE was able to achieve.

Quantitative Easing
is also unpopular because it’s associated in many people’s minds
with increasing wealth inequality. Once again, I think QE is being
unfairly judged. What causes asset prices to rise is low long term
interest rates. The decline in long term interest rates since the
1980s is in large part outside the control of policy makers. Long
term rates are influenced by central banks varying short term rates,
but they do this to keep inflation on target and aggregate demand
reasonably strong. The contribution of QE to the level of asset
prices is marginal compared to other factors, including the impact of
the central bank’s interest rate decisions. Of course low interest
rates also mean the income received from financial assets is lower,
so what the wealthy gain on the wealth side they lose on the income
side.

The wealth effect of
very low interest rates is also not inherent to interest rate
stabilisation, but is instead a reflection of bad fiscal policy. Good
fiscal policy should ensure that interest rates never need to fall to
zero, except in extreme circumstances where fiscal policy has not had
time to have an impact on the economy. The fact that we had interest rates at
their lower bound for so long after the GFC reflects the 2010
austerity mistake in the UK, US and the Eurozone.

There is a serious
issue involved in reversing QE, which I have looked at in a recent
post. Central banks are understandably
reluctant to sell the large quantities of government
debt they hold quickly (and use it to reduce reserves), which means
money creation is slow to be reversed. As central banks pay interest
on these reserves, when interest rates are high and rising as they
are today the public sector ends up transferring funds to the private
banks holding the reserves. But as my post points out, this is not a
necessary consequence of QE, and can be fixed in more than one way.

Last, but definitely
least, there is an argument some make that the expansion of QE during
the pandemic helped cause today’s high inflation. This is in my view
largely nonsense, and relies on either inflated views of the
importance of central bank money creation (a form of monetarism), or
incorrect views on what
determines bank lending. If pandemic QE hadn’t happened we would
still have had higher energy prices and the invasion of Ukraine. More
generally, given what happened after the GFC, it was important that
policy ensured a strong and quick recovery from the pandemic, which
is why I still think Biden’s fiscal stimulus in 2020/21 was the right
thing to do. As I note above, good fiscal policy should always
ensure interest rates are well above their lower bound.

While QE is not the
evil that some make out, a legitimate question is whether it has any
positive virtues. Why do you need an unreliable replacement for
cutting interest rates when interest rates hit their lower bound if
fiscal expansion is always superior? To answer that we need to go
back to the last time a money financed fiscal expansion occurred,
which was the pandemic. What the onset of the pandemic showed is that
bond markets (the markets for government debt) can be fickle. As the
pandemic broke they initially
refused to buy government debt (not just in the UK but
elsewhere), so without QE the government would have been forced to
repeat the mistake of 2010 and cut spending or raise taxes.

This is why the QE
option always has to be there, and why QE will always be part of the
policy toolkit. When a fiscal expansion is vital but the government
cannot sell its debt, there has to be the option of a money financed
fiscal expansion.

We can make the same
point another way. One of the excuses for 2010 austerity was
precisely that without it the bond markets might panic. QE was the
key reason why that argument was false, as I outlined in one of my
first
blog posts. When bond financed fiscal expansion is not
possible because of fickle bond markets, yet fiscal expansion is
necessary for the health of the economy, money financed fiscal
expansion has to be an option. QE is what makes that option possible.
It is very ironic that while central banks mis-sold QE as an
alternative to fiscal expansion, in reality QE was all you needed to
blow the main argument against fiscal expansion out of the water. [2]

So in my view the
bad press QE gets is largely unwarranted. It is true that QE is a
pretty unreliable stimulus tool in itself, and it should never be a
substitute for fiscal expansion during recessions. However QE is an
important policy instrument that allows those fiscal expansions when
the economy needs it, interest rates are so low they cannot provide
it, yet bond markets will not buy government debt. This combination
of circumstances is unlikely to happen very often, but even when it
doesn’t happen the existence of QE knocks down claims that it might.

[1] In a textbook
money financed fiscal expansion, the government saves having to pay
the current interest rate on the government bonds it would otherwise
have had to sell. With QE, the consolidated public sector (government+central
bank) saves having to pay the interest on the bonds the central bank
happens to buy. Another difference in detail is that furlough was more like fiscal
support rather than fiscal expansion.

[2] Is there a
problem because governments do fiscal expansions, but central banks
do QE? There shouldn’t be, because in recessions caused by
deficient demand central banks will want long term interest rates to
be low, and if the bond market is reluctant to buy government debt
long term interest rates will rise, so the central bank will buy that
government debt.