Tuesday, March 9, 2010

Considering Q.E. in isolation is pointless.

CentreForum have just published a paper (endorsed by the Financial Times) which claims that quantitative easing (QE) has been profitable for the wealthy with the less well off not benefiting as much as they should have. CentreForum’s solution is to continue with QE, with some rather bureaucractic procedures for ensuring the benefits flow to the less well off.

I suggest CentreForum are wrong, because considering QE in isolation is a bit like trying to forcast the weather just by looking at Sunspot activity, while ignoring other factors that influence the weather.

In particular QE is a reflationary measure and it would be odd if QE were implemented in the absence of other reflationary measures: in particular a budget deficit. Indeed in the UK in 2009 the entire budget deficit of around £200bn was QE’d.

And the effect of QE in isolation is completely different from QE plus deficit which in turn is completely different from deficit in isolation.

Deficit consists of 1, Treasury borrows £X, 2, Treasury gives £X of securities to those it has borrowed from, and 3, Treasury spends £X. Note that the latter sum of money will flow to a wide cross section of the population. That is because government spending flows to a wide cross section of the population: teachers, policemen, highway construction contractors, the unemployed and so on.

QE simply consists of reversing the above items “1” and “2”. Thus the net effect of QE plus deficit is “print money and spend it”. And this money flows, as noted above, to a wide section of the population. There is thus no need for the bureaucratic systems that CentreForum advocates.

That leaves an important question to answer: if, as suggested above, QE plus deficit causes extra government spending to flow to a wide section of the population, why did the wealthy do well from QE?

I cannot prove it, but possibly the reason is that the total amount of QE was more than was needed to prevent the crowding out that accompanies deficits. I’ll expand on that.

When government borrows and spends, this must to some extent drive up interest rates which in turn suppresses private sector borrowing and spending (a phenomenon called “crowding out”). This crowding out can obviously be countered by QE. But it is very hard to say in advance how much QE will be needed to do this (for a given amount of deficit) because it hard to say how much of a problem crowding out is.

But this “ignorance” doesn’t matter! The solution to the problem is simply to implement a deficit and then implement whatever amount of QE is needed to hold interest rates at zero or near zero. Indeed, central banks have been engaged in exactly this sort of operation for decades in that they control interest rates by buying or selling government debt (i.e. QE or "negative QE").

So the explanation for the profit made by the wealthy from QE could simply be that the total amount of QE was more than was needed to counter crowding out.

QE in isolation (or in excess of the amount needed to counter crowding out) is certainly ONE WAY of stimulating an economy. But it’s a daft way of doing it. It is taylor made to boost asset prices. I.e. it is taylor made to benefit Wall Street rather than Main Street. In contrast, a deficit plus just enough QE to make sure there is no crowding out makes a lot of sense.

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