Quantitative easing is no silver bullet for solving economic ills

THE ECB is under growing pressure to embark on a large scale government bond buying programme.

Recent wobbles in the financial markets along with further evidence of economic stagnation has added weight to calls for the implementation of some form of quantitative easing aimed at jump charging the eurozone economy. In mid-October, stock markets on the Continent suffered what was described as “the longest losing streak in 11 years”.

A few days ago, the ECB chairman met with Europe’s leaders in Brussels to try and chart a course. As so often in the past, the German chancellor, Angela Merkel, finds herself in pole posiiton. She will be pressed to give the go ahead to measures aimed at jump-starting the eurozone. The sharpest debate surrounds the monetary measures in the pipeline.

The debate coincides with the release of the results of the latest stress test of eurozone banks. The size of the holes unearthed is set to determine, in part, the response of the policymakers. QE-style measures would be viewed as positive from the standpoint of the banks, many of which continue to struggle with customer bad debts and a lack of decent lending opportunities. The bank chairman, Mario Draghi, favours what amounts to “QE- Lite”. He has secured the go ahead from his governing council for a programme of large-scale purchases of asset-backed securities and covered bonds.A one trillion euro expansion in the ECB balance sheet is envisaged. Draghi must walk a fine line between those who favour full blown QE, involving large scale purchases of sovereign bonds, and those, particularly in Germany who view the whole idea with deep suspicion. Writing in the Financial Times, the UK economist, Gavyn Davies, suggested Draghi had “left the markets disappointed and perplexed” with “doubts about whether the new policy could be implemented in sufficient size to deal with the deflationary threat in the euro area”.

However, Draghi appeared to address some of these concerns during a speech in Washington DC when he asserted that “the governing council is unanimous in its commitment to take additional unconventional measures to address the risks of too prolonged a period of low inflation”. The irresistible force in the direction of monetary easing continues to come up against an immoveable object in the form of Germany’s Bundesbank and its head, Jens Weidmann, who believes government bond markets represent a “dangerous path”.

The historian of the US Federal Reserve, Alan Meltzer says bond buying by the Fed did not encourage increased bank lending.

“With $3.5 trillion in excess reserves sitting in the banking system what good can the Fed do by adding to that? The answer is nothing,” he told Fortune magazine recently. According to Rick Rieder, Chief Investment Officer of investment group, BlackRock, the Fed has created serious distortions in financial markets by buying up so much of the world’s ‘safe assets.’ Andrew Huszar of Rutgers Business School helped oversee the rollout of ‘QE’ at the Fed, managing the Fed’s $1.25 trillion mortgage-backed security purchase programme. While Huszar believes QE was vital in the early stage of the crisis, it has been maintained for too long.

“My programme drove down the cost to the banks of making mortgage loans.. the banks pocketed a lot of the extra profit.”

The banks also earned plenty of commission as the Fed bought up the bonds via a network of dealers controlled by the banks. Mortgage lending actually fell between January 2009 and mid 2010. The banks “invested the extra money into securities to take advantage of the rising tide of asset prices.” As Huszar told Time magazine, “for the amount of money spent and the amount of risk the Fed is taking for itself and the US economy, it’s just not worth it”.

“Then there is the question of how the Fed unwinds its unprecedented expansion. This unwinding will have to be invented on the fly and it could have huge downside risks for the US economy.”

Talk of tapering off the bond purchases was enough to send the market into a spin. Huszar believes that monetary expansion via QE has allowed politicians off the hook when it comes to implementing fiscal reforms. This argument has resonence in Berlin and Frankfurt where the mantra is first, implement structural reform and then we will consider a relaxing of the reins.

Distrust of QE is not confined to the monetarist wing of economics and finance. Tom Palley of the New America foundation has produced what he calls a “Keynesian critique” of QE — a reference to the view of John Maynard Keynes, who created the template for how to ease the impact of major swings in economic activity. Palley, a critic of globalisation, accepts QE is necessary at times of extreme stress, but warns that in a deep recession, QE will not achive its task of reviving the High Street economy as too many of the channels are “blocked”.

The problem is that QE tends to cause asset bubbles which then cause damage when they burst, later on. Quantitative easing may produce positive wealth effects initially, but the psychological damage from the bursting of asset bubbles easily outweights this. Such bubbles risk causing systemic financial fragility, with capital being allocated towards speculative rather than productive uses. A repeat of the mistakes made in the early to mid Noughties, in other words.

The wealthy have done well out of QE, ordinary people far less so. Older savers have seen interest rates on savings and annuities plummet while younger people come up against rising house prices and rents. The City of London is keen for the ECB to move toward QE, but can we always trust the fur-lined denizens of high finance ? Perhaps it is time to consider globalisation and its effect on transferring resources from labour to capital, and pushing down wages and incomes in the advanced world. Global free trade remains central to our wellbeing, but is it not time to tweak the model, not simply through yet more measures to perfect the free movement of goods and service, such as those currently in train ? Moves to encourage the rise in real wages in places like East Asia would arguably do more to prop up incomes and spending back in places like Europe.

QE offers vital tools in a crisis, but is the crisis in the eurozone sufficiently severe for the policymakers to have resort to the monetary toolbox ? Would it be more desirable for Europe’s leaders to focus rather on fiscal measures such as a big expansion in public investment and structural reforms in labour markets, banking and other key sectors?