This blog post is the second in a series of posts that come from students of our capitalism and democracy undergraduate course. As part of the course, students were asked to write about an issue pertaining to the political economy of distribution. The best blog posts have been selected to provide an opportunity to exceptional young scholars at UCD to contribute to the debate on the future of European and global economic governance, and to promote the insightful scholarship being undertaken at UCD to a wider public audience.
Introduction
Conventional monetary policy consists of the Central Bank setting the interest and maintaining inflation rates of 2% per annum. Since the global financial crisis of 2008 however, conventional monetary policies seemed ineffective in maintaining the mandates of central bankers around the world. In the Eurozone the ECB still struggles with deflation. The FED and the BoE (which have dual mandates) both struggled to safeguard financial stability and economic recovery by simply adjusting interest rates to the lower bound. In light of this, central bankers have been forced to experiment with ‘unconventional monetary policies’. By far the most utilised has been asset purchasing programmes by expanding their balance sheets[1]. This ‘operational strategy’ is known as Quantitative Easing (QE).
In this blogpost I examine the monetary policy instrument of QE and its distributional impact, paying particular attention to the Federal Reserve and the Bank of England. I conclude by asking what the can ECB learn from their experience.
What is QE?
QE is a way Central Banks can inject money into the economy in order to increase demand in struggling economies, post crisis. It does this by ‘purchasing financial assets from the private sector’[2]. QE has often been described by the media as a money printing program. This is inaccurate and misleading. QE involves central banks purchasing financial assets from banks and crediting the cost of that purchase in the the banks reserve account held with the central bank. The bank can then use its extra reserves for liquidity and investment purposes.
The aim is that this additional money will then act as a stimulus into the economy. Figure 1 shows this process in the FED’s balance sheet expansion, but printed money remains in line with historical norms.
QE also has another objective. Although central banks main short-term interest rates are near 0, interest rates on mortgages/SME loans still remain high, and out of central banking control. In this instance central banks using QE lower long term interest rates by targeting US Treasury Bonds in their asset purchasing operations. By keeping the bond yield low, other interest rates such as SME loan rates would also be reduced. Therefore further adding stimulus to the economy.
QE its impacts:
It is widely agreed among economists the QE lowered long term interest rates, stopped deflationary spirals and boosted asset prices, which is all good for an economy in crisis[3]. This is why the IMF has recommended aggressive QE to be initiated by the ECB in order to avoid a decade of continued deflation. Mario Draghi last month announced a relatively modest QE program, with asset backed securities.
The success of QE in lowering long term interest rates, however, does not guarantee a translation of additional credit into ‘on the ground’ investment i.e. the real economy. The repeated over-estimates by the Federal reserve on how fast the economy was expected to grow, sums up the frustration of US policymakers, with the sluggish recovery now in its sixth year. This is in contrast to what is occurring in the stock market, which is rapidly recovering, and has led to recent rise in criticisms of QE’s distributional effects.[4]’[5]’[6]\
All of this begs the question, who benefits from QE? Is it the real economy, or the owners of financial assets?
The problem of R>G: Do the Rich get Richer?
Piketty’s concept of R>G (which suggests that when the rate of return on capital exceeds economic growth, inequality rises) has become the hot topic in economics and other empirical social sciences. It is therefore not surprising that the other hot topic in economics – QE – would soon collide somewhere along the way. QE has been criticised for its distributional effects, namely increasing the value of financial assets with the use of central banking funds. At a time when economic growth levels remain low or in recession, the inequality of R>G could not have asked for a better example than QE.
Increased R:
It is argued by people such as WIlliam Cohan of the New York Times[7] that QE has benefited certain sectors of the economy, such as the financial sector, but has yet to, and may not, increase real investment. As the BoE and the Federal Reserve purchase assets from the private sector, it is at the discretion of the private sector where the newly created (often considered public) funds go.
There is no guarantee that the liquidity created by the central banks will ever ‘trickle down’ to the labour market or increased national income. Instead as is clear from stock market volumes and price increases the private sector has tended to invest this money into financial assets – primarily owned by the rich. This may be seen as a transfer of central bank funds directly into increasing the wealth of the more affluent in society.
Further more, with very low treasury yields and the cost of borrowing is near 0, it is credible to believe (if history is anything to go by) that this may incentivise investors to place investments on riskier assets in search of higher returns. This is usually the place of birth for credit bubbles e.g Irish housing market. Could it be the case, as former FED governor Jeremy Stein warns, that if QE does fuels another bubble, it will cause more harm than good?
What about G?
Apart from raising asset prices and lowering interest rates, QE was mainly aimed at indirectly stimulating growth in post crisis economies. It is empirically true that QE did lower interest rates[8]. Declines in interest rates are generally held to boost economic output, and more importantly, avert possible declines in economic output in investment starved economies. As recent research by the BoE states, every 1% of GDP the FED spends on bond purchases, inflation and output rises by a third of a percentage point.[9] It is true that this is a small amount for such large quantities of bond purchases, however, in times of deflation, in heavily indebted financially constrained governments of the EMU, it is not to be ignored.
Data analysis on QE’s impact suggest there may be a trade-off between an increased rate of return on financial assets (r) , fuelled by central bank policies, but at the same time a lesser increase in growth (g). But it is still growth, all the same. It can be concluded from the data that QE in practice does increase R>G, however QE has still raised output and inflation – compared with deflation in non QE monetary regions i.e. the Eurozone.
Comparative Analysis: BoE, Fed, ECB:
In the figures below we can see the completely different approach taken by the ECB compared with the QE policies of the Fed and the BoE. From 2011 we can see a similarity in central bankers balance sheets. In 2011 the BoE begins expanding its balance sheet followed by the Fed in 2012. Both are increasing balance sheets in order to make asset purchases from the private sector. The ECB, at the same time, begins to reduce its balance sheet mid 2012. The effects are clear and profound. Divergences in unemployment, growth rates and deflation rates negatively affect the EMU, whilst the UK and US increased GDP and employment, and remain largely in low inflation boundaries. Although the EMU has its unique problems it is clear that since beginning an aggressive program of QE the UK and US economies have experienced positive gains.
Who Benefits from QE?
It is clear that QE does have worrying distributional effects. More specifically in QE regimes, the data clearly suggests that R is vastly outpacing economic and income growth. There is, therefore, a trade-off between increased income inequality but lower unemployment and higher inflation levels.
In the EMU there is deflation, higher unemployment and austerity. Public policy decisions are putting a disproportionate burden on low income workers and debtors. Unemployment is regressive as low income workers suffer higher unemployment rates and a disproportionate loss in living standards, and are at greater risk of falling into poverty. Deflation also makes debt less bearable, and those in debt tend to be those with lower income and savings. Austerity in the form of cuts to public expenditure also disproportionality affects lower income earners in need of public services.
In contrast, QE in the US and UK disproportionality benefits higher income earners, whilst benefiting the economy as a whole. The EMU, suffering from deflation and high unemployment benefits no-one. Throw in a dose of contractionary central banking and austerity as the solution and you hurt the economy as a whole, whilst increasing inequality. To quote directly from Piketty on page 541:
“ The worst solution in terms of both justice and efficiency is a prolonged dose of austerity – yet that is the course Europe is currently following”.
Evan Walker 22 year old Dublin student, Studying Economics at UCD. Interested in Eurozone economy, International Monetary Economics and European Political Economy. This blog post was completed as part of his coursework for the UCD Politics module: Capitalism and Democracy.
Data Sources:
Data presentations accredited to myself have been created through the Federal Reserve of St.Louis data programme ‘FRED’, STATA ‘13’, Excel ‘13’ Eurostat and ECB SDW generators. Graphs not accredited to myself have been referenced to their original sources.
The data used comes from the Federal Reserve, ECB, Eurostat and the Bank of England databases.
References
[1] “Monetary policy: An unconventional tool – FT.com.” 2014. 31 Oct. 2014 <http://www.ft.com/cms/s/0/22011490-4a30-11e4-8de3-00144feab7de.html>
[2] Benford, James et al. “Quantitative easing.” Bank of England Quarterly Bulletin 49.2 (2009): 90-100.
[3] “Monetary policy: An unconventional tool – FT.com.” 2014. 31 Oct. 2014 <http://www.ft.com/cms/s/0/22011490-4a30-11e4-8de3-00144feab7de.html>
[4] “Monetary policy: An unconventional tool – FT.com.” 2014. 31 Oct. 2014 <http://www.ft.com/cms/s/0/22011490-4a30-11e4-8de3-00144feab7de.html>
[5] “How Quantitative Easing Contributed to the Nation’s …” 2014. 31 Oct. 2014 <http://dealbook.nytimes.com/2014/10/22/how-quantitative-easing-contributed-to-the-nations-inequality-problem/>
[6] “Debate rages on quantitative easing’s effect on inequality …” 2014. 31 Oct. 2014 <http://www.ft.com/cms/s/0/c630d922-586f-11e4-942f-00144feab7de.html>
[7] “How Quantitative Easing Contributed to the … – DealBook.” 2014. 31 Oct. 2014 <http://dealbook.nytimes.com/2014/10/22/how-quantitative-easing-contributed-to-the-nations-inequality-problem/>
[8] “Bank of England External MPC Unit Discussion Paper No. 42.” 2014. 31 Oct. 2014 <http://www.bankofengland.co.uk/research/Documents/externalmpcpapers/extmpcpaper0042.pdf>
[9] “Bank of England External MPC Unit Discussion Paper No. 42.” 2014. 31 Oct. 2014 <http://www.bankofengland.co.uk/research/Documents/externalmpcpapers/extmpcpaper0042.pdf>
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