Quantitative easing

[wellinghall]

Taking a leaf out of philmophlegm's book -

Can someone (maybe the estimable philmophlegm himself) explain quantitative easing to me? More specifically - how can the government both be selling gilts to the market, and buying back gilts from the market, at the same time?

Thank you!

Comments

[philmophlegm.livejournal.com]

OK...

I'll start at the beginning.

There are fundamentally two ways for governments and central banks to influence the economy - through fiscal policy and through monetary policy. Fiscal policy instruments would be things like increasing government expenditure to increase demand in the economy or imposing restrictions on wages to reduce inflationary pressures. These were the instruments favoured by Keynes, and used by most governments in the two to three decades following the war. However, they were unable to deal with a situation of low growth and high inflation in the seventies ('stagflation') and so largely fell out of fashion. Monetarist economists (and their New Classicalist mates) would argue that this is because any increase in government expenditure in the economy 'crowds out' private sector investment. This means that the overall effect on the economy is smaller than the cost of borrowing to finance the extra public expenditure. Keynesian economists might acknowledge crowding out, but would argue that the effect is small. Monetarists would argue that it is large. New classicalists would argue that the crowding out effect is close to 100%.

Monetary policy concentrates on managing the supply of money in the economy - more money, more demand etc. Interest rates are the most common instrument that governments and central banks use. Too much inflation? Raise interest rates. By and large, monetary policy instruments have worked well since the 1980s, although they work best if other instruments are not interfered with - no large budget deficits and no fixed exchange rates. In particular if you fix your country's exchange rate in relation to another currency with different monetary pressures, you can really bugger things up (this is what Nigel Lawson did when he took Sterling into the European Exchange Rate Mechanism in the eighties). Supply side reform is also important - deregulation, reducing trade union power, increasing employment flexibility etc.

So if you have an economy in recession - or in danger of recession because commercial banks' abiliity to lend to businesses is restricted by their own exposure to risky debts - you would generally want to:
a) reduce interest rates;
b) increase government expenditure (if you take an old-fashioned Keynesian view of the crowding out effect); or
c) both.

But what if the government's budget deficit is already so high (and going to get worse because of reduced tax incomes during a recession) that increasing government expenditure isn't possible AND interest rates are already close to zero? That was the situation the government and the Bank of England faced in 2008. Reducing interest rates to negative rates is theoretically possible, but politically unlikely. Can you imagine building societies having to charge people to look after their money for them?

So, quantitative easing becomes one of few available instruments. It's worth pointing out that at least we had that option. Countries that don't have control of their own money supply (Greece for example and in fact all of the Eurozone countries) can't even do this. They're really buggered.

[philmophlegm.livejournal.com]

So what is quantitative easing?

First of all the Bank of England 'prints' money. Not literally, but essentially it increases the size of its own cash deposits out of thin air. Then the Bank uses this new cash to buy back government securities from financial institutions like banks. The commercial banks' balance sheets therefore become more liquid since they have replaced government securities with straight cash. This is important because banks are limited in the amount that they can lend to businesses and individuals by the amount of cash they hold in reserve (the 'reserve requirement') so by increasing the cash assets of a commercial bank, the Bank of England makes additional lending to industry and individuals possible, thereby stimulating the economy.

An additional impact is that because the central Bank is buying lots of gilts, the price of those gilts in the market goes up - they are more expensive. That means they are less attractive to investors and financial institutions, who find something else to invest in - perhaps company bonds or equities, again helping companies raise cash and therefore stimulating the economy. Even better, because those financial institutions now find it more attractive to lend to companies (by buying company bonds), the interest rate that companies have to pay on those bonds goes down - again making it easier for companies to raise cash and therefore stimulating the economy.

At some point in the future, the Bank of England is able to sell the government securities it bought and theoretically it would destroy the cash, so the long term effect of quantitative easing could be balanced out. Of course, the Bank could choose not to do this.

Now while all this is going on, the government still has a budget deficit to finance (actually a thumping great budget deficit). You might think that if the government is 'printing money' anyway, it could print some more to pay for all those vital and 'vital' public sector costs. Actually, 'printing' money to pay for a budget deficit (as opposed to printing money to ease credit) is very often disastrously inflationary (think Weimar Germany or Zimbabwe) and largely because of this it is expressly forbidden to EU member states (even those outside of the Eurozone) by the Treaty of Maastricht.

So to finance public sector expenditure, the government has to issue gilts to the market regardless of the quantitative easing taking place at the same time. There is a benefit to the exchequer of doing this while interest rates are low in that the new government debt issued can be at lower interest rates than the old government debt being bought back through quantitaive easing. The government has replaced debt on which it pays a higher rate of interest with new debt on which it pays a lower rate of interest. However, were the government's AAA credit rating reduced by the credit rating agencies, the new debt would be less attractive to investors and would have to be issued at higher interest rates.

So what could go wrong?

1. Regardless of their extra liquidity, the commercial banks fail to increase their lending to industry and individuals. There is some evidence that they are still reluctant, and you will hear politicians from different parties complaining about this from time to time.

2. It works too well and over-stimulates the economy, leading to inflation. A risk yes, but a manageable one in the current climate.

3. The UK loses its AAA credit rating. Still a risk - and this would be bad. This is ultimately the reason for the emergency budget we had recently. If you just look at the numbers (deficit to GDP ratios etc), we probably should have been downgraded under the last government, and it was probably the election of a government more committed to reducing the budget deficit that saved us.

[alitalf.livejournal.com]

Thanks, I think I understand that now.

[arda-unmarred.livejournal.com]

what surprises me about it all is this: those credit ratings agencies can easily be used as a political tool, right? So if I am in charge of a credit rating agency, or better still in a position that can influence a number of them I basically can play God over a country's economy (and not just economy) and tell them what to do. Not to mention risks of corruption etc.

I am surprised that the EU allows a small handful of organisations to wield such massive political power.

[wellinghall.livejournal.com]

I am curious as to why you have singled out the EU - they rate most / all countries' credit-worthiness, not just that f EU countries.

[arda-unmarred.livejournal.com]

oh, mainly just because the EU is the largest political entity that we belong to. There is little hope on any cohesive global action ever taking place, and the UK on its own is too small to take on the global financial world...

[philmophlegm.livejournal.com]

You make a valid point. It's one reason why the Chinese government has launched its own credit rating agency, which (perhaps not surprisingly) gives China a better rating (AA+) than most western economies, including the US (AA) and the UK (AA-). It's probably politically motivated, but their rationale is that the western agencies put too much emphasis on political stability and not enough on foreign currency reserves.

It's an argument. It's not an argument I'd agree with though - countries with stable regimes tend to pay their debts, countries whose regimes are overthrown often renege. However, suggesting that the budget deficits of certain western economies are unsustainable is not at all a bad thing.

The advantage of independent credit rating agencies is just that - they are independent and less likely to be put under political pressure. Since there are a few of them, they also act as a check on each others' work. Corruption risk? Yes, but probably lower than it would be if credit rating was performed by a quasi-governmental or supra-governmental organisation such as the IMF or the World Bank.

[arda-unmarred.livejournal.com]

I would very much question their independence however, especially after they gave effectively failing banks perfect ratings prior to the crisis. They also tend to act in unison rather than as a check on each other. The wiki list of criticisms is very trenchant - there are obvious conflicts of interest, and it has long been in the news that the agencies are basically in the pay of the companies they rate. Or they tell a government to introduce austerity measures in order not to lose its rating, and the government having obeyed, they downgrade it anyway because the said measures depress the economy even more.

Ultimately the agencies take away power from elected officials and give it to unelected foreigners, and that can't be great for anyone. If the citizens of a particular country want to choose regulation, strong unions and strong job security over what the current economic orthodoxy demands (as you describe in your first comment) they could be punished for their choices through a lowering of their credit rating.

[(Anonymous)]

"...especially after they gave effectively failing banks perfect ratings prior to the crisis"

Yes, I agree with you on this, although I would blame part of it on incompetence as well as non-independence.


"If the citizens of a particular country want to choose regulation, strong unions and strong job security over what the current economic orthodoxy demands (as you describe in your first comment) they could be punished for their choices through a lowering of their credit rating."

Well, yes, but those choices are choices that probably make the country a bigger credit risk compared to one that is more careful with its public finances, hence lower ratings. If you want to get a good credit rating to be able to borrow cheaply, it's pretty obvious that you shouldn't have record of defaulting on loans, behaving irresponsibly or borrowing more than you can comfortably afford. That principle applies to governments just as it applies to companies and individuals.

[arda-unmarred.livejournal.com]

True. Except there's no obvious link between strong regulation/job security, etc. and being a credit risk - the social democratic states of Western Europe, and even the US and UK before the their economies were liberalised, were not exactly in the same league as Zimbabwe. More like the reverse. In fact, as the crisis (which we have not seen the last of by any means) has shown, it's deregulation that was about the most irresponsible thing a country could do. If you compare like with like (which is to say, leave countries like Greece out of it), the less 'flexible' economies of Western Europe have done better than the UK on almost every one of the parameters you list (if newspaper reports can be believed at any rate).

[philmophlegm.livejournal.com]

Sorry - that was me.

[colinbj.livejournal.com]

Thank you, this is clearer than the Wikipedia article!

[philmophlegm.livejournal.com]

Yeah, I looked at that - it assumes rather more knowledge about macroeconomics than most people would have and it tries to explain in too much detail. I'm glad you liked my (also slightly rambling) explanation.

[philmophlegm.livejournal.com]

Do you really need a 'quantitative easing' tag?

[wellinghall.livejournal.com]

Well I won't have a problem finding the post again!

[philmophlegm.livejournal.com]

True. I was just worried that this is going to turn into a series...

[wellinghall.livejournal.com]

Have no fear! There may be one or two follow-up questions on points of detail in your comment, but I'm not angling for a job as Governor of the Bank of England. (Or doorman there, no matter how nice their coats).