After my previous post on the QE taper there was some discussion on the INET YSI Commons Facebook page about the QE programs. I think it might be constructive to sum up what was there discussed as it provides a very good overview of what the QE programs do, what they do not do and how they work.
First of all, however, it should be noted that the objectives of the QE programs appear to have changed over time. When the program was initially put in place by the Fed in 2008 — or, if one wants to go further back in time, when it was first enacted by the Bank of Japan in 2001 — it was generally thought that the program would boost investment in the real economy and thus create employment.
This would be the truly monetarist component of the QE program. The idea is that you increase the amount of money in the system, this money flows from the banks into the real economy and thus increases investment and employment. A variant on this — what might be called the New Keynesian variant — is very similar: the QE program increases the amount of money in the system, this drives interest rates down across the board and these lower interest rates force businesses to invest in tangible assets.
Such ideas were the initial impetus for the QE program and by these criteria it failed spectacularly — as MMT and endogenous money proponents suspected that it would. Over time, however, the commentariat have revised their estimations of the QE programs in line with what it has actually done and attempted to justify its results post factum; the Fed, in turn, has endorsed such maneuvers with glee and run with them.
These maneuvers are why I think the QE program to be a largely false distraction, ultimately cooked up for the amusement of economists and economic commentators; a soporific ingested in order to distract oneself from the true determinants of our current problems. If the initial impetus for the QE programs has proved false and pundits nevertheless judge it based on some of the things it has accomplished in a peripheral manner one is certainly hard pushed to think that it is not largely a nonsense policy — a mask, covering up the impotence of central banks since 2008.
All that said, let us now consider briefly what QE actually does and how it does it.
As everyone knows, the program works by central banks creating money and using this newly created money to purchase various assets — mostly bonds, but also securities and some other stuff. When these assets are purchased two things effectively occur: their value increases and their yield falls.
Another way to think about this process is that the central banks are limiting the supply of assets. Imagine that there a set number of such assets in a given market — say, 1,000 — and that the average price is also set — say, at $1,000. Now, say that the central banks steps in and uses newly created money to buy up half the assets and this, in turn, doubles the price. The supply of assets in the market falls by half and the price doubles. (This is not an accurate portrayal of either the extent of central bank purcahses or of the price dynamics, but just a stylised example to help us understand the dynamics at work).
At the same time, however, that the price of the assets rise, their yields fall. Thus, again for the sake of an example, imagine that the assets initially had an average yield of 5%. But then, after the central bank purchases, their yield falls by half to 2.5%.
The situation is now clear. Holders of the assets have seen an increase in their net worth as the value of the asset has doubled, but they have seen a fall in their income streams as the amount that their assets yield has halved. In the economics jargon we might say that as their stock of wealth has increased, their income flows have diminished. This is what we might call the “primary effect” of QE.
There are, however, secondary effects. Because the yield has fallen on their assets and because some people who used to hold assets but sold them to the central bank now hold cash, which basically yields 0% (actually, the real rate is 0.25% in the US and 0.50% in the UK), these investors will now search out other markets in which to make money. In doing so, this will drive up the value of the assets in these markets and drive down their yields. Thus we have a sort of cascade effect where the initial burst of value given by the QE is translated from one market into another. These are the secondary effects.
Neil Lancastle has reminded me that there is also a tertiary effect. When companies see the value of their assets rise, they also see the value of their equity rise. This encourages them to take on more leverage and spend this on more assets. This, in turn, boosts the value of the assets even more.
As we can see, however, this cascade process eventually comes to an end. And what we finish with is a market in which asset prices are substantially higher but yields are suppressed. This proves to be something of a double-edged sword for savers and investors. On the one hand, they are glad to see that their assets are worth more money, but on the other their income streams are substantially diminished. After a while, this becomes tedious for investors as it eats into their wealth — this is why some in the financial markets, especially pension funds, get annoyed by the QE programs: they make it extremely difficult to accrue steady flows of income.
While the effects the programs have on investors is mixed, the effects it has on asset prices and leverage are not: it increases them beyond what they would be if the programs did not exist. This can be enormously problematic. Many like Chris Cook and Izabella Kaminska (and myself), have argued that the programs have led to a run-up in commodities prices, for example. Such a run-up in asset prices may also — and on this point the central banks are more than aware — lead to bubbles. I have, for example, discussed how current dynamics in the stock market may become fragile if government spending is cut and the real economy stagnates.
As we can see then, there are risks and downsides to the QE programs. They hurt as well as help investors and savers and they may generate instability and fragility in financial markets. The program, from this perspective, basically provides a sugar rush for the market, but it is in no way clear that as the impetus added to asset prices wears off the overall level of income does not fall due to decreased interest income.
Meanwhile, however, the program has extremely positive effects for debtors. As the cascade drives down yields across the markets, interest rates on all sorts of loans for consumers fall. This reduces the amount that these debtors have to pay in terms of interest on debt. The following chart shows the amount of their disposable income US households are using to service their debts:
As we can see, this fell from some 13.5% before the QE programs to some 10.4% after. This is a net increase in US households’ disposable income of 3.1%. This is nothing to be sniffed at and, because they have more income to spend on other goods and services, this undoubtedly adds to demand and GDP.
It should be stressed, however, that these positive effects can only go so far. The first two round of QE were initiated between November 2008 and April 2011. As we can see, in this period debt service payments as a percent of disposable income for households fell substantially to 10.4%. The third round of QE which was initiated in September of 2012 has not had much of an effect at all; indeed from the data we do have for that quarter it appears that debt service payments as a percent of disposable income for households actually rose by about 0.2%. Talk about diminishing returns!
And that is it really. As we can see the effects of the QE programs are mixed. They can boost asset prices — but this is largely offset by the decline in yields that results. This also may have undesirable results and lead to fragility. The programs also alleviate the interest payment burden on debtors. This has a positive effect, but is subject to seriously diminishing returns.
Again we must stress though, the original idea behind QE was that it should increase real investment and employment. This simply has not happened and by this standard — which is the standard by which QE should be judged — the program has been an abysmal failure. A key lesson should be taken from this: business investment is first and foremost demand-led and does not simply respond to lower interest rates or increases in the base money supply. If the customers are not there to buy the goods and services, the companies will not invest and hire in the real economy.
It is for that reason that the QE programs are largely a distraction talked about by an economic establishment that feels powerless when confronted with the confusing facts of the post-2008 world. Rather than recognising the serious structural problems we face — from moribund governments undertaking failed austerity programs to ever-widening income inequality — the establishment prefers to chatter over the QE programs, as if the wonks still had some control over the system. Well, the harsh reality is that they don’t.