QE – new method please

For five years we`ve all got to know the term “Quantitative Easing“ (QE). It means increasing the money supply.  But it does not relate to the traditional way of reducing interest rates and thereby spurring greater creation of money in the banking system. It applies a more direct form: have the central bank buy assets (mainly government bonds) with newly created money. The idea behind it has been to keep the economy from lurching into “deflation“, which is deemed to be most dangerous: deflation raises the real value of debt in over-indebted economies and tends to make too-slowly-growing economies grow at an even slower pace – or put them into negative growth.

So lots of money has been created. In the US, for example, QE generated some 35% of the amount of M2 that existed before the program started. This has tended to go on and on, because inflation as measured by the CPI or core CPI has been deemed to remain at dangerously low levels. The US, admittedly, has recently ended its five year old QE program, but not Europe, which is just beginning.

Just using the interest rate tool hasn`t been enough to create more money. The “transmission mechanism” of banks responding to lower rates with more lending hasn`t worked. Part of the reason for this is regulators making rules for banks` capital safety much more stringent post the 2008 Western Financial Crisis, a case of conflicting policies cancelling each other out.

So the stronger money creation method of QE has been used. QE “transmits” to more money better, because a central bank- purchased government bond directly forces the hand of the investor who sold or would have liked to buy some or all of the same bonds to seek alternative investments. So where has the would-be bond buyer`s freed-up money gone? Well, it doesn`t appear to have gone into goods and services, because inflation has remained very low. Where it most likely has gone is into investments like houses, land, equities, art and wine – all items which have surged in price over the past five years, but which are not included (except wine maybe – but probably not the expensive stuff) in the consumer price index (CPI) and therefore don`t officially contribute to inflation.

But inflation in these items there certainly has been. It seems absurd for central bankers to focus exclusively on the CPI when trying to create modest 2%-or-so inflation, because so many of today`s rich world`s important prices are not included in the CPI. Are we seriously happy to say that the price of the weekly shop at the local supermarket is more important to the average person as the average price of homes?

Moreover, this distortion – of QE having pushed up investment prices while consumer prices stay flat – has greatly exacerbated one of the big troubles of our times: growing inequality of income and wealth in the developed west. The rich benefit disproportionately from rising investment values – at least until the next housing / art market / vintage cars etc. crash.

So, the existing means of implementing QE is (a) debasing our money (i.e. underlying inflation is actually worryingly very high, not worryingly low or non-existent), which is a bad thing for sound economic management; and (b) exacerbating worryingly high levels of inequality, which is bad for growth and bad for social stability – not to mention being amoral.

If we deem some type of QE is needed, and that some inflation is actually good for us in order to reduce real debt loads, during an extraordinary phase of low economic confidence in order to protect against a depression, then here`s an alternative way: send every citizen in the EU a cheque for €1,000 from the European Central Bank. This would amount to c. €507bn, or just under half of the QE package recently announced by Mario Draghi. This would be better than the existing method of QE because (a) it would transmit to the real economy more efficiently (even allowing for a certain growth in imports from China); (b) a flat credit to citizens is progressive, not regressive (i.e. the opposite of a pole tax), so reducing inequality; and (c) it could even be made more progressive, by leaving, say, the highest 10% of income earners off the mailing list.


Mekong Man

The writer`s views are his own and do not necessarily reflect those of Vietnam Holding Asset Management