James Faulkner on QE – a Poisoned Chalice

“The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost,” – Ben Bernanke

In recent times the printing press has been the ‘get out of jail card’ for the authorities. Could it ever occur to them that it was the printing press that put them there in the first place?

As the world once again threatens to spiral downwards into a renewed slowdown, you can bet your bottom dollar (if there is such a thing in a system of elastic paper money) that the central bankers will charge once more into the breach with a renewed round of monetary ‘stimulus’.

As the conventional wisdom goes, injecting fresh money into the economy through the purchase of government bonds from banks helps to stimulate investment through lowering long-term interest rates. At a superficial level at least, this holds true. However, the wider consequences of ‘quantitative easing’ and the long-term impact on the economy are not as rosy.

Let us begin with examining the impact of QE in a purely hypothetical situation where each economic participant receives a 10% increase to his existing cash holdings, and is also aware that other economic agents have received an identical allotment. As a producer, the economic agent would demand 10% more for his goods, while as a consumer he would be prepared to pay 10% more than previously; the money injection has simply served to raise prices by 10% throughout the economy.

However, while it is true that any increase in the money supply must ultimately lead to inflation – “always and everywhere a monetary phenomenon” (Friedman) – it is clear that our artificial example does not reflect how QE is applied in the real world – if it did, there wouldn’t be any point in policymakers using it.

Friedman

Rather than everyone receiving the new money simultaneously with perfect knowledge, imagine a situation where each economic agent receives the money but has no knowledge of the situation of his fellows. In this scenario, changes in prices will be sporadic and slower to materialise. Some agents may decide that their relative economic situation has improved and, in their role as consumer, use the new money to buy goods over and above their normal consumption habits from producers who are hitherto unaware of the increase in the money supply. In this scenario there has been both an increase in economic activity (i.e. a rise in GDP) AND a redistribution of economic resources (in this case from the producer to the consumer).

Although it is clear that our second example is also artificial, it demonstrates at a conceptual level how QE can generate a temporary rise in GDP by effectively fooling economic participants into thinking that a real increase in demand has occurred.

As we know, in reality QE is directed toward the banking system. By raising the cash holdings (reserves) of a bank, the state can achieve an increase in overall lending and thus increase the money supply. Even if there is no demand for loans, the bank can create new demand by lowering the interest rates offered on new loans (it has, after all, received the new money from the state at very limited cost). This prompts entrepreneurs to start investment projects at marginal rates of return that have become economically viable due to the lower interest rates. Employment will increase, as will the productive capacity of the economy. An increase in GDP has been achieved.

So what’s not to like?

The problem lies with interest rates and their role in the economy. Interest rates reflect the time preferences of the consumer. If the consumer has a low time preference he does not care much, on average, whether he consumes today or in the future: he will be willing to save a large portion of his income as his daily needs are sufficiently satisfied. On the other hand, a consumer with a high time preference wants to consume here and now: his propensity to save is low.

In an unbridled market economy (i.e. absent central banks), interest rates would be set by the public’s propensity to save, so if time preferences are generally high, interest rates will be high and vice versa. When new money is injected into the economy and interest rates are artificially lowered, entrepreneurs clearly have no way of knowing whether these interest rates are a result of increased saving or of newly printed money. In other words, investment projects that have not been sanctioned by the market are allowed to commence.

As we have seen, the impact of these new projects is initially positive. However, as the situation develops, significant dislocations are built up in the economy. The new projects, flush with the newly minted cash, are able to bid away resources from other areas of the economy, including labour. This diverts resources away from the production of consumption goods (demand for which, we have to assume, has remained the same) and towards capital investment (for which there has been no additional saving).

Eventually the drop in the supply of consumption goods causes the prices of those goods to rise (inflation). However, those economic agents who have not benefited from the new money now face having to alter their behaviour in order to account for the rise in prices. One of the ways they can do this is to reduce their savings, which in turn exerts upward pressure on interest rates – i.e. exactly the opposite effect to the one originally intended by the central bank.

And so the illusion continues… but for how long?

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