Tuesday, 25 October 2011

QE or not QE?

Quantitative easing is not the easiest thing to understand, both in how it works and how well it works. It’s even harder to understand why the Bank of England wanted to spend another £75bn on another QE round. But they did, and the Governor defended the decision in Parliament today.
To me, it’s silly. More than that, it’s really silly.

The Bank of England gives banks and other institutions cash in return for certain types of assets they hold (primarily gilts). The banks and institutions are meant to do useful things with that cash, including (hopefully) lending it to businesses and maybe even individuals. Generally however, they use it to make short term financial gains trading in money markets. They already have lots of cash because they are deliberately reducing their size and increasing their capital (to be able to cope with forthcoming losses). They don’t really need more to increase productive lending.

Thinking of QE as a method of boosting the economy is like putting your foot on a car accelerator when someone has cut the cable. There’s no direct connection. It might work (if for example the car is going downhill) but it might not.

We need to improve growth and business confidence. Surveys show that lending to the engine room of the economy, small businesses, is drying up and the pressure on their working capital is damaging confidence and future investment – and employment. This is where action is needed, urgently, and QE does nothing to help.

Some think QE is inflationary; the Bank thinks it won’t be because it thinks we are about to get deflation. There’s also an argument that this isn’t new permanent money in the system because it is buying assets. However, a cynic would say that inflation is one way of reducing the country’s debt burden. They would note that an abnormally large proportion of the Bank’s pension fund assets are in inflation linked instruments; that could be a co-incidence but it probably isn’t.
Inflation is having a bad effect on household discretionary spending and on household confidence. A lack of confidence prevents spending, increases saving and harms the economy. I’d agree that deflation would also be bad, for different reasons, and it’s not definite that QE will create more inflation. But it might, and is that a risk worth taking?

What QE definitely does do is distort gilt yields, it makes them abnormally low. These yields are used in pension calculations and this distortion has two negative effects:
- New pensioners (unless they are lucky enough to be in the public sector or in defined benefit schemes) have to take their pensions when the annuity rates are low. This, other things being equal, gives them a lower income for the rest of their lives
- The deficits in company pension schemes are increased, so companies have to put more money aside to meet the deficit and have less to use productively in helping growth.

These effects are certain. The benefits of QE are not.

Even if there are some benefits, the effort is not being targeted where the economy needs help: working capital for the SME sector so that business confidence can gradually be built up.

So: it’s a lot of money; it has uncertain benefits (the only certain one being that it is increasing banks’ profits and therefore capital*); it may increase inflation; it will damage new pensioners; it will suck cash out of large companies; and it won’t provide help where it’s needed.

That seems really silly to me.

* See my post about predictions for 2011: the banks are being told to do contradictory things but primarily they are being told to increase their capital and reduce risk.

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