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QE : a wrecking ball to crack a nut

QE : a wrecking ball to crack a nut

3 Sep 2016

On 4 August 2016, the Bank of England expanded the QE (quantitative easing) programme that it had begun in 2009. This expansion, which now includes corporate bonds as well as gilts, is ostensibly in response to the Brexit referendum result on 24 June. The Treasury and the Bank had warned that Brexit could lead to a bad recession.

You might need reminding that the official purpose of QE, since 2011, has been to stimulate the UK economy. You might think that, if this policy has been a success, it is rather a slow burner. But Andy Haldane (Bank of England Chief Economist) is in no doubt that it is the right thing to do and that this is no time to be faint hearted.

“I would rather run the risk of taking a sledgehammer to crack a nut than taking a miniature rock hammer to tunnel my way out of prison.”  

Mr Haldane may be an economist but he knows how employ a ridiculous metaphor to make a point. And although he – incredibly – affects populist ignorance of financial matters (giving interviews in which he says that pensions are too complicated to understand), he does not lack respect for his own ability. He explained that the decision to cut interest rates by 0.25% was in order to save hundreds of thousands of jobs, though whether this included his own was not clear.

QE actually commenced in 2009 as an emergency measure to prop up asset prices in a (so far) successful attempt to save the banking system. The banks held vast amounts of tradable assets that could become vulnerable to crises of confidence – so the central bank stepped in as a very public buyer and calm was largely restored. Phew.

The official line that this was a form of monetary policy that could stimulate economic growth snuck in later and is much more challenging to justify. It seems to me to be a rather strained argument. Here is the latest official serving.

BoE report 4 August 2016

The expansion of the Bank of England’s asset purchase programme for UK government bonds will impart monetary stimulus by lowering the yields on securities that are used to determine the cost of borrowing for households and businesses.  It is also likely to trigger portfolio rebalancing into riskier assets by current holders of government bonds, further enhancing the supply of credit to the broader economy.

There are two parts to this. First, if rates available for lending to the government fall, rates for lending to all will fall. Why? Because the rates offered by private lenders to private borrowers (households and businesses) are in some cases tied to or influenced by the rates set or influenced by the Bank of England. But again, why? Ultimately a loan is a private contract between two parties and the rate charged is the result of supply and demand. The supplier of the loan (e.g. a bank) will look at its counterparty (the borrower) and ask itself whether the reward justifies the risk. Lower interest rates ultimately mean higher risks and no amount of cheap money can change that.

The second justification offered by the Bank of England is that lowering yields on safe assets will drive savers to invest in riskier assets. If government bonds are too expensive (effectively because they yield nothing) I will buy some cheaper bonds from a company that is more likely to go bust. Yay.

QE is a great monetarist experiment that seeks to prove that enforced credit creation will act on the economy like an illegal stimulant on a Russian athlete (allegedly). Richard Werner, the inventor of the expression Quantitative Easing, says that it has not been tried correctly. Others, of course, say that it will never work without fiscal stimulation which, in the short term at least, will effectively mean more net borrowing by the government.

Nobody knows nor will ever know how correct any of these macroeconomic arguments are. All sides are probably burdened by bias of some kind. The tendency to start with one’s chosen explanation and to select facts to fit it is apparently almost irresistible.  

Although I am too ignorant or stupid or bored to have a strong view about the efficacy of yet more QE I can see and marvel at the side effects. I see three notable examples, which are listed in order of immediacy:

1)      The relentless widening of the wealth gap between those who own assets and those who do not.

2)      The rocketing current cost of future pension liabilities.

3)      The mind-blowing future debt burden to be dealt with by whoever is around after today’s politicians and central bankers have retired to their mansions in the country.

First, the wealth gap. At the risk of being condescendingly rude, can we please all understand the difference between assets and income? People with large illiquid assets to their name but low income are not in any meaningful sense rich. Think of those 20th century castle owners facing death duties amounting to 75%+ of the perceived value of their estates. Either they or their houses faced ruin. The houses usually copped it. Similarly a person earning £150,000 in the year 2016 but trying to buy a property in an area where family houses cost £2 million will be a borrower and not a saver. This person’s net wealth is likely to be negligible.

QE deliberately bids up the price of assets. It distorts. In terms of the UK, it has boosted the wealth of older people who often own property but have low incomes. I live near to the verdant London suburb of Blackheath. I know this area well. Many of its inhabitants live in properties whose value has multiplied by 10x or 20x or 30x since they moved in. They are typically retired people wondering at the fact that their houses are worth £1m or £2m. When I walk up these streets and look at these properties what do I see? What I see is paint peeling off the front doors and rotting wooden windows. Blackheath is full of people who are asset rich and income relatively poor.      

Meanwhile, half a mile down the road in Lewisham, someone is building blocks of ugly flats (between a confluence of main roads and a hub railway station) designed for younger people with much higher incomes.

This perverse distortion is the direct side effect of QE. Welcome to its world.

Second, the pension crisis. Final salary pensions are disappearing from the private sector because the liabilities are typically unpredictable, high and growing. The current actuarial cost of future liabilities is calculated according to the likely return on “risk free” assets which are typically government bonds or blue chip corporate bonds. The lower the yield on these bonds the higher the calculation of the pension liability.

Bidding up the price of assets makes the holders wealthy to the relative disadvantage of those who do not own assets. But final salary pension schemes are effectively short of these assets. They are not merely relatively disadvantaged but made materially worse off.

Some private companies which started life in the public sector or are just quite old retain huge pension liabilities as a result. BT and BAE are an obvious couple that spring to mind. But on 31 August a small company named Carclo made a negative stir with this announcement.

Subsequent to the EU Referendum result on 23 June 2016, corporate bond yields have decreased materially in the UK and, as this yield is used to discount the Group’s pension liability under IAS 19 “Employee Benefits”, if the corporate bond yield remains at its current low level then this will result in a significant increase in the Group’s pension deficit as at 30 September 2016. This likely increased IAS 19 pension deficit would have the effect of extinguishing the Company’s available distributable reserves, in which case the Company will not be able to pay the final dividend of 1.95 pence per share, declared on 7 June 2016, on 7 October 2016 to those members that were on the register at 26 August 2016.

Note that this increase in the pension deficit is subsequent to the Bank of England’s extension of QE and its decision to drive down the yields of corporate bonds – and the result is that a dividend that was declared in early June will not be paid.

Investors must be wary of such companies, obviously. But they are trivialities compared to what awaits when we consider the liabilities due to public sector employees. The NHS is the most obvious and pointed example.

Last year the NHS had an annual funding deficit of £2.4bn. This is known to one and all as a “funding crisis”. Yet there is an estimate that claims that the NHS pension deficit, which is the responsibility of the Treasury (i.e. future taxpayers) is £500bn.

And then there’s the rest of the civil service.

And local authorities.

Third, the overall debt burden. Some people seem to have the idea that the Bank of England operates as an independent monetary manager of the economy with the right, granted from somewhere on high, to print and cancel money.

The truth is that the Bank of England is an off-balance sheet liability of the Treasury. It is the nation’s broker and the nation wears the outcome of its trades.

QE means that, on our account, in every meaning of that phrase, the Bank is borrowing heavily for the purpose of making losing investments. By losing I mean that if you buy something for 120 and it pays you back 100 you know that you are going to lose money. Normally your compensation would be the interest payments but the Bank of England does not receive those. They go to the Treasury because it was argued (in 2012) that it was “economically inefficient” for the Treasury to pay interest to an institution (the Bank of England) that it ultimately owns. We are the Bank and the Bank is us.

The perceived independence of the Bank of England is in fact entirely the gift of the Treasury and it is a gift whose return can be demanded at any time.

Much was made of Gordon Brown’s announcement that he would devolve interest rate decisions to the Bank in 1997. But the real story of the subsequent statute, the Bank of England Act 1998, was quite different.

Treasury’s reserve powers

19.—(1) The Treasury, after consultation with the Governor of the Bank, may by order give the Bank directions with respect to monetary policy if they are satisfied that the directions are required in the public interest and by extreme economic circumstances.

If it has occurred to you that the Governor of the Bank of England and the Chancellor of the Exchequer display great public unity you should bear this in mind.

In summary, QE is a monetarist experiment that will never have a result that can be measured (though it will be analysed pointlessly for many years to come). But the side effects can be readily seen. It is making the owners of assets (especially property and shares and bonds) wealthier and widening the gap to non-owners. It is worsening the nation’s pension deficits. It is adding heavily to the overall national debt.

QE distorts all investment decisions. It is a wrecking ball to crack a nut.

There will be a follow up to this post which will attempt the improbable task of predicting how this plays out.   

4 comments

  1. I agree that QE is not brilliantly effective as an anti-recessionary measure. However it does have one possible merit, as follows.

    Milton Friedman and Warren Mosler among others argued that governments should borrow nothing at all. Certainly none of the traditional arguments for government borrowing seem very persuasive to me. So assuming Friedman, Mosler & Co are right, we ought to continue QEing till there’s no debt left.

    Of course that increases asset prices and increases inequality. But assuming F&M are right, those higher asset prices are in fact the optimum or “GDP maximising” price level for those assets. Put another way, the fact that we have government borrowing will have artificially lowered asset prices over the last century or more.

    If those new and higher asset prices result in a level of inequality that is deemed socially unacceptable, then that’s a perfectly reasonable view. The solution is higher taxes on the rich, particularly the asset rich.

    • Continuing QEing until there’s no debt left? But QE is just nationalising the debt, not making it disappear. The only way to make it disappear is to default.

      • Mike Ellwood /

        I respectfully disagree, and agree in principle with Ralph. At least, the treasury securities may not disappear, but the debt does, in effect.

        Before the securities were repurchased via QE, they represented a debt by government to the non-government sector. After repurchase by the central bank, they represent a debt held by one arm of government (the central bank) to itself (the Treasury or government). And a debt from you to yourself is no debt at all. And in fact the interest payment on the security is (at least in the US) is remitted back to the Treasury. I’ve read conflicting reports of what exactly happens to the interest in the UK, but I believe that in effect it is offset against the deficit.

        Here is Bill Mitchell in an article about the original QE:

        http://bilbo.economicoutlook.net/blog/?p=661

        Now, I thought that what I had written above was more or less accurate, but someone posting a comment under that article, much later, gives more detail which makes the situation slightly more complicated. Unfortunately, Bill hasn’t replied to it, so we don’t know whether he would agree with it or not:

        Stanley Mulaik says:
        Sunday, October 11, 2015 at 16:17
        One thing overlooked in discussion of QE is the fact that in buying Tsy securities from the banks, the Fed
        has effectively in most cases been taking up the national debt. The Fed will then take mature securities
        and swap them for new securities with the Treasury–at some point when the economy looks headed for
        inflation. When the Tsy gets the securities it extinguishes them. If the security was used to fund a deficit,
        this redeems the security and cancels a portion of the national debt. The Fed will then sell its new securities with new future maturity dates to banks and private investors to drain bank reserves and money out of circulation.
        Note too that in these transactions the Fed is not funding spending on the deficit, so Tsy securities are not
        created solely to fund the deficit. The Fed has new securities to sell. They were not created to fund a deficit.
        Could this have been the real reason for QE in connection with buying Tsy securities from banks. (Tsy and
        Fed can swap securities. They are prohibited in Fed creating money to buy securities directly from the Tsy.)

        (He’s obviously writing from a US perspective; I believe that in principle, it should be pretty much the same over here, with perhaps some detailed differences).

        By the way, another feature of QE which I hadn’t quite picked up on before in all my readings, and just stood out out when I was recently reading “Modern Money Theory” by L Randall Wray, is that QE actually removes potential stimulus from the economy because it is removing interest-bearing securities (and therefore income) from the private sector (and it’s also helping to reduce interest rates, which does the same thing). So another reason why it’s unsuccessful in stimulating the real economy (if indeed it was ever intended to do that, which I partly doubt).

        • The idea that the government can make its debt disappear by effectively purchasing it and then forgiving its own obligations to itself is compelling. I think this is what people mean when they talk of “printing money”. It effectively shifts the possibility of default from the treasury to the central bank.

          I don’t suppose this would have happened before 1946 when the Bank of England was really a bank, privately owned and sometimes paying dividends to its shareholders.

          After it was nationalised by the post-war Labour government it has gradually become an arm of the Treasury and is now scrutinised by Parliamentary committees consistent with that status. But the bottom line is that the ultimate obligation for the debts, wherever they are or whatever they are called, lies with UK taxpayers.

          PS The coupons earned on gilts owned by the Bank of England are indeed paid to the treasury, explicitly because the Bank and the Treasury are really the same entity. The treasury is also supposed to make good the substantial losses that the Bank has incurred by paying vastly over par for gilts and then holding them to loss-making maturity. But no doubt when the time comes the same logic will apply. Why transfer resources between government departments? Better to just add it to the bill for taxpayers as yet unborn.

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