In Defence of Quantitative Easing

In the absence of fiscal stimulus, that is an injection of government spending, and with interest rates at rock bottom, the alternative to quantitative easing is mass unemployment. We have no choice.

Fraser Nelson is no fan of the Monetary Policy Committee’s decision yesterday to increase the level of quantitative easing (QE) by a further £50 billion.

Writing in yesterday’s Daily Telegraph, he argues that, at the very least, Mervyn King and George Osborne should come clean about the effect on pensioners because it is their policy that has driven annuity rates so low.

As ever with economics, it is not that simple. To understand, why requires a bit of theory. Paul Krugman has set this out in a recent blog; but here is the main line of argument.

Interest rates are determined by the supply of savings and the demand for funds for investment. At any point in time, there is a level of the interest rate that will result in savings equalling investment at full employment.

The problem right now – because of deleveraging – is that this level of interest rates is negative. But interest rates cannot fall below zero (because people would simply keep their savings in cash). The result is that, even with interest rates effectively at zero, there is an excess supply of savings and insufficient demand in the economy.

 Krugman’s solution is more government spending (or tax cuts). In the UK, this option has been ruled out by the Chancellor.

 The alternative, therefore, is quantitative easing:crudely put, printing (electronic) money to buy government bonds and so lower long-term interest rates. This can support demand in the economy through a number of channels.

Lower bond yields mean lower mortgage rates. Lower yields on government bonds will also lead to lower yields on corporate bonds and higher share prices because the investors who sell government bonds to the Bank will want to invest the proceeds in other assets.

This makes it cheaper for companies to raise funds. And lower yields will also tend to make sterling less attractive to international investors and help to hold it down against the currencies of our key trading partners, particularly the euro.

Do debtors gain from this as Nelson argues? Yes they do. For example, if there was no QE, rates on fixed rate mortgages would be higher. Do savers lose out? Yes they do – but only up to a point.

While the yield available for anyone buying a government bond today is historically low, anyone who has been holding bonds in recent years will have seen their value appreciate significantly.

Similarly, anyone buying an annuity today will get what appears to be a low pay-out. But the value of their pension pot will be so much greater thanks to QE, particularly if it has been invested largely in government bonds, as most advisers would recommend for those close to retirement.

 In any case, it is wrong to put all the blame on Mervyn King and George Osborne for any transfer of wealth from savers to debtors.

Through QE they are implementing what the market cannot achieve. The overall economic situation – an economy in which output is currently almost 4 per cent lower than at its peak four years ago – requires lower interest rates, which also favour debtors over savers. But rates cannot go any lower; QE is the alternative.

 Fraser Nelson likes thought experiments: he starts his article with one. Here’s another one. Imagine George Osborne were to stand up in the House of Commons and declare that, despite the risk of a new economic crisis, he had ordered the Bank of England to end its policy of quantitative easing because of its effect on annuity rates and the income of pensioners.

Furthermore, interest rates would in future always be maintained at a level of 2 per cent or above. And no, he would not be relaxing fiscal policy because maintaining the UK’s credibility and credit rating was still of primary importance.

As a result, he might add, business and consumer confidence was expected to collapse, there would be a sharp increase in mortgage rates and the Office for Budget Responsibility is now forecasting a deep recession and youth unemployment of 1.5 million in 2013. This seems grossly unfair on the current generation of school and college leavers, but the alternative is poorer pensioners and that is unacceptable.

 QE is not perfect, and I am one of those who think that relaxing the pace of deficit reduction would be sensible while interest rates are at the zero bound and growth is turning out far weaker than expected. But it surely has a role to play in helping to ease the economy out of its current predicament.

 In one respect, Nelson is right: this is a big experiment and we cannot be sure of the outcome. But such is life. Unlike in the scientific world, there are no laboratories in which new economic policies can be tested out before they are used in the real world.

Sometimes the situation is so bad that policy makers have to experiment on the real economy. In the current circumstances surely that is better than the alternative of doing nothing.

See also:

• What does QE3 mean for the real economy – Ben Fox, February 10th 2012

• Quantitative easing is stimulating commodity training, not the real economy – Josh Ryan-Collins, February 9th 2012

• We’re all economists now, part one – Ben Mitchell, February 4th 2012

• Will quantitative easing work this time? – George Irvin, October 9th 2011

• Quantitative easing: The latest windfall from us all to “country London” – Ranjit Sidhu, October 8th 2011

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23 Responses to “In Defence of Quantitative Easing”

  1. Richard Darlington

    When I get that feeling, I need quantitative easing @IPPR chief economist on @leftfootfwd http://t.co/TrHrtTIy oh baby #economy

  2. leftlinks

    Left Foot Forward – In Defence of Quantitative Easing http://t.co/UardvUpS

  3. Nick Pearce, IPPR

    RT: “@leftfootfwd: In Defence of Quantitative Easing: http://t.co/xIN1CshA writes @IPPR's Tony Dolphin

  4. Political Planet

    In Defence of Quantitative Easing: In the absence of fiscal stimulus, that is an injection of government spendin… http://t.co/CfFlx8PO

  5. Trakgalvis

    RT @leftfootfwd: In Defence of Quantitative Easing: http://t.co/GSIfXz8x writes @IPPR's Tony Dolphin #NewsClub

  6. Pulp Ark

    In Defence of Quantitative Easing http://t.co/M6LThhd4 #Sustainable_Economy #Bank_of_England #muslim #tcot #sioa

  7. Michael

    In Defence of Quantitative Easing – http://t.co/74dqGRn5

  8. Anonymous

    But interest rates cannot fall below zero (because people would simply keep their savings in cash).

    ==============

    Oh yes they can. They have gone negative in Switzerland recently, and in the past. They went negative in Japan.

  9. Anonymous

    The result is that, even with interest rates effectively at zero, there is an excess supply of savings and insufficient demand in the economy.

    ==================

    Why then is the savings ratio so low? Since its so low there is not an excess supply of savings.

    More evidence for this is that the banks aren’t supplying lending, bar one customer. They can only supply the loans if people are saving. They aren’t.

    To state there is an excess of supply of savings is simply bollocks.

  10. Anonymous

    This can support demand in the economy through a number of channels.

    ===============

    It also reduces demand. It takes money away from a large section of poorer people by destroying their income. But you won’t put any points that contradict the fantasy.

    Krugman is just economic Voodoo. The current mess is too much spending and borrowing. More spending and borrowing won’t solve it.

    ===============

    As a result, he might add, business and consumer confidence was expected to collapse, there would be a sharp increase in mortgage rates

    Twaddle again. Investors and business needs to know that they won’t be subject to penal taxation because of government errors, and that inflation will be controlled.

    Cut the deficit to zero, get out of the off the book debt problem by making the decision to to take on any more off the book debts, and control inflation.

    If you control inflation you have to put up interest rates. That means more money to spend for a lot of poor people leading to growth. In increase the amount of money available for investment because people will start saving and the savings ratio will increase. Getting out of the state pension business (all debts – no assets) going forward means lots of money for saving and lots of money for investment.

    But as usual, its voodoo and the tooth fairy from the left.

    Time to confess, you owe people a state pension and its off the books like PFI.

  11. Stephen Wigmore

    What possibly annoyed me most was Nelson’s assertion that QE was a means of robbing savers and rewarding debtors because it pushed up inflation. Well, up to a point Lord Copper.

    On those terms any measure that encourages inflation and discourages deflation is robbing savers to benefit debtors. The BoE is robbing savers to help debtors by not orchestrating massive deflation as much as by attempting to maintain inflation at 2%.

    The fact is that we have a monetary target (2%) inflation and whether the BoE is taking the right policy to attempt to achieve that. By all means discuss whether the BoE is following the right policy to achieve 2% inflation, or whether that 2% target is in fact the correct one.

    To just accuse the Bank of robbing savers as though this were in of itself relevant is to entirely miss the point.

  12. Anonymous

    Except that inflation is at 5%. If you look back at the history of inflation, and the BoE had kept to target, prices would be 7% lower than they are now.

    It’s a fail across the board with their remit.

    It’s deliberate. The BoE moved its pension fund into inflation linked Gilts just after they let inflation rip.

    Nothing like the state insiders protecting themselves with insider trading is there.

    Nothing like the BoE not taking part in the Ponzi civil service scheme either. They know that is going to fail

  13. Pers Fin Update

    Retirement: In Defence of Quantitative Easing: Writing in yesterday's Daily Telegraph, he argues that, at the ve… http://t.co/pJ2CGFhW

  14. Mr. Sensible

    QE seems to be acting as Osborne’s own bailout mechanism. They need to change course on fiscal policy.

  15. Awake!

    ‘In one respect, Nelson is right: this is a big experiment and we cannot be sure of the outcome’
    Ok, for the unpteenth time. When one creates money in large noticeable indiscrete and ‘unbacked’ chunks, there is a certainty of inflation-CERTAINTY, and in economics almost nothing is certain. The inflation we’ve experienced to date is 2 fold, devaluation of our currency, and commodity inflation from emerging market contributions to global demand.
    Krugman is a clown economist, part of an apparatus that is being discovered for what it really is. Nobel prize in global trade flows? Shame that he coudn’t spot the imbalence whilst he wrote that dissertation… fiddling with 3rd order differentials when the CLEAR and PRESENT danger of the primary risk i.e. debt build up stared him in the face.

  16. Newsbot9

    Because inflation has been lower than the target recently. Oh, wait…

    The BoE has repeatedly missed the target. In any competent organisation, this would have lead to firings LONG ago.

  17. Stephen

    Keynes said that increasing the money supply (which is what QE really is) in order to cure a recession is like “trying to push a brick with a piece of string”. What the economy desperately needs is the fiscal stimulus that Osborne has ruled out. Rather than pump another £75bn into the banks, it would actually be better if the BoE simply handed every person in the country £1000 and said “spend it in the next month or lose it”.

  18. Newsbot9

    A typical demonstration of why you don’t have a clue. There’s a massive demand problem in the economy, caused by your slash and burn policies. You want far LESS demand and an even deeper recession.

  19. Newsbot9

    But you’re fine with destroying the income of poorer people. You want America, where poor people chose between eating, heating and medical costs. Increasing their costs by slashing services isn’t the answer. And Interest rates are meaningless to people with no savings and no hope of them.

    Ensuring that they have no pension and can never retire – working the poor to death – is your typical answer. I wish precisely onto you what you wish onto others.

  20. Awake!

    HASHHAHAHA
    Hey lets print 30k each instead? that would surely be better….

  21. Anonymous

    Cutting government spending takes no money out of the economy. It leaves it with the people you’ve stolen it from in the first place.

    ie. It moves money from fat cats in the public sector, to largely poor people who work for a living.

    So yes, you lose out, the majority and the economy gains, because you don’t get your cut.

  22. Anonymous

    Well, interest rates do matter, but indirectly.

    However the main reason they have no savings, is that the government is taxing them to the hilt.

    If someone on min wage had their NI diverted to a fund, they would have a pension pot that generates more income that the state deems them worthy.

    It’s the state that keeps them poor by denying them compound interest on the NI, and by taxing them when they are poor.

  23. Ed's Talking Balls

    Leon wishes people to be taxed into penury so that they can never possibly save. Disgusting attitude.

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