There is no more money!

Yesterday I had a conversation with several people who believed that the purpose of Quantitative Easing (QE) in the UK and the US was to provide cash to banks so that they could lend more.  They called it "printing money" and insisted that it would cause inflation and therefore lead to interest rate rises, which is a bad thing, of course, isn't it?

They have missed the point completely.

QE is an interest rate management tool.  Nominal interest rates (base lending rates) in both the US and UK have been nearly zero for a long time now.  Low interest rates would normally encourage spending - which is needed to stimulate economies - but both these economies were in such a poor state after the financial crisis and ensuing deep recession that near-zero rates made little difference and there was a serious risk of deflation. It was not possible to cut nominal rates further as this would make them negative, which would mean central banks were paying commercial banks to borrow money.  However, real interest rates in the form of bond yields needed to fall further to encourage financial divestment and spending.

Both the Fed and the Bank of England therefore initiated asset purchase programmes. They bought up corporate bonds and equities, along with their own debt instruments, in return for short-dated Treasury Bills. These Treasury Bills were new issues (i.e. invented money) - which is where the accusation of "printing money" comes from.

The effect of these asset purchases was to reduce the supply of corporate and government bonds and equities in the financial marketplace, which raised their prices and depressed bond interest rates (yields). That's what QE was supposed to do - and it did work to some extent. Real interest rates did indeed fall and deflation has (so far) been avoided.

There was a secondary effect, which was to increase the amount of liquidity in the financial system. Treasury Bills have to be intermediated into currency by banks, so all purchases of assets under the QE programme resulted in increases in bank deposits at least on a short-term basis.  In effect, financial institutions sold long-term investments for cash, and temporarily parked that cash at commercial banks, increasing their cash reserves. Now banks could indeed have lent this out to commercial borrowers - if they wanted to. But they didn't have to, and the evidence is that all they did was lend it to each other or (mainly) back to the central banks.  So QE did NOTHING to encourage bank lending. Nor was it intended to. The Bank of England itself says that although the extra cash reserves could be lent out, banks might not choose to do that when they are trying to repair their balance sheets. Contrary to popular belief, QE does not increase bank capital - and it is capital that banks need if they are to lend more.

My friends also thought that QE inflated commercial banks' balance sheets with extra cash reserves paid for by the taxpayer. This is nonsense. Firstly, the new issues of Treasury Bills were NOT paid for by the taxpayer - they were simply created "from thin air" by crediting recipient deposit accounts.  Secondly, the newly-created Treasury Bills were then used to buy an equivalent quantity of longer-dated financial assets, mostly from institutional investors rather than banks. So if there has been an influx of cash reserves in commercial bank balance sheets, it is because institutional investors have chosen to park their money there rather than spending it on other investments. Since banks generally are not increasing their lending portfolios, the increased deposit balances would be offset by a reduction in other forms of bank borrowing, so would not make any difference at all to the size of bank balance sheets. Bank balance sheets are no bigger than they were before. The only banks that DO have bigger balance sheets as a consequence of QE are, of course, the Fed and the Bank of England, who now hold large stocks of corporate bonds, equities and government bonds.  These will be sold in due course once the economy improves.

And now to the inflation question.

My friends believed that the newly-issued money actually made its way into circulation, increasing the amount of money in the economy and therefore debasing its value, which causes inflation.  This again is nonsense. The only way money can get into the economy is through bank lending and corporate bond issuance, and as I have already noted, banks weren't lending (and still aren't) and businesses are not investing. Even if they were, part of the reason for the poor performance of both US and UK economies is people and businesses in the private sector paying off debt, which reduces the amount of money in circulation. So although QE did increase the cash reserves available to banks, there is no evidence that much of it got into the real economy, and whatever did reach the real economy simply offset the money being destroyed by deleveraging. There is NO more money in the economy as a result of QE.

However, they were right about QE causing inflation. That was the purpose of the QE programme. A small amount of inflation is necessary in a healthy economy: zero inflation indicates stagnation, and negative inflation is deflation. Near-zero inflation rates in a demand-depressed economy are very bad news because they can signal the start of a deflationary spiral.  In the UK the Government sets an inflation target and the Bank of England is responsible for taking the measures necessary to keep inflation around that target. Dropping too far below the target is just as bad as exceeding it. So the purpose of QE was to raise the inflation rate to around the Government's target by stimulating demand in the economy. 

And yes, this should then lead to interest rate rises. Near-zero interest rates over the long term are indicative of an economy in very bad shape - as Japan's experience shows. A healthy economy not only needs some inflation, it needs positive interest rates. QE was intended to raise inflation by stimulating demand so that nominal interest rates could be increased to a more normal level. 

So yes, QE would increase inflation, and this should eventually lead to interest rate rises. However, it doesn't seem to have been very effective, at least in the UK. Inflation is now well above the government's target, but interest rates are still near-zero and there is a serious demand slump in the domestic economy.  Now if the inflation in the economy were due to QE, demand would have improved, wouldn't it? So it can't be due to that. In fact the inflation we are now seeing is due to external factors, especially high global prices for essential commodities and oil, coupled with consumption tax increases.

In fact QE has been a spectacular failure. And my friends were right about one thing - the lack of bank lending is the reason why it hasn't worked. QE requires banks to be lending normally and businesses to be investing normally in order for the additional liquidity to find its way into the real economy, which is where the demand stimulus is needed. But they aren't, and no amount of extra cash will persuade them to do so if they don't want to.

So the prevailing beliefs about QE, peddled by journalists who don't know anything and don't bother to do their research properly, are totally, utterly and completely wrong. Unfortunately a lot of people believe them. Which is why I wrote this blog. SOMEONE has to explain how it really works!


  1. And why are low interest rates a good thing?

  2. I didn't say they were, Ian - except for my sarcastic comment in the first paragraph. In fact I said that persistantly near-zero interest rates are indicative of an economy in bad shape, and healthy economies need positive interest rates.

    I suspect however that the direction of your question has to do with the crappy interest rates currently paid to savers. The interest rates I refer to in the blog are the rates at which the Bank of England lend to banks. They have nothing whatsoever to do with the rates banks pay to savers. Banks would like us to believe that commercial interest rates depend on the base rate, because it ensures that we blame government policy for what is actually yet another example of banks ripping off customers. But in fact the rates they pay savers are defined entirely by commercial considerations. I have written a blog on this which you might like to read - it's called "Feckless spenders, prudent savers and the Bank of England".

  3. Interesting post, confirming my intuitive view on QE. Am I right in saying the issue of shorter dated bills to buy longer dated gilts would be a yield curve flattener trade?

    Also, would't the inflationary risk be when the gilts are resold back into the market i.e. supply driving up yields?

  4. Hi Sam.

    Yes to your first point.

    Re the second - no, the inflationary risk comes if gilts are NOT resold. Increased supply pushes down prices, which is counter-inflationary. And since in QE yields are used as a proxy for interest rates, driving up the yields would be equivalent to raising the base rate by a few basis points, which is also counter-inflationary.

  5. Oops...
    It would seems that I'm as uninformed as your friends, and that we are not alone. Do Government Ministers, know the difference either,or are the majority including the media, buying a "pig in a poke" (believing new phrases - Q.E. - to be a godsend), I wonder.


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