Quantitative Easing – Getting less from more

The European Central Bank has been late to try quantitative easing and may find that additional euros cannot buy much relief

We all have the tendency to rely on the tried and true tricks we have found helpful in the past even when their usefulness has faded.  This also seems true of central banks who have come to rely on quantitative easing even though its effects show signs of fading.  Even the initial boost provided by the first attempts at quantitative easing was limited and the situation has deteriorated amid its continued application.  As the last major central bank to give it a go, the European Central Bank will not get much return from any extra cash. 

Why more is not always more

Economist should know that repeating the same policies does not always work considering a well-used idea in economic theory known as diminishing returns.  This concept refers to the way in which more of the same often comes with fewer additional benefits.  Economists use this to describe why the second plate of ice cream does not taste as good as the first or why one more cook in a crowded kitchen doesn’t necessarily improve the food. 

Printing more money, which is the basis for quantitative easing, sounds like a sure-fire way to generate economic growth but any economy can only handle so much money.  The world is already awash with cash even before central banks started with quantitative easing.  This means that every additional dollar, euro, or pound printed as part of quantitative easing is being added to an already substantial pile of cash.  With money already being hoarded by many companies and governments not wanting to spend more cash, there is not much use for any more.

No need for more

With the meagre effects of quantitative easing on the wane, it was the earlier versions that would have generated the most bang for each additional buck.  It was the Federal Reserve and the Bank of England that tried out the first rounds of quantitative easing – the goal was to push investors away from government bonds to more risky investments such as corporate bonds or stocks.  The hope was that this would help provide companies with easier access to cash and to perk up investors by boosting share prices. 

Not all of the extra dollars and pounds would have stayed local but also headed overseas to find places to earn more money.  This meant that the effects of quantitative easing would have been felt far beyond the countries where the cash was originally coming from.  It has been helpful in places such as Portugal and Spain with overseas investors buying bonds issued by the Portuguese and Spanish governments as worries about Europe eased.

With the effects of quantitative easing having already spilled across international borders, there is not much more to be gained from even more cash.  As such, the additional euros coming out of the European Central Bank following the recent launch of quantitative easing in Europe may not amount to much.  Any further action may also be limited as the saga over whether or not to implement quantitative easing has highlighted how the European Central Bank only has limited room for manoeuvre when running in opposition to Germany.  Now, more than ever, it is time to try something new.

Getting more from Monetary Policy

Japan has made lots of mistakes and it is time that Europe learnt from them

We can all learn from watching others make mistakes and the experiences of Japan continue to provide valuable lessons.  Japan has stumbled into another recession following a hike in taxes to fix the government’s finances.  The other key policy doing the rounds in Japan, using expansive monetary policy to put an end to deflation, also seems to be flagging.  It is Europe that has most to learn from the unfortunate trials and tribulations in Japan since many of the same problems are shared by both.  What should Europe do to avoid making the same mistakes and decades of stagnation?

Following in the same footsteps

Japan has been hit first with many of the same problems that are increasingly expected to plague Europe and other Western countries.  For starters, new-borns in Japan are increasingly outnumbered by pensioners which have pushed the population into decline in recent years with an aversion to immigration further accentuating this trend.  This translates to fewer workers to provide the taxes needed for the rising costs involved with taking care of old people.  The situation is made worse by government debt which is already more than double GDP due to years of inefficient government spending.

Japanese consumer prices have been falling for years as a reflection of the weak demand.  There are few opportunities to profit from in Japan due to the falling population and even Japanese firms are looking elsewhere to invest.  Weak global demand means that even one of Japan’s strengths, exporting, offers only limited respite even with a weaker yen due to its loose monetary policy.  All of this means that the Japanese economy itself is like a tottery pensioner - even a small rise of sales tax from 5% to 8% was enough to push Japan back into recession.  This does not bode well for Europe where the economy is sputtering along due to many of the same problems while the governments there are also trying to get a grip on their finances.

Trying different directions

Having been stuck with these problems for longer, policy makers in Japan are increasingly more aggressive in coming up with solutions.  The current prime minister, Shinzo Abe, launched a raft of new measures dominated by a massive expansion of the money supply to target falling prices.  This new aggressive approach to monetary policy was facilitated by the government installing a new governor to the Bank of Japan who was willing to give up its independence and toe the line.

This is the complete opposite to the situation in Europe.  The head of the European Central Bank is eager to do more with monetary policy but is prevented from doing so by the German government.  German politicians want to reforms to come first due to an expectation that their neighbours will not implement the necessary policies. Whereas, in Japan, the aim was to use the loose monetary policy to help build momentum that will allow the government to implement reforms. 

Yet, the Abe government has been disappointing in its reform efforts (as Your Neighbourhood Economist predicted) and this will bolster the stance taken by Germany.  With the Bank of Japan finding it tough to generate sufficient inflation despite a rapidly expanding money supply through quantitative easing, many will question about the reasons behind using a similar policy in Europe.  Central banks are struggling to have much influence in a world that is already awash with surplus cash.  

Time for Plan C

It seems like the key lesson from Japan is that monetary policy cannot do much by itself.  Japan still languishes despite the best efforts of the central bank as the Abe government shirks the much needed measures to free up the economy.  Yet, bullying countries in Europe to reform by withholding the full extent of monetary policy is not helpful either.  A grand bargain marrying reforms with looser monetary policy, as was supposed to be the case in Japan, seems the obvious solution. 

This takes more political willpower when the many countries of Europe are involved but is not something beyond the realms of possibility.  Ironically, the chances for such a deal may be improving as deflation becomes more of a concerns and the economic stagnation in Europe also spreads to Germany.  Japan has already paid the price for years of economic mismanagement – there is no reason for Europe to do the same.

Central Bank – Emperor's New Clothes

With the myth of its power having been shattered, central banks need to get nasty to win back respect

Central banks are looking a bit naked as if stripped of their power.  Previously, central bankers such as Alan Greenspan were held in awe and ruled over the hearts and minds of investors.  This position of power stemmed from the perceived ability to soothe the fire-breathing financial markets.  Yet, the global financial crisis and its aftermath have shown this to be but a myth.  Part of the problem was that central banks wanted to be liked and keep investors onside.  With its generosity proving its downfall, the naked emperor may need to stop being so nice.

Pretenders to the throne

This fall from grace has happened swiftly.  The powers of central banks reached their peak just before the crisis hit.  Quick to blow their own trumpet, economists talked of a “Great Moderation” – a prolonged period of steady and stable economic growth coupled with low inflation.   Central banks had also shown themselves willing to step in during moments of strife and prop up the stock market.  This won them a strong following among investors who could be sure that central banks would send in the cavalry if there was trouble. 

The proverbial crown slipped and fell dramatically with the global financial crisis.  Not only were central banks proved to be not suitable guardians of the economy but their capacity to rally at times of trouble was limited.  Low interest rates and quantitative easing offered little respite from the plague eating away at the economy.  The potency of central bank policy has been eroded as its primary source of power, the ability to print money, does not mean much in a world awash with money.

The problem was exacerbated by central banks not having the freedom to act as their almighty reputation might suggest.  Part of this was due to internal restraints such as a chronic (but misplaced) fear of inflation.  Such worries about rising prices keep central banks from unleashing their full firepower when faced with crisis.  In addition to this, politics also often acts to stifle central banks.  Germans’ heightened aversion to inflation has kept the European Central Bank from doing more.  The Federal Reserve has also had to be mindful that its actions did not draw ire from Republicans who are typically hostile to any government intervention. 

Cursed by hubris

It also became obvious with hindsight that central banks may have built their dominance on a dubious myth.  The “Great Moderation” may have just resulted from good luck rather than good management.  It is easy to keep inflation down when cheap goods are flooding in from China while money was cheap as China was sending a considerable portion of its earnings as reserves and sending it back to the US.  Yet, the misplaced belief in the rule of central banks over the economy lead to ignorance of risks that central banks thought they had slayed. 

Central banks were happy to live off this aura while also being generous in its dealing with investors.  Yet, this kindness turned out to have a cruel twist with the support shown by central banks to financial markets sowing the seeds of crisis.  Although lauded at the time, the reign of Alan Greenspan has instead been shown to be like a king trying too hard to please his subjects.  Over this period, the Federal Reserve kept interest rates too low while investors made merry amid a booming stock market.   

Better to be feared than loved

The unruly nature of financial markets coupled with the flood of cash sloshing around in global finance means that a guiding hand is needed more than ever.  Having been knocked from their high towers, central banks have to restore some assembly of order in a world where the pull of its ability to print cash is diminished.  It may be best to follow the words of Machiavelli, a renaissance philosopher who theorised on power struggles in Medieval Italy, in that it is better to be feared than loved. 

In this vein, if it was a need-to-be-loved that got central banks, and the rest of us, into trouble, it might be time to get nasty.  Taking a harsh line against any potential distortions in the economy (using macroprudential policies) would win more respect than being too friendly.  To rule with a firmer fist seems a better fit at a time when the consequences of financial excesses are so pertinent.  This would help to usher in a more peaceful period if combined with greater regulation to keep the banking sector from getting out of hand.  More stability may even get investors to appreciate the value of tough love.  

Interest Rate Hike – Easy on the Brakes

The Bank of England threatens to be too heavy on the brakes with higher interest rates and the economic recovery may stall as a result

Tinkering with complex machinery is tricky as changing one thing may have unintended consequences elsewhere.  This also applies to the economy.  The prospect of having to raise interest rates at a time when the economic recovery is still fragile is daunting enough.  Yet, there is a number of moving parts of an economy linked with interest rates which could throw an extra spanner in the works – one concern is that higher interest rates will push up the currency and hurt exporting firms.  This may push central banks to use other monetary policy tools to bide their time.

Complicated piece of machinery

What we refer to as the economy is the accumulation of an incredibly intricate multitude of monetary transactions in which we all are a small part.  In comparison, monetary policy is rather basic relying mainly on the lever of interest rates with extra bells and whistles, such as quantitative easing, added only when needed.  Monetary policy has been exceptionally loose but has still struggled to get the economy moving again.  These expansive polices cannot stay in place for ever and there are growing calls for interest rates to be raised off record lows. 

Interest rates normally affect the economy through the costs involved with taking out a loan.  But this is not the only route of influence.  One example is how higher interest rates will attract in money due to a higher pay-out for savings and this extra cash coming into the economy will push up the value of the currency.  A strengthening currency will adversely affect firms exporting to other countries as prices for their goods typically must rise and this risks putting them at a disadvantage relative to competitors. 

The potential for this is larger when one country moves to tighten its monetary ahead of its peers.  Such is the predicament facing the UK as the Bank of England contemplates the possibility of raising interest rates sometime in the next six to twelve months.  The mere expectation of this has propelled the pound higher relative to other currencies and may put further upward pressure on the pound if interest rates are predicted to rise faster than elsewhere. 

This problem comes about due to the freedom of money to chase around the globe after the best return.  Financial firms have made of most of moving cash around using strategies such as the carry trade – borrowing in a currency with a low interest rate and changing the money into a currency where the interest rates is higher.  This is just one way of how excess liquidity in global markets can work to distort exchange rates relative to the actual physical economy.

Warning lights flashing

Normally higher interest rates are used to slow an overheating economy and a stronger currency would help with this.  Yet, the upcoming hikes to interest rates have the goal of returning monetary policy to normality – a state where interest rates and the rate of growth in the economy are roughly equal.  An accompanying rise in exchange rates therefore acts as a further obstacle to economic recovery which is not intended or desirable. 

The weak recovery means that the UK economy is not quite ready for the double whammy of higher interest rates and a stronger pound.  The effects of both may be benign considering the lower rates of borrowing among businesses and sluggish demand for exports from markets such as Europe.  But there is still the potential for a rise in interest rates to put the economy in reverse at a time when the economy is gearing up for recovery. 

The main issue behind calls for tighter monetary policy is a buoyant housing market.  Yet, the Bank of England has a new range of tools to deal with this such as caps on mortgage lending.  So there is room to wait for other countries, most significantly the US, to catch up in terms of interest rates.  With the threat of waiting too long to act mitigated by housing market measures, it is the downside of braking too soon that the Bank of England should watch out for.

Monetary Policy – Losing its Power?

With the finance sector already awash with cash, we can no longer rely on central banks to help us out of trouble

After having worked like a charm for a long time, monetary policy now seems to be losing its mojo.  The source of power for central banks mainly comes through their tricks of printing money and controlling interest rates.  With many governments mired in debt, it has only been the wizardry of central banks that has stood between us and a greater tragedy.  It is of great concern that the capabilities of the once almighty central banks to manipulate the economy are under threat from the large amounts of liquidity in the financial system.  The spells with which central banks hold sway over the economy may amount to little more than illusion when there is already lots of cash around.

Where has the magic gone?

The power to create money seems nothing short of sorcery; however, the rise of digital cash means that it is in fact easier than ever.  Central banks have even lost their monopoly over generating electronic cash with normal banks able to pull off the same trick by making loans.  It was thought that control of interest rates would be sufficient to steer the economy through any ups and downs.  Yet central banks left interest rates too low in line with their narrow focus on keeping inflation in check and banks were free to churn out loans at an unprecedented rate.  The prices of assets such as property have surged upward as a result but only until the inevitable crash in prices.

Central banks stepped in with record low interest rates and new policy tricks such as quantitative easing.  Yet these measures lack potency considering that cash was already cheap and in abundance.  Both banks and businesses hoarded cash – the former worried about their own survival while the latter had few investment options available due to the weak economy.  To add to this, many emerging markets such as China had been building up massive reserves since well before the global financial crisis. 

With the international financial system already flooded with cash, it has been no surprise that monetary policy has not worked as well as expected.  It has been like trying to use sweets to modify the behaviour of a child that lives in a candy shop.  Instead of being much help, the extra funds from central banks have seen the financial markets deformed and distorted as if suffering from some form of voodoo.  Some emerging markets have also suffered from this black magic with their banking sectors unable to handle the volume of cash on offer.

Nothing up their sleeves

Central banks have been looking to develop new powers to influence different sectors of banking.  The Bank of England has been given greater scope to deal with a runaway property market.  Yet, the central bank seems ill at ease with its new policy options, such as restrictions on mortgages, and prefers to rely on its old act of manipulating interest rates.  If central banks no longer have the power to bewitch the economy, it will be tougher to clean up after a crisis like the one we have just been through.

This shifts the goal of policy to stopping problems forming rather than merely attempting to limit the ensuing trouble.  Restricting the dark arts conjured up by banks will be essential to preventing future disasters.  The fairy-tale time when we could believe in the magic of central banks may have passed – we will need to rein in the wicked elements of the economy now that there is nothing to save us from potential misfortune.