Quantitative easing: A first analysis of this policy based on US and Euro zone cases.

Officially, the FED decided to use the quantitative easing (QE) policy after the crisis of 2007-09:  however, QE1 was already applied in 2008, but this first phase was more an intervention to stabilize both mortgage market and banks’ balance sheets than a “real” QE exercise, when its last intervention QE3 was done in October 2014. The Euro Zone (EZ) central Bank (ECB), followed this unorthodox approach only in January 2015 and its program is still running now. Despite a clear time lag between their implementation, a common goal characterized these interventions: FED & BCE were just changing their policy target; moving from a policy of stabilisation of the long-term inflation rate, to one of reinvigoration of the economy activity through the stimulation of global demand.

Now, in this essay, we do not want to focus on the unorthodox nature of this policy, which can be summarised as seeing central banks shifting down the medium long term yield curve (often by massively buying medium long term government bonds) instead of the usual money market interventions (i.e. only short-term interest impacted).
What matters for us it is to stress and discuss the underlying theoretical premises characterizing this policy. This discussion will allow us to answer some basic questions, which are often not considered:
Why do central banks believe in the potency of QE? What is the main mechanism which is intended to guarantee the success of this policy? Are we sure that underlying forces assuring the success of QE are present in our economies? And if the QE is not working as expected, what sort of dangers might be foreseen for our economies?
Let’s start with a clear definition of a QE policy and its underlying mechanism.

To start with, QE brings, as with any economic policy, a distortion in terms of market forces: by purchasing medium-long term (high grades) bonds, central banks are injecting liquidity in the financial system and increasing the price of those assets (which explains why yields move lower). Now, this new liquidity ends up on financial institutions’ hands, mainly banks and insurance companies (the latter are major players in the EZ case). Those institutions are supposed to play the role of middleman: They should convey this excess money into the real economy by expanding their credit lines to firms and entrepreneurs. This is the (classic) channel which any central bank views as a method to stimulate the economy: credit becomes cheaper and this should encourage more (private) investment in the economy. From this point of view, it just remains for central banks to gauge the economic reaction to these stimuli, and ultimately to stop them once the inflation starts to weak up. Clearly, if inflation remains quiet then the central bank can keep running the QE policy. There are numerous caveats underlying this ideal process. We will stress those which might challenge most the success of QE.

I. Historically, in both cases, US and EZ, central banks started QE because they were obliged to fight against a phenomenal debt crisis. This crisis had a common ground in both cases. In both, we got a huge transfer of money from wealthy areas -US costs, North EZ countries- into peripheral areas in which main economic activities were (are) specialised either on housing construction or, in EZ, on government grants activities. When debt creation dried up (i.e. families’ income streams were no longer in line with house prices, for instance), the transfer mechanism broken and then the crisis started. At this moment, in both cases, economic heterogeneity increases: the lack of demand hit violently the remote areas, where economic activity was highly dependent on the money transfer. Whereas, in the wealthy parts, the willingness to transfer additional money into poor areas decreases (i.e. the faith on a stable financial system decreases): This element was (is) key in the EZ case, where the monetary union was (is) not supported by a federal state, i.e. a political entity which might autonomously force a fiscal stimulus or transfer to the poor areas.
Given this heterogeneity, is the QE policy the right policy to reinvigorate the economy activity? It is doubtful.
As mentioned earlier, the goal of a QE policy was (is) to favour private investment. Still, in depressed areas, there will simply not be enough hungry entrepreneurs to absorb the banks’ easy credit offers. In those areas, you need to intervene with fiscal policies, i.e. favour public spending in infrastructure, workforce skills upgrade programs, research and development and so on.
As a conclusion, the QE’s aim (i.e. to reactivate the economy) has been slightly achieved. The real main positive impact has been on banks’ balance sheets: here, thanks to QE, banks (and with them also the wealthy areas) did gain the time and means to offload bad debts from their books and restore faith in the credit system.
Nonetheless, politically, this operation is costly: if no fiscal policy initiatives are taken simultaneously to the QE, the heterogeneous character of the economy worsens and, in the weak areas, discontent and anger will just increase.

II. With QE policy, central banks are making the assumption that the source of the crisis is a lack of demand in the economy, rather than an economy’s structural change. As we already pointed out, this lack of demand is the right diagnosis for post-crisis peripheral areas, but what about the wealthy areas? Those areas are likely to exist on a radically different plane, in which global demand is likely to be a lot more resilient even in crisis and in their ability to react to other forces.
Before the crisis, wealthy parts in both the US & EZ did fully embrace (and even gave life to) two forces: globalisation and digital revolution.
Let’s take a close look at the subject of globalisation by referring to the seminal German case. Germany was known as the sick man of Europe in the late 1990s, due to its job market reforms which were disapproved of. Now, in 2000 the European Union agreed to implement the Lisbon agenda: in order to reinvigorate growth in Europe, EU members should stimulate investment in new technologies and implement more liberal policies in the labour market. The German government focused on this last part of the plan and in 2003 a major reform of their social state and job market was announced and implemented (the famous Agenda 2010). The outcome of this policy-and also thanks to a huge, firm by firm, new decentralized wave of salary bargaining-  was dramatically to increase the competitiveness of the German economy inside the EZ, by lowering the cost of labour of a very high skilled and motivated workforce.
Now, in these globalized and highly technological areas like west Germany, consumer prices were pushed down. As such, global demand in these areas was increasing, pushed mainly by the arrival of new (highly skilled) workers migrating from the remote areas. Neither the downward movement of prices, nor the healthy global demand stopped with the start of the crisis.
Under these conditions, judging when to stop QE based only on the inflation flag seems particularly misleading: in a heterogeneous economic environment, can we be sure that inflation represents the right indicator to gauge if the economy is out of the crisis?
What about changing the focus and looking at a statistic like unemployment rate instead? But are we sure that QE needs to be stopped when real economic indicators are moving?
Or have the current experiments told us something different? Namely, we should stop this policy a lot quicker, without waiting for a signal in the real economy!

III. The QE’s dreamed scenario envisaged that financial institutions would find credit hungry actors in the real economy. As already discussed this is nothing more than wishful thinking in the remote (non-globalized) areas; even in globalized and wealthy areas, no such massive hunger for new credit is present, i.e. what needs to be financed is already done and the new QE’s means are superfluous.
So, the assumption of seeing the flow of new money injected into the financial system being quickly (or with a reasonable delay) migrated into the real economy remains an unrealistic one.
Under these conditions, the outcome of an important QE is likely to be the creation of one (several) bubble(s) in one (several) financial market (s), e.g. the current situation of Euro zone government bond market or the current valuation of the US stocks. This implies an increase in the volatility of financial assets, which is likely to increase an overall process of misallocation of resources.
These bubbles just indicate that banks are only marginally playing their role as middleman between financial system and real economy. Besides, in the case of EURO zone, the crisis has reinforced the division between the North & the peripheral banking system. Thus we have seen the creation of a dual banking system. In this configuration, inter-bank credits between “wealthy” North players and peripheral (South) ones dried up: this is another factor which supports the idea that banks are not playing fully their expected role as middleman. Meanwhile, ECB continues to play the game because this is the only way to keep afloat the South banking system and to assure those banks with low charges in term of interest payments.

So, to conclude the analysis of this last paragraph, in addition to the initial distortion related to the QE policy, central banks are likely to face others distortions in several financial markets. This is a phenomenon which clearly complicates a soft landing of these markets once the QE ends. Moreover, the presence of the market bubbles obscures the waters even further, making a decision on when to stop the QE policy more difficult, and increasing the fragility of the entire system!

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