The financial crisis post 2008 forced regulators to consider unconventional steps in monetary policy. At first, the US Fed used various tools in its economic arsenal to set the country on a fast growth path and to prop up the inflation numbers that would indicate an enhanced demand of goods and commodities. When everything failed, the US Fed and the Government decided to go ahead with a plan called Quantitative Easing. The plan simply consisted of buying bonds and other government securities by printing money which would introduce money into the system, keeping some other factors constant. This method was part of the Keynesian Economic theory which called for government intervention in such situations. Most Keynesian economists supported the government’s initiative to try this experiment and the bill also got approved in the Congress.
Based on the US experiment, other European countries including the UK that were experiencing a similar slowdown launched their own versions of various stimulus packages. The US government executed this plan for quite a long period of time starting from around 2009 to until recently when it started unwinding interest rates. However, most economists have been extremely critical of this method of handling the financial crisis from the outset. Some of them accuse the US government of driving up asset prices with such policies without having any real impact on the financial crisis situation. This essay will commence by examining the exact rationale and methodology behind the Quantitative Easing process and will attempt to answer if QE was really an effective solution to the financial crisis.
Quantitative Easing – Methodology
The most high-profile form of unconventional monetary policy has been Quantitative Easing (QE). The expression was first applied to Japan as it dealt with the bursting of a real estate bubble and the deflationary pressures that followed in the 1990s. Most Conventional monetary policies operate by affecting the short-term interest rates through a method called Open Market Operations (OMO). This is effectively a method of pumping money into the system.
As the name suggests Quantitative Easing or QE is the process of boosting money supply in an economic system. This method is usually resorted by Central Banks when the common methods of interest rate variations fail to move the economy in a desired direction. At a certain point, when interest rates cannot be cut further, economists usually start resorting to the QE approach. In such a situation, it may still be possible to increase the money quantity in the system. In order to do this, the central bank must buy assets in exchange for money from just about anyone who holds them. In practice, quantitative easing involves the purchase of government debt, mortgage-backed securities or even equities from banks. The Central Bank raises this money through the printing of fresh money or sometimes even in digital form so no physical printing takes place. In such cases, the Central Bank simply increases the size of the banks’ reserves with the push of button. As per law, all banks have to hold some reserves at the central bank. In the event of a quantitative easing, these banks begin building up “excess reserves”. (Hadas & Dixon)
If these banks swap the financial instruments held by them for enhanced reserves at the Central Bank, the size of the bank’s own balance sheets shrinks. On the contrary, the balance sheet size of the Central Bank expands in a proportional manner. In doing so, policy makers assume that banks want to keep their own balance sheets static, which then results in the commencement of lending to end borrowers. In this manner, liquidity starts getting introduced into the economy also fuelled in part by all time low interest rates. It is from this point on that policy-makers start measuring various metrics such as inflation, unemployment and spending to check if further stimulus is required.
In order to test the efficacy of the Quantitative Easing process, it becomes imperative that one tests it for both the US and Europe as well as the effects of QE on emerging markets.
QE and the US Markets
The Quantitative Easing Process has had a profound effect on the finances of the US Fed. The balance sheet of the Fed has simply grown from the pre crisis levels of $700 billion to almost $4 trillion (Rogoff). However, such a massive debt growth has not resulted in a proportionate rise in inflation since the intermediary institutions such as banks have not lent money in the projected proportion.
Further, QE as a policy instrument is a weak tool compared to interest rate movements since its effects are uncertain and unpredictable (Rogoff). For this very reason, it doesn’t come as a big surprise that this policy has not really yielded returns along expected lines for the government. Further, the government is stuck with assets which if it offloads can have disastrous consequences for the economy. The other problem is that it is nearly impossible to tell whether an economic recovery happened due to the QE method or if there were other factors at play that contributed to the economic recovery. It is for this reason that quantitative easing as a policy instrument has been a bone of contention amongst economists in the US and elsewhere. Most economists had stringent objections to the use of the quantitative easing methodology as a policy tool.
A report published by the Federal Reserve of St. Louis shows that relevant analysis clearly proved that the QE as a policy tool had very little or almost no effect in the reduction of long-term yields in relation to what they would have otherwise been. Therefore, if the QE program was not instrumental in significantly reducing long-term yields relative to what they would have otherwise been, one can surmise that the QE could not have played any significant role in an increased output or employment either (Thornton).
However, some other publications differ on this outcome. For instance, another publication by the St.Louis Fed opined that imperfect asset substitutability and related financial frictions in an economy provided a meaningful avenue for policymakers and applicable monetary policy to influence long-term real interest rates, notwithstanding the short-term interest rate target (Fawley). However, it is not always easy to identify such asset imperfections within an economy with an increasing efficiency. In most cases, governments get stuck for decades with low or even negative interest rates as mentioned earlier in the case of Japan. At present, the US is in a stage where the Fed is trying really hard to exit the QE but finding it difficult to do so since it finds that a host of factors – both local and global have turned against it. While the US economy is not as weak as it was in 2009, it is not as robust as it was in the previous years before that either. For this reason, one cannot conclude that the QE program was a success to the extent that it should have been. As compared to the interest rate change, the effects of the QE program are unpredictable and there can be no telling when things could turn around for the worse given the massive balance sheet expansion of the US Fed. Therefore, in all, one can conclude that the QE program was not responsible for the uptick in the US economic numbers. There could possibly have been other factors at play that could have resulted in this particular scenario.
QE and Other Markets
The Quantitative Easing methodology was not used solely by the US during the financial crisis. The central banks of the Euro area (ECB) and the UK (Bank of England) have all followed Japan in adopting similar policies. These policies have resulted in sizeable increases in their balance sheets. However, one must understand that there are significant differences between the policies of these countries in terms of how they have implemented such unconventional policies.
The Bank of England has bought an overwhelming number of UK government bonds from the non-bank private sector through its QE operations (Joyce 274). On the other hand, the Fed has bought a combination of US Treasuries as well as a significant quantity of agency debt combined with agency-backed mortgage backed securities (MBS). In fact, if one examines these purchases closely, one finds that the assets bought by the US Fed and the Bank of England are very similar in nature, because the bulk of the mortgage-backed securities are guaranteed by the US government owned agencies. Therefore, while the structure may appear different on the outside it is almost the same on a closer examination.
Likewise, the growth of the European Central Bank (ECB) balance sheet is largely due to repo operations. Such operations primarily result in the provision of predominantly long term loans in exchange for collateral such as bank loans, while government bonds are excluded from this list. Therefore, one can see that the ECB operations vary widely from the US and UK central bank purchases. One can possibly view them as a response to a different problem than that faced by the Fed in the US and the Bank of England. (Joyce 275) These policies are in response to Stresses within the euro area, particularly in 2011 and into 2012 that led to a steady and very substantial outflow of euro deposits from banks in some of the peripheral countries and into banks in other euro-area countries. (Joyce 275) This outflow caused a major disparity within the euro-area banking system. The magnitude of these imbalances became reflected in the so-called Target system imbalances run by the ECB. Therefore, in a way, the ECB long-term repo operations were designed to assuage the acute funding difficulties that were generated during the financial crises. In other words, it was constructed keeping in mind the liquidity crunch existing in the economy at that time.
On the other hand, both the US Fed and the Bank of England QE operations were not designed keeping in mind a liquidity problem within the banking system. On the contrary, they were primarily designed to affect the prices or yields on assets such as bonds issued to finance lending to companies as well as households. Therefore, it makes sense for one to assess the success or otherwise of those operations in affecting yields rather than addressing problems of liquidity.
However, this essay would attempt to address if the QE in Europe was a success and did it manage to address the problems of liquidity that plagued Europe in those times. In the singular case of Europe, Mario Draghi (ECB President) still feels that Europe needs more unconventional monetary instruments. The current level of asset buying stands at Euro 60 billion a month and if the ECB increases this figure further they run probable systemic risks. Unfortunately for that zone, the Central Bank is running out of assets to buy due to which they have come to a particular point where they are actually mulling cutting of interest rates to levels below zero. (Gilbert)
However, if interest rates get cut below zero, government bond yields will fall leading to an increase in the prices of bonds and similar assets. This simply means that the ECB runs a risk of making the whole system ineffective. With inflation at 0.1%, it is obvious that the Quantitative Easing program has severely failed to meet inflation targets of 2%. (Gilbert) In order to rectify the situation, the ECB is trying to discover if bringing corporate bonds into the asset purchase ambit would make sense since it would open a whole new market for the government purchase program.
QE and emerging markets
If one has to measure the success (or failure) of the QE program, one must take a global approach and also examine the effects of the program initiated by these developed countries on emerging markets. This is especially true since we live in a modern world where the events that occur in one country have a direct effect on other countries – be they economic or political.
If one sees that in recent times the US Fed has judged that there have been nominal improvements in the economic conditions due to which the government should focus on unwinding the QE program. Most emerging markets are affected during both the phases of the QE program – when it began and during the unwinding. After it started, the QE program lead to excess money in the US system which gradually started to make its way to most high growth emerging markets. This led to a growth in the prices of all kinds of securities in these countries to levels which were unwarranted and undeserved.
When the economic activity within the United States began showing signs of improvement, the Fed announced that it would reduce its QE3 programme. It proposed to decrease its monthly purchases from US $85 to US$75 billion of fixed-income securities. This announcement has had a negative impact on emerging markets because it led to massive capital outflows from some of these emerging countries to the United States as investors considered the implications of the end of the third phase of the QE program. (Bouraoui 1563) While some countries like China and India were hit lesser than others, most other smaller emerging markets such as Turkey and the South East Asian nations were hard hit. The flight of capital to the United States has resulted, therefore, in an inconceivable decline in some of these emerging economies. In some of these countries, this has resulted in an increase in interest rates and bond yields, plunging stock markets, and deterioration in the balance of payments situation at the macroeconomic level. Further, almost all the emerging nations have seen the values of their currencies depreciate against the dollar.
In the study conducted by Taoufik Bouraoui (2015), it becomes clear that the five major emerging markets studied by him have been casualties of the QE withdrawal albeit in varying degrees. The fact that he has considered the FDI and the portfolio investments as the major factor in the study for calculating the impact was a smart one since it is these two streams that contribute significantly to currency movements in most emerging markets. In all, one can easily conclude that the QE programs (especially withdrawals) can have disastrous consequences for most emerging markets.
Was the QE a success?
After having reviewed these points of consideration to decide the success of the QE program, one comes to the moot question. Was the QE program really the kind of the success that the government would have everyone think?
In the US scenario, the QE program did not succeed to the extent that policy makers would have liked it to since it did not impact the interest rates in the desired manner (Thornton) Further, the program neither resulted in an increase in output nor in the unemployment figures. If one were to refer to history, one can see that Japan’s tryst with the QE program has been an unmitigated disaster of epic proportions. Similarly, in the US credit conditions still remain tight and the Fed is only left with a balance sheet that has swollen to difficult proportions (Hadas and Dixon). Most economists argue that the QE program has not succeeded in wiping out unemployment as fast as it had anticipated. This is indeed a crucial point of argument against this program. The QE program has also, as of now, failed to raise inflation figures to the necessary target. It is for this very reason that after the first interest rate increase the US Fed has adopted a more conservative stance.
If there was one example of the QE Program having gone bad after Japan, it is Europe. Clearly, policymakers in Europe have nowhere to go with interest rates at near zero levels and their asset purchase program reaching a near ceiling in terms of asset availability. If the objective of the QE program was to eventually increase inflation and then increase interest rates to a sustainable level, then the QE has miserably failed to live up to the expectations of the policy makers at ECB.
The ECB and its President has almost flirted with the idea of below zero interest rates in order to keep the momentum going, but at this time have chosen to discard the same in favor of other policy tools. As of now, the fresh money infusion into the various Euro zone nations hasn’t helped at all. However, the biggest risk that the QE program or its existence has created is the risk of asset bubbles. Since the program primarily hinges on acquiring assets, one can understand that it becomes inevitable that asset bubbles get created. If and when these asset bubbles burst, the Central Bank will have a new task at hand to repair the situation.
Micheal Joyce (2012) clearly points out that the sluggishness in the Western Economies is largely due to the fact that QE does not work or it has been done on an insufficient scale (Joyce 286). Most of the research done on this subject reaches the same consensus that QE is largely ineffective since it is extremely difficult to control and implement the program in a manner that boosts a given economy to a sufficient extent. The other point of concern is the burgeoning balance sheet that a Central Bank acquires at the end of one such asset purchase program and the means to alleviate the same. To that extent, most economists also recommend that central bankers and financial regulators must strengthen frameworks so that the government would never feel the need of implementing a QE program in the future.
The concerns mentioned above clearly point to the fact that the QE as a policy tool is ineffective in the face of a financial crisis since it does not provide the solutions that one could expect out of a sound and robust monetary policy.
Conclusion
In conclusion, one can clearly understand that the Quantitative Easing program suffers from multiple concerns. The primary concern is the state of the Central Bank finances at the end of such an intensive asset purchase program. The second concern is about any underlying asset bubbles that may emerge during or after the implementation of such a program. However, the biggest concern is that the present times as well as history has shown that QE is largely ineffective. Most countries that have had such a program in place have to continue the same for years together. Such a program, then, neither increases output nor affects unemployment. In all, one can conclude that the QE program is definitely not a solution to the financial crisis given its various operational and implementation difficulties.
An alternative to the Quantitative Easing mentioned is the QE for the people. In such a form of QE, the money that the governments spends on asset purchases could be used by the government on providing better public transportation, education and healthcare services. Such an initiative could improve the real economy, thus resulting in an automatic revival of economies. Additionally, this would result in lower personal debt and lower poverty due to the creation of jobs required to carry out the above. Additionally, the QE for the people is sustainable in nature, while the QE program in its current form is self destructive in a way and prone to collapse. Therefore, it makes sense for the government to consider this aspect and seriously consider the QE for the people program.
Works Cited
Bouraoui, Taoufik. “The effect of reducing quantitative easing on emerging markets.” Applied Economics 47.15 (2015). 1562 – 1573. Web. 10 Apr 2016.
Fawley, Brett. “Quantitative Easing: Lessons we’ve learned.” The Regional Economist. 2012, July. Web. 10 Apr 2016.
Hadas, Edward & Dixon, Hugo. “Quantitative Easing: The modern way to print money or a therapy of the last resort.” The Telegraph, 8 Jan 2009. Web. 10 Apr 2016.
Gilbert, Mark. “The Quantitative Easing Experiment is Failing.” Bloomberg, 29 Oct 2015. Web. 10 Apr 2016.
Joyce, Michael, et.al. “Quantitative Easing and Unconventional Monetary Policy.” TheEconomic Journal, 122 (2012). F271–F288. Web. 10 Apr 2016.
Rogoff, Kenneth. “Was Quantitative Easing best way to boost US Economy?” The Boston Globe, 01 Mar 2015. Web. 10 Apr 2016.
Thornton, Daniel. “Has QE been effective?” Economic Synopses 2014 (3). 1 – 2. Web. 10 Apr 2016.
