“Political Ravishment” by Gillray (1797): Prime Minister William Pitt loots the Bank of England by printing money to pay for a war
Many British schoolchildren will be familiar with the song “Magic Penny”: Hold it tight and you won’t have any Lend it, spend it, and you’ll have so many They’ll roll all over the floor
Though written by an American, its popularity in this country is unsurprising. It was here, after all, that David Hume and John Stuart Mill developed the quantity theory of money, the basis for modern monetarism. So it is entirely appropriate that Britain is now engaged in the world’s biggest experiment in the creation of magic money. Quantitative easing (QE), as it is officially known, or “printing money,” as it is traditionally described, has seen a flood of magic pennies wash through the country. So far £200bn has been conjured up by the Bank of England since March 2009.
Britain is not alone; almost all the world’s major economies have dabbled in QE since the financial crisis struck in 2008. This year the European Central Bank (ECB) sheepishly joined Britain, the US and Japan. In the spring, it was widely assumed that QE programmes had run their course, having pumped the targeted amount into their economies. But now policymakers in big western economies are considering “QE2”: another burst of monetary mysticism.
Yet as the world’s central bankers reach for their magic cash machines again, odd, unintended consequences of QE with social, political and even diplomatic repercussions are coming to light. For a start, the world’s leading economists seem unable to agree whether it has worked or not. The IMF’s verdict in August 2009 was that QE is “not a panacea... does not have to be a curse... and is not a non-event.” So at least we know what it is not. But what it is remains a mystery.
“It was one of the many measures to get confidence back in the system,” says former chancellor Alistair Darling, the man who had to sign off on the Bank of England experiment. “Nobody really knows what impact it’s having,” he says with shocking candour. “Look at the Bank of England [monetary policy committee] minutes, even they are split.”
Monetary policy is conventionally about raising or lowering interest rates. The central bank has an “official base rate,” which is the short-term rate on what it lends to commercial banks. When this official rate is lowered, it usually gets passed on to consumers in lower mortgage costs and to companies in lower borrowing costs. Think of the Bank of England lowering its base rate as monetary price easing. If that price, or the interest rate, approaches zero, that is not necessarily the end of the matter. The Bank can then switch its attentions to the quantity of money, shovelling it into the economy, hence “quantitative easing.” This more unconventional policy is meant to bring down other, longer-term, interest rates such as those on government, corporate and household debt.
Another way to understand this is to imagine that Britain is suffering from scurvy. Our benign dictator, King Mervyn (in real life, governor of the Bank of England) knows that Vitamin C is the answer, so he uses his monopoly on the supply of oranges to bring down the price and encourage their use. Eventually oranges are basically free, yet still scurvy endures. Then, he uses magic to create even more oranges out of thin air, rents out a fleet of trucks and has them handed out in every market square in Britain. Such is the fruit flood that it brings down the price of derivative products like orange juice, marmalade and Vitamin C tablets, and King Mervyn solves the scurvy problem.
In practice, money has been injected into the economy by offering to buy assets—primarily government debt—from any holder of that debt with the Bank’s invented cash. Pension funds and insurance companies in particular faced plummeting returns for holding government debts as interest rates fell, giving them an incentive to do something more risky with their money, thus stimulating borrowing and investment.
That is the basic mechanism of QE. But to understand fully where the money went, you need to know its origins.
*****
Quantitative easing was an initiative by central bankers. After the collapse of Lehman Brothers in September 2008, it was clear that British base rates, then at 5 per cent, were going to be cut towards zero. Global trade collapsed in a manner not seen since the 1920s, and the world’s ports were full of ships with no cargo.
The central bankers’ arsenal of stimulatory weapons had to be widened. Mervyn King recalled the injunction from Japanese officials who, at IMF meetings in the autumn of 2008, issued stark warnings to their international colleagues to avoid the mistakes made by Japan a decade before.
So the Bank began to map out how to use its unique power to create money, in order to buy up assets. But, in Britain at least, the institutional structures of the economy had not been shaped with quantitative easing in mind. QE required a closer relationship between the government and central bank than had been envisaged when the Bank was given the power to set interest rates in 1997. The Bank needed the treasury to indemnify any losses that might arise out of its asset purchases, and that made it a little less independent. In theory, this could have damaged its inflation-busting credentials.
But at the time inflation was a distant concern compared with the collapsing economy. Gordon Brown and Darling worked with the Bank to come up with a new structure that would preserve its independence but allow QE to go ahead— namely the establishment of the “asset purchase facility.”
In January 2009, as these discussions were taking place, there was much grumbling from the opposition. The office of George Osborne, then shadow chancellor, issued a press release saying that “printing money is the last resort of desperate governments,” as it “risks losing control of inflation.” Vince Cable, as Liberal Democrat treasury spokesman, invoked the prospect of Zimbabwean hyper-inflation, claiming that QE risked leading Britain down “the road to Harare.”
David Cameron’s response was more measured. I met him at that time and he seemed to have recently mugged up on advanced monetary economics. He referenced economist Willem Buiter’s blog in depth and regaled me with his knowledge of the difference between quantitative easing (the sheer amount of buying the central bank could do) and qualitative easing (an attempt to lower interest rates in specific markets, such as mortgage debt and corporate credit).
In the end, QE was a policy decided upon by the Bank, but with considerable input from the government. The treasury assumed the structure created would be used, as in the US, to buy a wide range of commercial, government and mortgage debt—but that was to be an operational decision for the Bank.
And so, on 5th March 2009, quantitative easing arrived in Britain, accompanying a cut in rates to 0.5 per cent. King announced £75bn of asset purchases, with treasury authorisation for the same amount again, if required. (One year later, the full £150bn had been used, plus another £50bn.) At lunchtime, at an hour’s notice, the major broadcasters, including myself from Channel 4 News, were unexpectedly invited to the Bank to interview the governor. Unlike his counterparts at the US central bank, the Federal Reserve and the ECB, the governor had, until then, given no television interviews, despite the economic crisis. But he was the epitome of cool authority. The message was: keep calm and carry on while we try this new thing, which should work—eventually.
Senior Bank officials did their best to explain the policy. One said there was no theoretical limit to how far the policy could be pushed—though he wryly admitted that it would have to end if the Bank bought every asset in Britain. The Bank fended off questions about whether this was a back-door way of funding the deficit—not through raising taxes or cutting spending but through printing money, with all its inflationary dangers. King tried to reassure us that the actions were “a standard central bank procedure.”
But what counts as “success”? I suggested to King that he could not know that this policy was going to work. “I believe these measures will work, though I cannot tell you exactly when or indeed the scale of purchases we may need to carry out in order to reach our objective,” he said. “But our objective is clear: to see an increase in the supply of money in the economy, so we can see a level of spending return and a beginning to economic recovery.”
I pressed King on the idea the banks would simply hoard the cash. He replied: “We are putting money directly into the wider economy. It doesn’t have to go through the banks.” But my question was more important than I realised at the time.
By 2010, QE had been pushed further and faster in Britain than had ever been tried before, relative to the size of our economy. “Is QE working?” had become a £200bn question.
Passing judgement on QE is a bit like divining the impact of water fluoridation on dental standards. The sparklier teeth in our credit markets are evident, but is this down to QE? And what about the wider stimulation of the economy?
About a year after QE was launched, the economy came out of its slump to post a strong growth rate of 1.2 per cent between April and June 2010. Unemployment and repossessions were far lower than in previous, milder recessions.
But the direct effect of QE appears to have been negligible. The broad money supply was not going up, and this had been one of the main aims outlined by King. The bank’s magic money was finding its way into corporate credit markets, but it wasn’t being passed on by commercial banks to businesses.
One effect of QE is not controversial. At a time of record issuance of British public debt (mainly in the form of government bonds or gilts, with a fixed annual interest payment attached), the interest paid on that debt was driven down—thanks to the Bank becoming a large new customer.
The mechanism by which the Bank bought government debt was convoluted, for operational and legal reasons. On any given morning the debt management office (DMO), an arm of the treasury, sold billions of pounds worth of British gilts to the world. Then in the afternoon, barely 400 metres away, the Bank held a reverse auction where it, in effect, bought up billions of similar government debts. Under EU rules it would have been illegal for the DMO and the Bank to trade with one another. So instead the City stepped in, making profits on trading both sides of this bizarre monetary merry-go-round for over a year.
“I fully admit it does look strange,” said Robert Stheeman, head of the DMO. “On the other hand, we must make the distinction—we are raising money by selling new gilts but the Bank is buying old gilts in the secondary market.”
The end result, though, is that the Bank bought about the same amount of government debt as was issued in a record year. Now it owns a quarter of Britain’s outstanding gilts, and points to falls in interest rate on gilts of about 1 percentage point as evidence of QE’s positive impact.
Some of the commercial banks saw it another way. Appearing before the treasury select committee in January, Stephen Hester, the chief executive of Royal Bank of Scotland, was asked how RBS had been boosted by QE. He replied: “Quantitative easing so far has taken the form of the government effectively funding its deficit by printing money.”
This “monetisation of debt” is a common view in the City. Former treasury aides say it is “nonsense” but have been frustrated by the decision to buy government rather than corporate debt. Moreover, the Bank has barely used a treasury-backed option for qualitative easing to buy up to £50bn of private debts. One aide said he felt “a little tricked” by the Bank.
To understand the sensitivities here, consider the 1797 Gillray cartoon (p32) on display outside the room at the Bank of England where the votes on interest rates and QE are held. “O you villain! What, have I kept my honour so long to have it broke up by you at last?” cries the Bank of England, in the form of the Old Lady of Threadneedle Street, while prime minister William Pitt prints money to fund the war with France. The message is that the Bank must guard itself against political meddling—and that it must be seen to do so. If not, so begins the self-fulfilling cycle of elevated expectations of inflation and rapid growth in prices. Twas ever thus.
Apart from reducing the government interest bill, then, what else has QE achieved so far? There has been a flurry of activity by big companies bypassing the banks and raising money direct from capital markets, typically by issuing corporate bonds to pension funds and insurance companies. But if they use this borrowing to pay back bank debt, then it acts as a drag on bank lending and pulls down the desired growth in the broad money supply. Despite the £200bn injection so far, annual growth in the wider measure of the money supply, including bank deposits, has been a paltry 1 to 2 per cent for most of this year. Where are the missing pounds?
“QE didn’t go into broad money because a lot of it was used to repay lending from the banks—that negated the boost to M4 [a measure of the broad money supply],” says Simon Ward, chief economist at asset management house Henderson. A wounded banking system also meant that money was not circulating through the economy as it should. But in June, the velocity of the circulation of money shot up to its fastest rate since 1980. As the song suggests, the pounds and pennies may just be being lent and spent again, boosting the economy. “It didn’t work out as I expected, but QE has helped us back on track,” says Ward.
Other economists are unconvinced. A former Bank economist Danny Gabay, of City consultancy Fathom, says: “The Bank has chopped and changed its metrics of what QE is meant to do. Even though M4 growth is close to zero, they now say look at how much worse it would have been, the counterfactual, which is unprovable.” Gabay even questions the claim that QE has lowered the interest rates paid on government debts. He points out that these gilt yields have fallen even more since QE was put on pause in February.
*****
With no consensus among British economists, who better to consult than Richard Werner, who coined the term “quantitative easing” in 1994. Werner, now of Southampton University, is an expert on Japan. “Quantitative easing” is a translation of a specific Japanese term that he devised to shine a light on the inadequate, sluggish policies of the Bank of Japan (BoJ).
Werner believes that quantitative easing in Britain has been a “sham”—as it was in Japan—and not really QE at all. “The Bank has dug a PR hole for itself with QE—I don’t know why they are using my expression,” he tells me. He says his idea involved efforts to increase credit, because the money transmission system, the banking system, was broken. He derides the monetarists and their obsession with obscure measures of money, and instead suggests a focus on creating credit. When the BoJ acted in 2001, he argues their policy was not QE, but a bog-standard monetary policy that the BoJ dressed up as new for political reasons. It was a type of economic placebo. Now, he claims, something similar is happening in Britain.
“It’s not to say that what the Bank is doing is useless—it has helped the banks, but it doesn’t inject new money. That is only injected when the money leaves the banking sector and goes into the economy. So far the money has just been passed from central banks to commercial banks,” he says.
Werner is particularly withering about a new generation of computer models used in the world’s central banks to model economic behaviour. They are known as dynamic stochastic general equilibrium (DSGE) models. “These models are nonsense—until the crisis they didn’t even include the banking sector—they are mathematical dreamworlds, irrelevant for the situation we find ourselves in,” he tells me. The Bank has a suite of such models introduced by King, called the Bank of England quarterly model (BEQM). They use it to calculate the impact of decisions on interest rates and QE.
Why does this econometric dreamworld matter? Because we are all being invited to view QE decisions as if they are analogous to a 0.25 or 0.5 per cent interest rate decision, the subject of an involved science. Yet it seems apparent that it is more of an art. One technique used is to pretend that £200bn of QE is in fact a negative interest rate, of say -2 per cent.
A negative interest rate is an intriguing concept. In the scurvy example, it would mean paying people to eat the oranges. In credit terms it would mean paying borrowers and charging savers. It is a vivid illustration of how QE has had a significant, and unfair, distributional impact.
Nowhere is this more clearly seen than in the paltry incomes of retiring pensioners who were unlucky enough to have swapped their pension pots for annuities since QE began. As the pensions expert and director general of Saga, Ros Altmann, says: “QE is the worst thing that could happen to pensions, it is devaluing and destroying pensioners’ income.”
I put this point to the Bank’s deputy governor, Charlie Bean, in September. “It would certainly be true if you’d taken out an annuity recently that it will have been impacted by our QE, because that has had the effect of driving down longer-term rates,” he said. “On the other hand, if you were somebody who already held some government or corporate bonds, then you would have benefited from QE because the underlying price of those has been driven up by our actions.”
Winners from QE include the City trading desks that saw the value of their bond portfolios soar. Other beneficiaries include the sovereign bond dealers who passed bonds from the DMO to the Bank at almost no risk, and the commercial banks who gained a supportive source of free funding.
Indeed, the treasury under Labour was convinced that much of the City was making riskless profits from QE. In mid-2009 private talks between leading bankers and senior treasury aides, the issue of QE profiteering cropped up. The treasury told the banks that these windfalls were part of the justification for its planned tax on bank bonus pools.
Meanwhile, another injustice of QE has been the differential access to credit for small companies and large companies. For those large corporations that can tap capital markets directly, QE has opened up cheaper finance, a return to merger and acquisitions activity, and helped to bypass the banking system in favour of direct funding from pensions and insurance companies. For the smaller and medium-sized enterprises (SMEs) dependent on the banking system for credit, there is no such luck. Unfortunately, those SMEs happen to employ 60 per cent of the private sector workforce.
*****
It is for these and other reasons that Britain’s former chancellor says it is time to “take stock” of QE. Darling still believes that the decision to launch QE was correct. But he told me that after £200bn of QE the policy should now be reviewed and that he was “concerned” about profiteering—so much so, that he would not have automatically granted the Bank an extension of the QE programme.
“Were I still chancellor and the Bank came to see me again then I would want to see some assessment of what has happened,” says Darling. “In the current climate I can’t see any problem with it being a public report. Where is this money? We need a treasury and Bank of England evaluation as to where it is. Is it in circulation, or sitting in bank vaults?”
Perhaps this is easier to muse about when you have left office. But if Darling had blocked another round of QE it could have created a huge stink, and raised those institutional questions about the extent of Bank independence.
And what would such a report reveal? This article is a first effort at such a report, and it has been neither quantitative, nor easy. In any case, the impetus towards QE2 is strong. The Conservative establishment, including the Institute of Directors and think tank Policy Exchange, have been calling for more QE since August. Since the election, Osborne has been describing his budget austerity policy as a way in which the Bank can keep interest rates lower for longer. And in early October he indicated that he would support a request from the Bank for more QE if it believed this would help growth.
Monetary and fiscal policy are no longer clearly separable. Two years ago, Cameron’s view was that the failure in Japan related to a two-year delay in moving from zero interest rates to QE. This view has shaped the coalition’s strategy. The treasury’s job is to get the public finances in order. Economic fine-tuning can then be left to the Bank. Recently, Cameron has made supportive noises about more QE. He has described himself as “a fiscal conservative but a monetary activist.”
Robert Lucas, a Nobel prize-winning economist at the University of Chicago, sees it the same way for the US. “It’s explicit in Milton Friedman’s assessment of the 1930s that policies like QE should have been done. Instead, the Federal Reserve sat around and watched the economy sink deeper into the depression. This time round we are doing something. Most of the work is being done by monetary policy, not the stimulus package, but the line isn’t that sharp,” he says.
But Richard Koo, chief economist of the Nomura Research Institute and the foremost expert on the post-bubble economic policy failures in Japan, believes that this is wrong. “There are some statements from the Bank of England that suggest that with QE they can solve all problems,” he says. “But in Japan nothing happened. Asset prices kept on falling, and the economy kept on weakening. When we removed it, still nothing happened. Even if there is a lot of liquidity injected into the system through QE, that liquidity will sit in the banking system and won’t be able to come out because these [overindebted] people won’t borrow, and that’s basically what happened in Japan.”
A furious debate is also now raging in the US about a huge new trillion dollar bout of QE, of the kind tried in Britain—via buying US treasury bonds. Questions have been raised about the real motive behind such a move, with an assertive China suspecting that this is a backdoor dollar devaluation.
*****
There is some irony that Washington is looking to a London-style QE when there is so little evidence that it has been a success. And, yet, at the same time, influential voices here are pushing Britain towards adopting more of an American-style variety of QE, aimed at stimulating a broader range of activity.
Back in 2009, people in the treasury wanted the magic money to be used to stir the mortgage bond market into life, or for more direct lending to companies—the qualitative easing that David Cameron mentioned. But the Bank said, “No.”
Last month, Adam Posen, a member of the Bank’s monetary policy committee, suggested that such a policy would make a useful contribution as a Plan B. Giles Wilkes, the author of a Lib-Dem pamphlet which advocated using magic money to direct funding to small businesses through a treasury fund, is now an adviser to Vince Cable. And Danny Gabay has the most innovative plan. He contends the failure to cleanse Japan’s bank balance sheets of zombie property companies (insolvent companies kept afloat by the banks) caused its lost decade. Zombie households with large debts and overvalued property is the British equivalent. QE could be used to buy up houses at a discount, jump-starting a stalled property market.
“I’m a supporter of QE, but it needs to be more imaginative. Britain has been doing it in a very unimaginative way. We need a sniper rifle rather than a scatter gun. So far we are filling a big manual on what doesn’t work,” says Gabay.
Simon Ward could not disagree more. He points to that upturn in the velocity of broad money (cash and bank deposits), and believes more QE, or QE2, risks the rise of the inflationary dragon. “QE1 wasn’t inflationary, it was antideflationary, but QE2 would be very dangerous, because there is no shortage of liquidity and the banking system is stronger.”
Almost all economists believe that too much QE will lead to raging inflation. Just as the Bank bought the debt, so it will soon have to sell it. But when should QE shift to QT—quantitative tightening? As this has not been done before, the Bank needs to think carefully. There were clues in Mervyn King’s Mansion House speech in June. Rates will go up first, with room to fall back if necessary. Then pre-announced sales of the Bank’s gilts, spread over months, seems to be the plan.
Or not. Some economists are assuming that this pile of government debt will never be sold. There is even some suspicion about how seriously the Bank is taking its 2 per cent inflation target. Inflation has been above it in 41 out of the past 50 months.
For Werner, it is time for the Bank to quietly park that target and publicly embrace its quest for moderate inflation in a manner that Japan was too shy about. “The Bank needs to set a nominal GDP growth target,” he says. A nominal GDP target incorporates a bit of inflation and a bit of growth in one target. In September, the Federal Reserve considered such a move, alongside a “price level” target, that would allow for higher inflation. Before joining the government, Wilkes suggested a five-year nominal GDP growth target of 6 per cent.
And therein lies the rub. Is QE consistent with Britain’s anti-inflation settlement, which began in 1997 under new Labour, with independence for the Bank of England? Is Britain’s economic predicament credibly consistent with an inflation target exceeded for four of the past five years? Can the target be altered without igniting inflationary expectations?
There is an imminent decision to be made about a second phase of QE in both Britain and the US. It looks likely in the US, despite disputes within the Federal Reserve. Then the QE2 could well set sail again across the Atlantic, though it is not a done deal. And the unhelpful answer from economists on whether Britain should book a berth on the monetary QE2 has been “definitely/dangerous/it doesn’t matter.”
Adam Posen, who is leading the charge for more QE on the Bank of England’s monetary policy committee, thinks we face social unrest if we get it wrong. In the absence of public spending growth, he thinks it is innovative monetary policy that will keep people in jobs over the next half decade. But the impact of the magic penny is far from certain.
Quantitative easing explained in brief
Between March 2009 and February 2010 the Bank of England created £200bn of new money and injected it into the economy to give it a boost after the 2008 financial crash. This policy, which the government supported, is known as quantitative easing.
• Why did we need it? When the economy is weak and the banking system is still in shock, even a low cost of money, low interest rates, may not on its own boost activity. An additional weapon is an increase in the quantity of money. Also, after the crash, many financial institutions remain very cautious, and tend to buy only safe investments like government bonds. But if the Bank of England uses QE money to buy bonds, it drives down the return on them and encourages investment in riskier assets to stimulate economic growth.
• Is it risky? Yes, pumping money into the economy can lead to higher inflation—although there is no sign it has had this effect yet.
• Where’s the £200bn? Nobody’s quite sure. It seems to have got tied up in the banking sector rather than being released into the economy.
• Who has benefited? City bond traders, and banks where some of the £200bn is sitting—it’s been cheap cash for them. And the government, because QE has lowered the interest on its own debt.
• Who has lost out? Pensioners tend to lose out when interest rates are low for long periods. And small and medium-sized businesses, because they have not had direct access to the QE money.
• What happens next? The Bank of England may soon decide on a second wave of QE—QE2—to boost the economy. Alistair Darling, chancellor at the time of the initial round of QE, is concerned: “I would want to see some assessment of what has happened… Where’s the money? Is it in circulation, or sitting in bank vaults?” he told Prospect.
Many British schoolchildren will be familiar with the song “Magic Penny”: Hold it tight and you won’t have any Lend it, spend it, and you’ll have so many They’ll roll all over the floor
Though written by an American, its popularity in this country is unsurprising. It was here, after all, that David Hume and John Stuart Mill developed the quantity theory of money, the basis for modern monetarism. So it is entirely appropriate that Britain is now engaged in the world’s biggest experiment in the creation of magic money. Quantitative easing (QE), as it is officially known, or “printing money,” as it is traditionally described, has seen a flood of magic pennies wash through the country. So far £200bn has been conjured up by the Bank of England since March 2009.
Britain is not alone; almost all the world’s major economies have dabbled in QE since the financial crisis struck in 2008. This year the European Central Bank (ECB) sheepishly joined Britain, the US and Japan. In the spring, it was widely assumed that QE programmes had run their course, having pumped the targeted amount into their economies. But now policymakers in big western economies are considering “QE2”: another burst of monetary mysticism.
Yet as the world’s central bankers reach for their magic cash machines again, odd, unintended consequences of QE with social, political and even diplomatic repercussions are coming to light. For a start, the world’s leading economists seem unable to agree whether it has worked or not. The IMF’s verdict in August 2009 was that QE is “not a panacea... does not have to be a curse... and is not a non-event.” So at least we know what it is not. But what it is remains a mystery.
“It was one of the many measures to get confidence back in the system,” says former chancellor Alistair Darling, the man who had to sign off on the Bank of England experiment. “Nobody really knows what impact it’s having,” he says with shocking candour. “Look at the Bank of England [monetary policy committee] minutes, even they are split.”
Monetary policy is conventionally about raising or lowering interest rates. The central bank has an “official base rate,” which is the short-term rate on what it lends to commercial banks. When this official rate is lowered, it usually gets passed on to consumers in lower mortgage costs and to companies in lower borrowing costs. Think of the Bank of England lowering its base rate as monetary price easing. If that price, or the interest rate, approaches zero, that is not necessarily the end of the matter. The Bank can then switch its attentions to the quantity of money, shovelling it into the economy, hence “quantitative easing.” This more unconventional policy is meant to bring down other, longer-term, interest rates such as those on government, corporate and household debt.
Another way to understand this is to imagine that Britain is suffering from scurvy. Our benign dictator, King Mervyn (in real life, governor of the Bank of England) knows that Vitamin C is the answer, so he uses his monopoly on the supply of oranges to bring down the price and encourage their use. Eventually oranges are basically free, yet still scurvy endures. Then, he uses magic to create even more oranges out of thin air, rents out a fleet of trucks and has them handed out in every market square in Britain. Such is the fruit flood that it brings down the price of derivative products like orange juice, marmalade and Vitamin C tablets, and King Mervyn solves the scurvy problem.
In practice, money has been injected into the economy by offering to buy assets—primarily government debt—from any holder of that debt with the Bank’s invented cash. Pension funds and insurance companies in particular faced plummeting returns for holding government debts as interest rates fell, giving them an incentive to do something more risky with their money, thus stimulating borrowing and investment.
That is the basic mechanism of QE. But to understand fully where the money went, you need to know its origins.
*****
Quantitative easing was an initiative by central bankers. After the collapse of Lehman Brothers in September 2008, it was clear that British base rates, then at 5 per cent, were going to be cut towards zero. Global trade collapsed in a manner not seen since the 1920s, and the world’s ports were full of ships with no cargo.
The central bankers’ arsenal of stimulatory weapons had to be widened. Mervyn King recalled the injunction from Japanese officials who, at IMF meetings in the autumn of 2008, issued stark warnings to their international colleagues to avoid the mistakes made by Japan a decade before.
So the Bank began to map out how to use its unique power to create money, in order to buy up assets. But, in Britain at least, the institutional structures of the economy had not been shaped with quantitative easing in mind. QE required a closer relationship between the government and central bank than had been envisaged when the Bank was given the power to set interest rates in 1997. The Bank needed the treasury to indemnify any losses that might arise out of its asset purchases, and that made it a little less independent. In theory, this could have damaged its inflation-busting credentials.
But at the time inflation was a distant concern compared with the collapsing economy. Gordon Brown and Darling worked with the Bank to come up with a new structure that would preserve its independence but allow QE to go ahead— namely the establishment of the “asset purchase facility.”
In January 2009, as these discussions were taking place, there was much grumbling from the opposition. The office of George Osborne, then shadow chancellor, issued a press release saying that “printing money is the last resort of desperate governments,” as it “risks losing control of inflation.” Vince Cable, as Liberal Democrat treasury spokesman, invoked the prospect of Zimbabwean hyper-inflation, claiming that QE risked leading Britain down “the road to Harare.”
David Cameron’s response was more measured. I met him at that time and he seemed to have recently mugged up on advanced monetary economics. He referenced economist Willem Buiter’s blog in depth and regaled me with his knowledge of the difference between quantitative easing (the sheer amount of buying the central bank could do) and qualitative easing (an attempt to lower interest rates in specific markets, such as mortgage debt and corporate credit).
In the end, QE was a policy decided upon by the Bank, but with considerable input from the government. The treasury assumed the structure created would be used, as in the US, to buy a wide range of commercial, government and mortgage debt—but that was to be an operational decision for the Bank.
And so, on 5th March 2009, quantitative easing arrived in Britain, accompanying a cut in rates to 0.5 per cent. King announced £75bn of asset purchases, with treasury authorisation for the same amount again, if required. (One year later, the full £150bn had been used, plus another £50bn.) At lunchtime, at an hour’s notice, the major broadcasters, including myself from Channel 4 News, were unexpectedly invited to the Bank to interview the governor. Unlike his counterparts at the US central bank, the Federal Reserve and the ECB, the governor had, until then, given no television interviews, despite the economic crisis. But he was the epitome of cool authority. The message was: keep calm and carry on while we try this new thing, which should work—eventually.
Senior Bank officials did their best to explain the policy. One said there was no theoretical limit to how far the policy could be pushed—though he wryly admitted that it would have to end if the Bank bought every asset in Britain. The Bank fended off questions about whether this was a back-door way of funding the deficit—not through raising taxes or cutting spending but through printing money, with all its inflationary dangers. King tried to reassure us that the actions were “a standard central bank procedure.”
But what counts as “success”? I suggested to King that he could not know that this policy was going to work. “I believe these measures will work, though I cannot tell you exactly when or indeed the scale of purchases we may need to carry out in order to reach our objective,” he said. “But our objective is clear: to see an increase in the supply of money in the economy, so we can see a level of spending return and a beginning to economic recovery.”
I pressed King on the idea the banks would simply hoard the cash. He replied: “We are putting money directly into the wider economy. It doesn’t have to go through the banks.” But my question was more important than I realised at the time.
By 2010, QE had been pushed further and faster in Britain than had ever been tried before, relative to the size of our economy. “Is QE working?” had become a £200bn question.
Passing judgement on QE is a bit like divining the impact of water fluoridation on dental standards. The sparklier teeth in our credit markets are evident, but is this down to QE? And what about the wider stimulation of the economy?
About a year after QE was launched, the economy came out of its slump to post a strong growth rate of 1.2 per cent between April and June 2010. Unemployment and repossessions were far lower than in previous, milder recessions.
But the direct effect of QE appears to have been negligible. The broad money supply was not going up, and this had been one of the main aims outlined by King. The bank’s magic money was finding its way into corporate credit markets, but it wasn’t being passed on by commercial banks to businesses.
One effect of QE is not controversial. At a time of record issuance of British public debt (mainly in the form of government bonds or gilts, with a fixed annual interest payment attached), the interest paid on that debt was driven down—thanks to the Bank becoming a large new customer.
The mechanism by which the Bank bought government debt was convoluted, for operational and legal reasons. On any given morning the debt management office (DMO), an arm of the treasury, sold billions of pounds worth of British gilts to the world. Then in the afternoon, barely 400 metres away, the Bank held a reverse auction where it, in effect, bought up billions of similar government debts. Under EU rules it would have been illegal for the DMO and the Bank to trade with one another. So instead the City stepped in, making profits on trading both sides of this bizarre monetary merry-go-round for over a year.
“I fully admit it does look strange,” said Robert Stheeman, head of the DMO. “On the other hand, we must make the distinction—we are raising money by selling new gilts but the Bank is buying old gilts in the secondary market.”
The end result, though, is that the Bank bought about the same amount of government debt as was issued in a record year. Now it owns a quarter of Britain’s outstanding gilts, and points to falls in interest rate on gilts of about 1 percentage point as evidence of QE’s positive impact.
Some of the commercial banks saw it another way. Appearing before the treasury select committee in January, Stephen Hester, the chief executive of Royal Bank of Scotland, was asked how RBS had been boosted by QE. He replied: “Quantitative easing so far has taken the form of the government effectively funding its deficit by printing money.”
This “monetisation of debt” is a common view in the City. Former treasury aides say it is “nonsense” but have been frustrated by the decision to buy government rather than corporate debt. Moreover, the Bank has barely used a treasury-backed option for qualitative easing to buy up to £50bn of private debts. One aide said he felt “a little tricked” by the Bank.
To understand the sensitivities here, consider the 1797 Gillray cartoon (p32) on display outside the room at the Bank of England where the votes on interest rates and QE are held. “O you villain! What, have I kept my honour so long to have it broke up by you at last?” cries the Bank of England, in the form of the Old Lady of Threadneedle Street, while prime minister William Pitt prints money to fund the war with France. The message is that the Bank must guard itself against political meddling—and that it must be seen to do so. If not, so begins the self-fulfilling cycle of elevated expectations of inflation and rapid growth in prices. Twas ever thus.
Apart from reducing the government interest bill, then, what else has QE achieved so far? There has been a flurry of activity by big companies bypassing the banks and raising money direct from capital markets, typically by issuing corporate bonds to pension funds and insurance companies. But if they use this borrowing to pay back bank debt, then it acts as a drag on bank lending and pulls down the desired growth in the broad money supply. Despite the £200bn injection so far, annual growth in the wider measure of the money supply, including bank deposits, has been a paltry 1 to 2 per cent for most of this year. Where are the missing pounds?
“QE didn’t go into broad money because a lot of it was used to repay lending from the banks—that negated the boost to M4 [a measure of the broad money supply],” says Simon Ward, chief economist at asset management house Henderson. A wounded banking system also meant that money was not circulating through the economy as it should. But in June, the velocity of the circulation of money shot up to its fastest rate since 1980. As the song suggests, the pounds and pennies may just be being lent and spent again, boosting the economy. “It didn’t work out as I expected, but QE has helped us back on track,” says Ward.
Other economists are unconvinced. A former Bank economist Danny Gabay, of City consultancy Fathom, says: “The Bank has chopped and changed its metrics of what QE is meant to do. Even though M4 growth is close to zero, they now say look at how much worse it would have been, the counterfactual, which is unprovable.” Gabay even questions the claim that QE has lowered the interest rates paid on government debts. He points out that these gilt yields have fallen even more since QE was put on pause in February.
*****
With no consensus among British economists, who better to consult than Richard Werner, who coined the term “quantitative easing” in 1994. Werner, now of Southampton University, is an expert on Japan. “Quantitative easing” is a translation of a specific Japanese term that he devised to shine a light on the inadequate, sluggish policies of the Bank of Japan (BoJ).
Werner believes that quantitative easing in Britain has been a “sham”—as it was in Japan—and not really QE at all. “The Bank has dug a PR hole for itself with QE—I don’t know why they are using my expression,” he tells me. He says his idea involved efforts to increase credit, because the money transmission system, the banking system, was broken. He derides the monetarists and their obsession with obscure measures of money, and instead suggests a focus on creating credit. When the BoJ acted in 2001, he argues their policy was not QE, but a bog-standard monetary policy that the BoJ dressed up as new for political reasons. It was a type of economic placebo. Now, he claims, something similar is happening in Britain.
“It’s not to say that what the Bank is doing is useless—it has helped the banks, but it doesn’t inject new money. That is only injected when the money leaves the banking sector and goes into the economy. So far the money has just been passed from central banks to commercial banks,” he says.
Werner is particularly withering about a new generation of computer models used in the world’s central banks to model economic behaviour. They are known as dynamic stochastic general equilibrium (DSGE) models. “These models are nonsense—until the crisis they didn’t even include the banking sector—they are mathematical dreamworlds, irrelevant for the situation we find ourselves in,” he tells me. The Bank has a suite of such models introduced by King, called the Bank of England quarterly model (BEQM). They use it to calculate the impact of decisions on interest rates and QE.
Why does this econometric dreamworld matter? Because we are all being invited to view QE decisions as if they are analogous to a 0.25 or 0.5 per cent interest rate decision, the subject of an involved science. Yet it seems apparent that it is more of an art. One technique used is to pretend that £200bn of QE is in fact a negative interest rate, of say -2 per cent.
A negative interest rate is an intriguing concept. In the scurvy example, it would mean paying people to eat the oranges. In credit terms it would mean paying borrowers and charging savers. It is a vivid illustration of how QE has had a significant, and unfair, distributional impact.
Nowhere is this more clearly seen than in the paltry incomes of retiring pensioners who were unlucky enough to have swapped their pension pots for annuities since QE began. As the pensions expert and director general of Saga, Ros Altmann, says: “QE is the worst thing that could happen to pensions, it is devaluing and destroying pensioners’ income.”
I put this point to the Bank’s deputy governor, Charlie Bean, in September. “It would certainly be true if you’d taken out an annuity recently that it will have been impacted by our QE, because that has had the effect of driving down longer-term rates,” he said. “On the other hand, if you were somebody who already held some government or corporate bonds, then you would have benefited from QE because the underlying price of those has been driven up by our actions.”
Winners from QE include the City trading desks that saw the value of their bond portfolios soar. Other beneficiaries include the sovereign bond dealers who passed bonds from the DMO to the Bank at almost no risk, and the commercial banks who gained a supportive source of free funding.
Indeed, the treasury under Labour was convinced that much of the City was making riskless profits from QE. In mid-2009 private talks between leading bankers and senior treasury aides, the issue of QE profiteering cropped up. The treasury told the banks that these windfalls were part of the justification for its planned tax on bank bonus pools.
Meanwhile, another injustice of QE has been the differential access to credit for small companies and large companies. For those large corporations that can tap capital markets directly, QE has opened up cheaper finance, a return to merger and acquisitions activity, and helped to bypass the banking system in favour of direct funding from pensions and insurance companies. For the smaller and medium-sized enterprises (SMEs) dependent on the banking system for credit, there is no such luck. Unfortunately, those SMEs happen to employ 60 per cent of the private sector workforce.
*****
It is for these and other reasons that Britain’s former chancellor says it is time to “take stock” of QE. Darling still believes that the decision to launch QE was correct. But he told me that after £200bn of QE the policy should now be reviewed and that he was “concerned” about profiteering—so much so, that he would not have automatically granted the Bank an extension of the QE programme.
“Were I still chancellor and the Bank came to see me again then I would want to see some assessment of what has happened,” says Darling. “In the current climate I can’t see any problem with it being a public report. Where is this money? We need a treasury and Bank of England evaluation as to where it is. Is it in circulation, or sitting in bank vaults?”
Perhaps this is easier to muse about when you have left office. But if Darling had blocked another round of QE it could have created a huge stink, and raised those institutional questions about the extent of Bank independence.
And what would such a report reveal? This article is a first effort at such a report, and it has been neither quantitative, nor easy. In any case, the impetus towards QE2 is strong. The Conservative establishment, including the Institute of Directors and think tank Policy Exchange, have been calling for more QE since August. Since the election, Osborne has been describing his budget austerity policy as a way in which the Bank can keep interest rates lower for longer. And in early October he indicated that he would support a request from the Bank for more QE if it believed this would help growth.
Monetary and fiscal policy are no longer clearly separable. Two years ago, Cameron’s view was that the failure in Japan related to a two-year delay in moving from zero interest rates to QE. This view has shaped the coalition’s strategy. The treasury’s job is to get the public finances in order. Economic fine-tuning can then be left to the Bank. Recently, Cameron has made supportive noises about more QE. He has described himself as “a fiscal conservative but a monetary activist.”
Robert Lucas, a Nobel prize-winning economist at the University of Chicago, sees it the same way for the US. “It’s explicit in Milton Friedman’s assessment of the 1930s that policies like QE should have been done. Instead, the Federal Reserve sat around and watched the economy sink deeper into the depression. This time round we are doing something. Most of the work is being done by monetary policy, not the stimulus package, but the line isn’t that sharp,” he says.
But Richard Koo, chief economist of the Nomura Research Institute and the foremost expert on the post-bubble economic policy failures in Japan, believes that this is wrong. “There are some statements from the Bank of England that suggest that with QE they can solve all problems,” he says. “But in Japan nothing happened. Asset prices kept on falling, and the economy kept on weakening. When we removed it, still nothing happened. Even if there is a lot of liquidity injected into the system through QE, that liquidity will sit in the banking system and won’t be able to come out because these [overindebted] people won’t borrow, and that’s basically what happened in Japan.”
A furious debate is also now raging in the US about a huge new trillion dollar bout of QE, of the kind tried in Britain—via buying US treasury bonds. Questions have been raised about the real motive behind such a move, with an assertive China suspecting that this is a backdoor dollar devaluation.
*****
There is some irony that Washington is looking to a London-style QE when there is so little evidence that it has been a success. And, yet, at the same time, influential voices here are pushing Britain towards adopting more of an American-style variety of QE, aimed at stimulating a broader range of activity.
Back in 2009, people in the treasury wanted the magic money to be used to stir the mortgage bond market into life, or for more direct lending to companies—the qualitative easing that David Cameron mentioned. But the Bank said, “No.”
Last month, Adam Posen, a member of the Bank’s monetary policy committee, suggested that such a policy would make a useful contribution as a Plan B. Giles Wilkes, the author of a Lib-Dem pamphlet which advocated using magic money to direct funding to small businesses through a treasury fund, is now an adviser to Vince Cable. And Danny Gabay has the most innovative plan. He contends the failure to cleanse Japan’s bank balance sheets of zombie property companies (insolvent companies kept afloat by the banks) caused its lost decade. Zombie households with large debts and overvalued property is the British equivalent. QE could be used to buy up houses at a discount, jump-starting a stalled property market.
“I’m a supporter of QE, but it needs to be more imaginative. Britain has been doing it in a very unimaginative way. We need a sniper rifle rather than a scatter gun. So far we are filling a big manual on what doesn’t work,” says Gabay.
Simon Ward could not disagree more. He points to that upturn in the velocity of broad money (cash and bank deposits), and believes more QE, or QE2, risks the rise of the inflationary dragon. “QE1 wasn’t inflationary, it was antideflationary, but QE2 would be very dangerous, because there is no shortage of liquidity and the banking system is stronger.”
Almost all economists believe that too much QE will lead to raging inflation. Just as the Bank bought the debt, so it will soon have to sell it. But when should QE shift to QT—quantitative tightening? As this has not been done before, the Bank needs to think carefully. There were clues in Mervyn King’s Mansion House speech in June. Rates will go up first, with room to fall back if necessary. Then pre-announced sales of the Bank’s gilts, spread over months, seems to be the plan.
Or not. Some economists are assuming that this pile of government debt will never be sold. There is even some suspicion about how seriously the Bank is taking its 2 per cent inflation target. Inflation has been above it in 41 out of the past 50 months.
For Werner, it is time for the Bank to quietly park that target and publicly embrace its quest for moderate inflation in a manner that Japan was too shy about. “The Bank needs to set a nominal GDP growth target,” he says. A nominal GDP target incorporates a bit of inflation and a bit of growth in one target. In September, the Federal Reserve considered such a move, alongside a “price level” target, that would allow for higher inflation. Before joining the government, Wilkes suggested a five-year nominal GDP growth target of 6 per cent.
And therein lies the rub. Is QE consistent with Britain’s anti-inflation settlement, which began in 1997 under new Labour, with independence for the Bank of England? Is Britain’s economic predicament credibly consistent with an inflation target exceeded for four of the past five years? Can the target be altered without igniting inflationary expectations?
There is an imminent decision to be made about a second phase of QE in both Britain and the US. It looks likely in the US, despite disputes within the Federal Reserve. Then the QE2 could well set sail again across the Atlantic, though it is not a done deal. And the unhelpful answer from economists on whether Britain should book a berth on the monetary QE2 has been “definitely/dangerous/it doesn’t matter.”
Adam Posen, who is leading the charge for more QE on the Bank of England’s monetary policy committee, thinks we face social unrest if we get it wrong. In the absence of public spending growth, he thinks it is innovative monetary policy that will keep people in jobs over the next half decade. But the impact of the magic penny is far from certain.
Quantitative easing explained in brief
Between March 2009 and February 2010 the Bank of England created £200bn of new money and injected it into the economy to give it a boost after the 2008 financial crash. This policy, which the government supported, is known as quantitative easing.
• Why did we need it? When the economy is weak and the banking system is still in shock, even a low cost of money, low interest rates, may not on its own boost activity. An additional weapon is an increase in the quantity of money. Also, after the crash, many financial institutions remain very cautious, and tend to buy only safe investments like government bonds. But if the Bank of England uses QE money to buy bonds, it drives down the return on them and encourages investment in riskier assets to stimulate economic growth.
• Is it risky? Yes, pumping money into the economy can lead to higher inflation—although there is no sign it has had this effect yet.
• Where’s the £200bn? Nobody’s quite sure. It seems to have got tied up in the banking sector rather than being released into the economy.
• Who has benefited? City bond traders, and banks where some of the £200bn is sitting—it’s been cheap cash for them. And the government, because QE has lowered the interest on its own debt.
• Who has lost out? Pensioners tend to lose out when interest rates are low for long periods. And small and medium-sized businesses, because they have not had direct access to the QE money.
• What happens next? The Bank of England may soon decide on a second wave of QE—QE2—to boost the economy. Alistair Darling, chancellor at the time of the initial round of QE, is concerned: “I would want to see some assessment of what has happened… Where’s the money? Is it in circulation, or sitting in bank vaults?” he told Prospect.
