Financial markets have become increasingly concerned with the outlook that the US Federal Reserve (Fed) could abandon its policy of “quantitative easing” (“QE”). The Fed adopted the policy of QE in 2008 as a response to the financial and economic crisis.
A QE policy means that the central bank purchases bonds in the market place. If a central bank buys a bond, it increases the demand for it, thereby raising its price above the level that would prevail had there been no central bank purchases. In other words: QE pushes the bond price above its “true” equilibrium price.
This is equivalent to saying that QE lowers market interest rates to below the interest rate level that would prevail hadn’t there been any central bank bond purchases. That is to say a policy of QE pushes the market interest rate to below its so-called natural interest rate.
In what follows, I want to show that QE (1) amounts to an economically harmful interest rate manipulation, (2) causes an expansion of the quantity of money and is thus inflationary, and that, if it is not brought to a halt, (3) ends in a big disaster.
Minimum price policy for bonds
To set the ball rolling, a policy of QE must be seen as a minimum price policy for bonds. This can be explained by the chart below. It shows on the right hand side the supply of and demand for bonds, and on the left hand side it shows the supply of money.
The bond supply curve (S) has a positive slope: The higher the price of the bond is, the higher is the supply of bonds. The bond demand schedule (D) has a negative slope: The lower the bond price is, the higher is the demand for bonds. The intersection between the supply of and demand for bonds is the equilibrium price P0.
Under QE, the central bank wants to push the bond price above the prevailing equilibrium price, in our example it wants to push the price from P0 to PMIN. At PMIN, however, there will be an excess supply of bonds in the market (B’ – B’’).
For keeping PMIN, the central bank has to purchases the excess supply of bond. This, in turn, will have a direct impact on the money supply in the economy, as the central bank pays its purchases with newly created base money – as indicated by the shift of the money supply schedule to the right, from M0 to M1.
Now assume that investors become concerned about inflation, and they reduce their demand for bonds so that the demand schedule moves from D to D’. In this case the excess bond supply increases to B’ – B’’’, which has to be bought up by the central bank to keep prices at PMIN. This will, of course, increase the quantity of money further (not shown in the graph).
Expansion of the money supply
It is important to note that if a central bank purchases bonds (or any asset, for that matter), it increases the base money supply: As the money production monopolist the central banks literally creates new money out of thin air and sends it onto the sellers’ checking account.
When it comes to affecting the quantity of money, it makes a big difference from whom the central bank buys the bonds.
If the central bank purchases bonds held by banks, it increases banks’ excess reserves, while the commercial money stock, that is M1 and M2, remains unaffected. The latter would be increased only if and when banks use their excess reserves for additional lending and/or asset purchases.
If the central bank purchases bonds held by non-banks (such as, for instance, insurance companies, pension funds and private savers), it increases the commercial money stock – M1 and M2 – directly: This is because the purchasing price will be credited to the seller’s checking account, which is included in M1 and M2.
In other words, the central bank can influence the outstanding stock of money directly if it decides to purchase bonds held, or newly issued, by non-banks. And this is what seems to have been increasingly happening in the US since around 2011.
In the financial and economic crisis, bank credit expansion started declining as from 2008 and even became negative in 2010. This, in turn, dampened the rise in M2: While a rise in bank credit increases the stock of deposit money, a decline in bank credit reduces deposit money.
In other words: The Fed’s QE policy, which had started in late 2008, didn’t help preventing the rise in the stock of M2 from decelerating. This changed in 2011, though, as the Fed changed course.
In 2011, the Fed’s appears to have increasingly bought bonds held by non-banks. By doing so, the Fed send additionally created money directly to sellers’ checking accounts. And as the latter are included in M1 and M2, the commercial money stocks increased.
Given the deceleration of money creation through bank credit expansion as from the middle of 2012, however, it is hard to see that the Fed will be in a position to “tapering” its QE policy anytime soon, let alone abandon it altogether.
This is because phasing out QE at this point will most likely dampen economic activity, or could even result in outright recession – as rising interest rates will reveal malinvestments which have been built up under a regime of artificially lowered interest rates.
A recession is a painful but necessary process through which the free market system cleanses itself of unsound investments. However, there is typically a fairly strong political incentive to employ policies for keeping the artificial “boom” going, such as QE.
A monetary policy of pushing interest rates below their natural rate level may well set into motion a vicious circle. If interest rates are to be held at artificially suppressed levels to fend off recession, investors might want to decrease their bond holdings.
To prevent the bond sell-off from raising yields, the central bank has to step in and purchase any excess supply of bonds, thereby issuing new money – which, in turn, induces investors to reduce their bond holdings even further.
At some point the central bank will have to either set free interest rates, end money printing, and the economy into recession-depression. Or the central bank will have to continue its QE, a policy that could, in the extreme, end in high inflation or even hyperinflation.
Hyperinflation as a result of central banks desperately clinging to QE is by no means a remote danger. Ludwig von Mises (1881 – 1973), the dean of the Austrian School of Economics, was aware of the inflation danger. He offered the following political-economic explanation:
“The emergency that brings about inflation is this: The people or the majority of the people are not prepared to defray the costs incurred by their rulers’ policies. They support these policies only to the extent that they believe their conduct does not burden themselves. They vote, for instance, only for such taxes as are to be paid by other people, viz. the rich, because they think that these taxes do not impair their own material well-being. The reaction of the government to this attitude of the nation is, at least sometimes, directed by the sincere wish to serve what it considers to be the true interests of the people in the best possible way. But if the government resorts for this purpose to inflation, it is employing methods which are contrary to the principles of representative government, although formally it may have fully complied with the letter of the constitution. It is taking advantage of the masses’ ignorance, it is cheating the voters instead of trying to convince them.”
Against Mises’s insight one may see what a policy of QE really means: It is an attempt to keep the inflation regime going, by all means. A policy of artificially lowering the interest rate and increasing the money supply wreaks havoc on the economy, though.
A policy of QE does not pave the way to recovery, it is sowing the seeds of an even bigger crisis going forward – in terms falling output and employment, rising political and social calamity, and the destruction of the purchasing power of money.