What does QE do?

Anthony Evans writes about QE:

No central agency possesses the knowledge required to ‘know’ how much money should be in circulation…Policies like QE increase regime uncertainty and generate systemic instability. They have the potential to make matters worse, and ignore the fact that you cannot buy confidence.

This is, I think, mostly true and important. The underlying problem here is: what, exactly, are the links between the financial and real economies?
There are two extreme views, both mistaken.
One - simple-minded monetarism - says that there are close links; people who sell bonds to the Fed will spend the money on goods and services, thus raising aggregate demand. We know this is wrong because the first $1.7 trillion of US QE - equivalent to around 12% of GDP - did not unleash a boom.
The other extreme says there’s no link at all because we’re in a Keynesian liquidity trap, in which the demand for money is “virtually absolute” and so money raised from selling bonds merely flows into cash, with the result that “the monetary authority [has] lost effective control over the rate of interest.“
This is wrong because QE has affected asset prices: it has reduced bond yields in the US and UK, weakened the dollar and raised share prices.
The uncertainty mentioned by Anthony focuses on the question: what will be the real effects of higher asset prices? There’s no shortage of possibilities. The weaker dollar should raise US net exports. Lower bond yields should encourage firms to borrow to invest. Higher share prices should stimulate investment (via Tobin’s q) and consumer spending (via wealth effects); the allegation that QE will cause a bubble in emerging markets is not a complaint, but a hope.
I have two concerns here. One is that there’s another effect of QE. It is also raising raw materials prices and the costs of production; Richard Murphy is (for once!) right.
Secondly, these mechanisms are weak; investment isn’t very responsive to asset prices, nor exports to exchange rate.
One reason for this is that firms’ desire to invest is weak now: whether this is merely because of “animal spirits” or because, with productivity growth low and a dearth of investment opportunities, there are rational grounds the reluctance is a moot point.  In this context, smallish changes in asset prices mightn’t much stimulate investment and employment. What’s more, real options theory tells us that when people are uncertain about the future, they have more incentive to hold onto the option to invest rather than to exercise it.
In this sense, Anthony is bang right to say that you cannot buy confidence.
I quibble on just one point. Anthony says that QE increases regime uncertainty. He’s probably right. But I’m not sure it increases overall uncertainty. In the absence of QE, we’d still be uncertain about whether confidence will return and how fast the real adjustments (away from debt and construction) in the economy will take place. QE doesn’t add to this uncertainty, so much as displace a little of it; there‘s more uncertainty about policy, but less about the real economy, to the extent that the risk of a catastrophe is diminished.

Comments

[Tim Worstall]

"Richard Murphy is (for once!) right. "

Bit of a shock really. But then he makes the next hugely interesting leap. Instead of having £200 billion of QE we should print £200 billion and then spend it in the real economy.

Seemingly not realising that the very reason we do £200 billion of it is because we know that not all of it feeds through into the real economy. While, if there is indeed a government spending multiplier (which Ritchie would insist there is) then spending £200 billion directly would mean an addition of £300, £400 billion to demand: something hugely higher than any estimation of the output gap, meaning that a goodly chunk of his "qualitative easing" would, necessarily, flow straight through into inflation.

Plus, of course, Obama's point that there's no such thing as "shovel ready projects" meaning that we couldn't spend it all fast enough anyway.

[aje]

Thanks Chris

I have clarified my post in light of your excellent comments:

http://thefilter.blogs.com/thefilter/2010/11/the-threat-of-qe2.html

[Mark Wadsworth]

What does QE do?

1. Not much. It just shuffles bits of paper in a closed loop between central banks and commercial banks.

2. Because the central bank overpays slightly, it makes a nice little profit for the commercial banks.

3. It pushes down interest rates on government borrowing - partly due to overpaying for gilts - but primarily because it replaces long term liabilities (ten year gilts) with very short term liabilities (the central bank then borrows the 'money' straight back, i.e. commercial banks deposit the proceeds straight back with Bank of England).

In the short term, this actually saves the taxpayer money, but is a risky strategy.

4. Finally, as we learned from Japan, QE also tends to encourage the carry trade, i.e. push down the value of the currency and encourage people to invest aborad.

[Matthew]

I don't quite follow the raw materias piece. For a start sterling rose in October. What actually is the mechanism for US QE increasing the sterilng price of, say, oil?

[Luis Enrique]

Matthew

This is just a guess, but it might be speculation. I think if the expected return on financial assets is negative (which it might well be now) commodities were a good investment (I use past tense because prices might have been bid up already).

[chris]

@ Matthew - there are several mechanisms:
1. Portfolio rebalancing. Some of the cash obtained from selling Treasuries is reinvested in commodities.
2. Luis's point - if expected risk-adjusted returns on financial assets falls, so too - ceteris paribus - must expected returns on commodities. This means their prices rise as well.
3. There's a natural tendency for the dollar price of commodities to rise when the dollar falls.
4. Some people (wrongly IMHO) think QE is inflationary, so these buy commodities as a hedge. Commodities are so volatile that it is risky for the smart money to bet against this by going short of them.

[Business directory]

The real economy is often replaced by a virtual.

[Postkey]

From B Benanke,
Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.
Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html

[vimothy]

What does (UK) QE do?

QE lowers the cost of corporate debt and equity issuance. It looks to have been fairly unambiguously successful in this regard.

QE is not a closed loop between commercial banks and the BoE. The Bank is not buying assets from commercial banks. It is buying them from non-banks, because it wants them to hold less gilts and more corporate bonds and paper.

[vimothy]

Mark,

The reserves used to pay for the assets end up in banks' reserve accounts at the BoE because that's where all reserves end up. No other outcome is possible.

Chris,

Agree that the effect on investment is likely to be weak. I think that the corporate sector is using this cheaper source of funding to pay down past loans rather than fund new investments. This explains why we saw a £200bn QE programme produce only £8bn in broad money growth.