Update: Read Prof Farmer’s response to readers’ comments
By Roger E. A Farmer
I argue in this piece that:
- Quantitative easing should be expanded
- Even if the Bank of England were to buy the entire UK national debt that this policy would not be inflationary
- The global recovery is faltering and an expansionary policy is needed to encourage private investors to create jobs
- Additional quantitative easing could save as much as £38.5bn a year in interest costs to the taxpayer
May 18, 2006 was an important day. It was the day when the Bank of England began to pay interest on reserves. In October 2008 the Fed followed suit. This monumental change in policy gave the Bank an important new tool in its arsenal. It allowed the Bank to influence the economy not just through expansion or contraction of the stock of money, but also through the composition of its balance sheet.
In March 2009 the Bank and the Fed made a second unprecedented change in policy. They began to buy long term assets; both central banks have increased their asset holdings over the past year by roughly 11 per cent of GDP. The Bank and the Fed are each sitting on inflated balance sheets that are more than twice their normal size.
The asset purchases by the Bank of England and the Fed have not resulted in corresponding increases in the UK and US money supplies because when a central bank pays interest on reserves, the money supply is no longer tied to the asset base of the bank. A broad measure of the US money supply has been contracting at a rate of 9.6 per cent per annum, a rate that has not been seen since the Great Depression, and growth in the broad UK money supply has been steady.
Private investors can choose to hold their wealth in the form of safe assets or risky assets. At the safe end of the spectrum there is cash. At the risky end there is equity and low grade bonds. Unemployment remains at 7.8 per cent in the UK and 9.5 per cent in the US because investors are scared to put their money into activities that create jobs. The appetite for risk has vanished.
Quantitative easing encourages the private sector to create more jobs. As yields on long term assets fall, some of that money moves into equity and newly capitalised firms expand and begin to hire workers. In light of a slowdown in the global recovery, quantitative easing is a programme that should be vastly expanded.
Unlike fiscal expansion, which increases the national debt, quantitative easing saves money for the Treasury. Take the UK case, where the Bank of England has bought mainly gilts. The expansion of the Bank balance sheet by £200bn generated a net flow income of roughly £6bn since gilts pay, on average, a return of 3.5 per cent and the Bank returns 0.5 per cent to commercial banks as interest on reserves. That income is returned to the exchequer and makes a modest contribution to UK revenues. If the Bank bought the entire UK national debt there would be an interest saving to the Treasury of approximately £38.5bn a year. That is roughly a quarter of the total UK public sector deficit.
Isn’t quantitative easing inflationary? No. There is currently no sign of an increase in inflationary expectations, despite a temporary uptick in price inflation following recent fuel price increases and the coming increase in VAT next January. But inflation will emerge again eventually. And that’s why May 18, 2006 is such an important day. The policy of paying interest on reserves allows the Bank to separate the activity of buying assets from creating money.
In order for an expansion in the Bank’s balance sheet to be inflationary, the money has to flow into the economy and be spent on goods and services. Currently, private investors are holding onto liquid assets because they are afraid that asset values will fall further.
As the economy begins to recover, private demand will put upward pressure on interest rates. In order to prevent an explosion in domestic credit creation that could fuel inflation, the Bank will raise the Bank rate. At the same time, it will raise the rate that it pays on reserves.
As the short term interest rate climbs, so the value of gilts in the Bank’s portfolio will fall since bond prices are inversely related to short term interest rates. There are two options at this point. The Bank can sell the gilts on the private market at a loss. Or it can hold them to maturity and continue to pay market rates on reserves. Either method will remove liquidity from the economy, drain cash from the system and prevent excessive domestic credit expansion.
Won’t a policy to remove liquidity be costly to the Treasury? Yes. The seigniorage revenues from money creation will no longer flow from the Bank to the Treasury and the £38.5bn interest burden will come home to roost. But if the Bank lets the interest rate rise, it will be because the economy is recovering. As unemployment falls and more people find jobs, the fall in seigniorage revenues from money creation will be more than offset by an increase in tax revenues.
There is a better way of managing the Bank’s asset portfolio. No private wealth manager would put all of his/her assets into gilts because the portfolio will take a hit when interest rates rise. As I have argued elsewhere, the Bank should invest not just in gilts, but also in equity. But that is an argument for another column.
Related reading:
A few tidbits about the BoE and QE – Chris Giles, FT Money Supply blog
Don’t give up on quantitative easing: We can have our cake and eat it too – Roger Farmer, FT Economists’ Forum
Prof Farmer is chair of the economics department at UCLA and the author of two books on the current global economic crisis. How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies, is written for the general reader and specialist alike and Expectations, Employment and Prices is written for academics and professional economists. Both are newly released by Oxford University Press. © Roger E. A. Farmer
