In a recent letter to the FT, 19 prominent economists suggested that there were better ways to boost the Eurozone economy and employment than through QE. Senior lecturer at IFS college, John Hearn, responded to their letter suggesting that they are all wrong, and have “A mistaken estimate of what QE can do”.
Hearn begins his article by agreeing with the letter’s claim:
“The first point they make is that ‘QE is an unreliable tool for boosting GDP or employment’. This is of course correct because despite inflated claims, QE can only ever have a secondary and tenuous effect on these variables.”
Hearn then suggests that:
“The primary task of QE is to achieve target inflation in its given currency. The hope is then that stabilising the economy at target inflation will cause confidence to return and set the economy on a growth path.”
The theory is that only when prices begin to rise will stability, confidence, and growth eventually return. The problem here is one of causality. Hearn is suggesting that the amount of money in the economy needs to exceed demand, then inflation will take place, and then everything will be rosy again. So only when people start to see prices rising again, will they begin spending.
According to this logic, increases in prices prompt spending, and the private sector isn’t spending because prices aren’t increasing (or expected to increase). While we can’t speak for the 19 economists, we would argue that the private sector in the Eurozone isn’t spending because they are more concerned with paying down their debts, with saving, or due to uncertainty about their future incomes (expectations). The lack of rising prices is not the reason why people are not spending.
Hearn is also implicitly suggesting that businesses will only spend/invest if they expect inflation. Businesses don’t make investment based on whether inflation is going to take place or not, businesses generally make investments if they expect there to be demand (or future demand) for their goods or services – regardless of whether inflation will take place or not.
Hearn, then remarks on the point made by the 19 economists that “monetary policy no longer works”, and then follows up by saying that “…QE has a small impact on interest rates”. In effect, Hearn and the 19 economists seem to be in agreement. Hearn implies that interest rates were already very low before QE began, and the 19 economists actually stated “In the Eurozone, where interest rates are at rock bottom and bond yields have already turned negative, injecting even more liquidity into the markets will do little to help the real economy”.
The primary difference is what is being implied by making these remarks. The economists are essentially stating that the conditions that QE is trying to create – low interest rate and low bond yields – are already in place, so it isn’t necessary. Hearn is stating the conditions are already in place, which is why it isn’t clear why he still thinks QE is necessary.
Hearn doesn’t mention exactly how he expects inflation to take place through QE. In his defence, this is most likely because letters to the FT have to be short and concise. However, it is worth noting that merely increasing the stock of bank reserves will not prompt inflation. In economic jargon, the main driving force behind inflation is flows, not stocks. Put differently, inflation can only occur if there is sufficient demand for bank lending. But as mentioned above, the private sector doesn’t want to spend (i.e. it isn’t demanding new loans).
This point is nicely stated by Professor William Dunkelberg, chief economist for the American Nation Federation of Independent Business since 1971. While he is referring to America, his thoughts can be applied to the UK and Europe.
“The mistaken view that pervades thinking on Wall Street and in Washington D.C. that a major reason for the slow economic recovery is that banks wont lend…The real problem is loan demand (confirmed while speaking to bank organizations in half a dozen states over the past year). Loans have to be repaid, meaning that the money must be used to finance the acquisition of employees or equipment that will “pay back” the loan. Common Sense. But they don’t get it in Washington D.C. And not understanding the problem produces bad policy, and there has been plenty of that.”
Professor Dunkelberg then states:
“If lending is picking up, it is because customers are showing up and there is a reason to invest and hire. The reverse doesn’t work – you can’t force feed the credit to owners and have more customers suddenly show up (even interest free loans would have to be repaid!). That’s “pushing on a string”. Just ask the banks.”
Finally, Hearn states that QE is more efficient than a type of Sovereign Money:
“In this way it is more likely to be used efficiently as it spreads through the economy than if it is being controlled by well-meaning groups of civil servants or economists.”
This is because, as Hearn states:
“My point is that QE is not injected, as they state, “into the financial markets”. Rather it is injected into the economy through financial markets…”
Perhaps this claim would be somewhat accurate if QE did spread through the economy. But this would rely on a “wealth effect” (in the parlance of the Bank of England) that drives the wealthy to go out and spend their artificially increased wealth. In other words, it relies on a trickle-down effect that seems not to be taking place. It is precisely because it is so inefficient, that 19 prominent economists have collaborated to suggest that there are better options out there.
Interestingly, if QE were to spread through the economy it would require this wealth effect to take place. Yet, Hearn seemingly disagrees with the Bank of England and suggests that QE doesn’t drive up the price of assets. Which then, according to Hearn’s logic, begs the question of how QE is supposed to spread through the economy?
In conclusion, Hearn’s letter suggests he has his causality confused, and for the most part appears to be agreeing with the 19 economists that he set out to disagree with.