QE2 Sank, Can We Risk More?
As is the case with many of the complex financial concepts that land in the mainstream, quantitative easing has become an economic panacea beyond really significant debate. Despite this it is striking how many people do not fully understand the mechanics of this economic tool, even those who speak confidently about aspects of the process. Within a relatively short period of being announced as a primary weapon for the US Federal Reserve’s battle with nasty recession and deflation, it was adopted by the UK and to a lesser extent the Euro zone.
In very short order an abbreviation was added, enabling ‘QE’ to be batted about extensively in high brow conversation, effectively legitimising it beyond real hard debate and glossing over many people’s patchy understanding. And so it is QE3 has been on the table in the US for months and will likely proceed, with the UK announcing that they will increase their level of QE to encompass the purchase of £275 billion worth of assets.
That is, the UK will have created £275,000,000,000 at the stroke of a key on a computer. It is that simple to create this money. Fiat currency is paper that we all trust our governments to accept as tax payments and which we exchange to each other while believing in its value; after all, it is just paper. Any threat to this perception of value or physical supply and there are very serious repercussions. The advantages of a fiat currency system are beyond debate, it is the integrity of the system that has to be defended.
Our German partners are no strangers to the impact of a mismanaged fiat currency system, with that fear shaping the anti-inflationary stance of the ECB, evident in Jean Claude Trichet’s often unpopular decisions on Euro area rates. This rational fear stems from the 1920s, when Germany’s Weimar Republic experienced hyperinflation and saw the absolute collapse of the value of the Mark. While the case is by no means unique in financial history, it is the legacy of this particular period that has ramifications for Europe and particularly Ireland today.
During the 1920s the German government owed significant reparations to the rest of Europe and, as these bills fell due they simply printed the fiat cash to pay the bills rather than cutting expenditure or increasing taxes. The problems raise their head when the physical currency lands in the economy and consumers begin to spend. The supply of money has increased but the wealth in the economy to back it has not – we have the same consumption, and more physical money in pockets. Thus, people pay more for the same amount of goods and services leading to price inflation. Inflation unabated leads to hyperinflation and, in the case of the Weimar Republic, people were ultimately buying loaves of bread with wheel barrows full of cash, or even wall papering their homes in Marks as they were so worthless.
As the masters of the western financial universe crank up the printers – or, more realistically, add a few zeros to an electronic account – it is important that we don’t make it too easy for them. This notional money will land on a computer screen somewhere and then be put out to work buying bonds off balance sheets in banks. The hope is that the price of the bond will increase, thanks to the demand created by this new money, in turn reducing the interest rate that the bond yields. As banks are in the business of making money from money, they’ve then lost bond investing as a money spinner and have to put the money to work elsewhere – the central banks hope that will be lending. This is where businesses and the private consumer are expected to step in and borrow the money from the banks and this, sadly, is where the plan falls down.
Western consumers are indebted to the hilt and have no interest in taking on more debt that they currently cannot afford. This failure to borrow is called the liquidity trap in economics – the population simply don’t have the appetite to play the part leaders have assigned to them – and it raises serious questions about the value of quantitative easing as a cure all for the economy. We’ve seen mergers and acquisitions with all the cheap money but small business and the guy in the street simply will not borrow.
A large gamble on QE in an environment that is not conducive to QE could prove very costly. Heavy doses of money can crash into an economy and cause havoc with interest rates and inflation. We need to heed the lessons of history and a good start would be informed debate. These are powerful tools that are being played with and they will have a legacy for all of us. Managed correctly QE may well work, but it is dangerous.