The latest criticism is that Quantitative Easing has been ‘good for the rich’, but ‘bad for investment’. Even the financial advice pages of the broadsheet press seem to be going down this route, which is bizarre given that the readers are mostly rich and ought to appreciate a policy allegedly in their interests. (In the note below I quote some remarks by Merryn Somerset Webb in a 12th October article in the Financial Times.)
The truth is that profits are more volatile than national income, while the equity market (which is ultimately only a capitalization of profit streams) is more volatile than profits. The large fluctuations in equity prices are partly down to changing sentiment, but also critical are wide swings in the rate of growth of the quantity of money, particularly in the money holdings of the financial institutions which specialize in asset selection. (See, for example, my 2005 study for the Institute of Economic Affairs on Money and Asset Prices in Boom and Bust for an analysis.) In the short run (i.e., in the course of one business cycle) changes in asset prices are influenced by variations in the rate of money growth. So Quantitative Easing from early 2009 did help the equity market (and in that sense ‘the rich’), but it was also beneficial for demand, output and employment more widely. In the long run changes in the rate of money growth cannot affect anything much on the real side of the economy. (A caveat is that extreme inflation or deflation causes severe economic inefficiency in various ways, and that is why inflation and deflation should be avoided.) The FTSE 100 index is lower today than it was in 1999. Is Quantitative Easing (which began in earnest in March 2009) somehow to be blamed for that? Or should the policy or policy-maker supposedly responsible for the poor post-1999 performance be thanked for keeping share prices down? Indeed, does Ms. Somerset Webb think that any policy which enriches people is, by definition, wicked and evil?
The need for Quantitative Easing in early 2009
Poor old ‘quantitative easing’. Has there ever been an important economic policy that has been more thoroughly misunderstood and misjudged? The rationale of QE is simple and can be explained in a few paragraphs. But much confused nonsense has been written about it, and that nonsense has led to foolish and unjustified criticism.
Standard theory and a great deal of evidence argue that the demand to hold money balances is stable. This stability of the money demand function means that changes in the quantity of money and nominal national income are roughly equi-proportionate in the medium and long runs. In other words, a change of a certain percentage in the quantity of money is accompanied by a change of more or less the same percentage in nominal national income. Data from many countries over long periods of time show that this assumption is not silly, even if the short-run relationship between money and income is problematic.
Given these facts, most sensible people would accept that steady expansion of the quantity of money ought to be one aspect of macroeconomic policy. They might have doubts and reservations about the emphasis to be placed on this principle, but almost everyone would surely endorse the view that stability in money growth is preferable to instability. Unfortunately, in late 2008 and early 2009 many leading economies, including the UK, were close to a monetary disaster. If nothing had been done, the quantity of money was about to collapse by hundreds of billions of pounds. Indeed, the prospective rate of decline, of about 1 per cent a month (or 10 per cent a year), was similar to that seen in the USA’s Great Depression of 1929 to 1933, when the quantity of money went down by over a third in under four years.
The reasons for this parlous state of affairs are debated. Some ‘experts’ blame the banks for having too much risk in their balance sheets, and so being in danger of ‘going bust’ and failing to repay depositors in full. Others say that banks were solvent throughout the crisis, and that they were obliged to shrink their loan portfolios and securities holdings only because of a sudden and misguided tightening of bank regulation which began in October 2008. But, whatever the precise cause of the trouble, a big fall in the quantity of money was imminent.
Fortunately, the creation of money by the state is easy. All that is required is for the government or the central bank to borrow from the commercial banks, and to use the proceeds of the loans to purchase anything (government securities, tanks and planes, old boots) from the non-bank private sector. The effect of the purchases is to increase the bank deposits held by the private sector agents. People and companies can write cheques against the deposits, which are therefore money, and the new money balances can then circulate an indefinitely large number of times.
Quantitative Easing was good for asset prices and the rich, but only in the short run
In essence, Quantitative Easing was and remains nothing more than the large-scale creation of money by the state. In the particular case of the UK since early 2009 the amount involved has been about £400 billion. Sure enough, in detail the mechanics of Quantitative Easing and the analysis of its effects can be hugely complicated. But the heart of it is that it caused the quantity of money to be about £400 billion – or roughly between 15 per cent and 20 per cent – higher in mid-2013 than it would otherwise have been. Even allowing for some technical caveats, an unambitious conclusion is that nominal national income today is over 10 per cent above what it would have been without Quantitative Easing. Further, Quantitative Easing did stop the Great Recession becoming the Great Depression that was threatening in early 2009.
It would be nice to think that Quantitative Easing would be given three cheers by the commentariat. However, that is not at all the case. Many pundits give it one cheer for stopping a worse economic downturn, but say that it rescued the bankers, and bankers are wicked and undeserving by definition. Well-known columnists like Liam Halligan in The Sunday Telegraph claim that QE is the last refuge of banana republics and bankrupt empires, and that it foreshadows hyperinflation. Another boo has come from critics who assert that Quantitative Easing gave an artificial boost to asset prices and was therefore biased in favour of the rich. According to Merryn Somerset Webb in an article (‘A policy that stigmatises the well-off’) in the Financial Times on 12th October, in the aftermath of QE “those with money have simply bid up prices of existing assets”. The further consequences have been that Quantitative Easing “has pushed down the purchasing power of the general population and devastated their savings”.
But Quantitative Easing is part of monetary policy and monetary policy cannot in the end change so-called “real variables” like the distribution of income between labour and capital, or the valuation of some capital assets relative to others. It must be admitted to Ms. Somerset Webb that asset prices fluctuate far more volatile than national income and that short-run changes in asset prices are partly attributable to movements in the quantity of money. (Indeed, this was the core thesis of my 2005 Hobart Essay for the Institute of Economic Affairs on Money and Asset Prices in Boom and Bust.) But in the long run the real value of corporate and property assets depends on real forces such as savers’ preferences and returns on capital investment, not on monetary variables. Since the beginning of UK equity investment on modern professional lines in the early 20th century, the quantity of money and the level of national income have increased a very large number of times, but the valuation of equities has changed relatively little. (See the accompanying chart. In the 20 years from 1991 the compound annual rate of increase in UK share prices and UK nominal GDP were similar at 4.4% and 4.6% respectively, but the annual changes in share prices were much larger than those in nominal GDP and the year-by-year correlation between them was poor.)
Because of the cyclical volatility of the stock market, share prices were depressed in early 2009, with the FTSE 100 index down at its worst point in March to a low of 3512. That was little better than half the all-time peak FTSE 100 figure of 6930 at the end of 1999. Since early 2009 the stock market has moved back towards the all-time peak, but never quite made it. (At the time of writing – mid-October 2013 – the FTSE 100 stands at just over 6500.)
The recovery in the stock market between early 2009 and today was partly attributable to the increase in the quantity of money due to Quantitative Easing. Agreed. Without QE the quantity of money and the UK equity market would have been much lower, and the recession would have been more intense than it was. Also agreed. But Quantitative Easing cannot be blamed for the surge in share prices to the 1999 peak, since Quantitative Easing had not at that stage been invented. Moreover, despite all this alleged favouritism of public policy towards the rich, the level of UK share prices today is lower than it was over a decade ago at the 1999 peak.
More generally, although asset prices are affected by monetary policy in the course of one business cycle, monetary policy cannot affect the real level of share prices, or income and wealth distribution, across a number of business cycles. Further, it needs to be emphasized that Quantitative Easing has been good for demand, output and jobs, and the extra employment has been of greatest benefit to the poor.