Quantitative easing occurs when Governments create new money through Central Bank operations. Until recently, quantitative easing was called ‘unconventional monetary policy’. Nevertheless, many countries have used it in the past, particularly following the GFC.
Quantitative easing has now shifted to become mainstream as the dominant monetary response to COVID-19 economic conditions. It has also led to capital markets being flooded with money searching for a home.
As a monetary policy, quantitative easing is an obvious way to increase inflation to meet inflation targets. It is also intended to be an economic growth stimulant. Further, it can provide a funding solution for government financial deficits. Of course, lunch seldom comes free.
The impact of quantitative easing on retail interest rates has been powerful across the globe. Those interest rates have crashed. Its longer-term impact on citizen behaviours is only starting to unfold. The consequential impacts may not align with what is either hoped for or expected.
Here in New Zealand we were somewhat slow to undertake substantial quantitative easing compared to either Europe or the USA. Right now, we are making up for that big time!
Current guidance from the Reserve Bank is for $60 billion of quantitative easing via its large-scale asset purchase (LSAP) program for the year through to 31 March 2021. This is the base amount, with lending and credit multipliers further increasing the money supply.
The Reserve Bank is explicit that the goal is to keep driving interest rates down. And it will surely achieve this if it sticks to the planned level of quantitative easing. The resultant flood of capital looking for an investment home is unique in New Zealand’s history.
Many years ago, quantitative easing by another name was known here in New Zealand as the key economic policy behind the Social Credit political party. It was widely referred to, somewhat derisively, as ‘funny money’. The notion was that the Government should print as much money as required to get everyone into jobs and solve unemployment. The aim was to ensure demand for goods increased to balance the supposed capacity of the economy to produce those goods.
The Social Credit philosophies first came to life in Britain but then took root in Canada, New Zealand and elsewhere, albeit always at the fringes within developed Western economies. In some developing countries things went to extreme, although not necessarily under that name – think Argentina and Zimbabwe. In those countries it became unconstrained money printing.
The philosophy of quantitative easing has come back into vogue as Modern Monetary Theory (MMT). The concept is that governments can fund part of their spending deficits by creating money rather than borrowing it from private citizens and institutions. COVID-19 has now brought MMT from the sidelines to the centre.
The ‘free lunch’ limit to quantitative easing, under whatever title it chooses, is that it can only stimulate economic growth if there are unutilised resources available in the economy. In that environment it can have a role. Otherwise it has to be inflationary. Whether that inflation plays out predominantly as asset inflation or as inflation of goods and services will depend on how citizen and corporate behaviours. In an open economy with inflation, there must also be a consequential impact on foreign exchange rates.
Right now, there can be little doubt that across much of the world there are unutilised resources of labour. A big question is the extent to which putting more money into the economy can solve that problem. If it doesn’t get people back into work, then the conditions are ripe for stagflation.
In the global depression that is now upon us, it is not particularly helpful to think of quantitative easing as being either right or wrong. Rather, it is a case of how much is appropriate to the unique global conditions. Also, the amount of quantitative easing that is appropriate in New Zealand, which is weathering the COVID storm so much better than most either Europe or the US, should be less than what is needed in those other countries.
Traditional economic theory says that lowering interest rates will lead to increased investment. Economists can argue convincingly that there is lots of empirical evidence to support that theory. However, that evidence comes from history and right now we are making a new history that is different from the past.
Despite the low interest rates, it seems that both here in New Zealand and almost everywhere else in the world, businesses have little wish to invest. As for consumers, they are choosing to save money rather than spend it, once again reflecting the huge uncertainties ahead.
With interest rates continuing to drop, the cost of mortgage servicing is declining. Mortgagees who have new spending options are either repaying principal, investing in Sharesies or similar, or simply building their savings at the bank.
Older people who rely on now-declining interest from fixed deposits to supplement their pensions are also having to give thought to changing their spending behaviours and spending less.
It really does not matter how much lower interest rates decline from here, it seems unlikely that investment spending will increase. It is other factors, not interest rates, that are controlling investment decisions. And there lies the nub of the issue.
Given all of these things, consideration needs to be given as to whether the Reserve Bank, currently going hell for leather for more and more quantitative easing, has got the wrong end of the stick.
Government has other options for the financing of its burgeoning deficits alongside the use of quantitative easing. The Treasury can still issue bonds – this week it has issued another $7 billion. The key issue is the extent to which the Reserve Bank soaks up those bonds or leaves them in the hands of the market.
Essentially there are two separate entities of the Government pushing the economic levers. There is the Treasury under the control of the Minister of Finance who authorises the Treasury to fund Government deficits through issue of Treasury bonds. Then there is the Reserve Bank that can choose to buy those bonds through a policy of quantitative easing, using money newly created by the bank itself. The final net outcome is balancing entries in various electronic books of account, and new money has been created in the greater system. Yes, you really can create money out of thin air!
Despite the so-called independence of the Reserve Bank, in practice everything is co-ordinated. Part of the charade is that the Reserve Bank only buys and sells from secondary markets with non-government financial institutions.
The financial institutions are effectively acting as intermediaries between the Treasury and the Reserve Bank. In the process, the institutions can and do clip the ticket. The institutions can do their intermediation and hence ticket clipping in confidence because the Reserve Bank announces in advance its overall buying strategy for secondary markets.
I have no problem with the transparency demonstrated by the Reserve Bank in signalling its intentions, albeit within an overall charade between the Treasury and the Reserve Bank. The important issue is the extent of the quantitative easing and where it is heading.
If the Reserve Bank undertook less money creation and hence less quantitative easing, then those Treasury bonds would be purchased and held by financial institutions. That would soak up much of the deposit funds currently sloshing around looking for a home.
The economic notion that lowering interest rates leads to inflation, which then stimulates real growth in the economy, which in turn reduces unemployment, goes back a long way and seems to remain a ‘lock-in’ of mainstream economic theory. However, to borrow from a supposed statement of economist John Maynard Keynes: ‘When the facts change, I change. What do you do Sir?’.
The empirics of the mainstream theory are very much based on specific citizen and corporate behaviours. Right now, we are in uncharted territory and that includes behaviours.
In New Zealand, the Reserve Bank is required by the Government to act so as to try and maintain inflation between 1% and 3%, and aiming broadly for the mid-point of 2%. There is a second objective of limiting unemployment and the attempt to do so might well take inflation beyond 3%.
In the current environment, it is this overarching guidance from Government, combined with the Reserve Bank’s reading of the tea leaves as to future unemployment, that leads the Reserve Bank into massive quantitative easing.
What we now need is renewed debate as to whether inflation targeting of around 2%, which has been fundamental to New Zealand’s economic policies, is necessary. What is so wrong with allowing inflation to remain at lower levels than this, without trying to pump it up?
For more than 20 years I taught students how to play the inflation game. It meant, particularly in the NZ environment of untaxed capital gain, investing in land-based assets using leverage and then letting inflation ‘do its thing’ for equity.
My role was to help students find a way to succeed in the prevailing economic environment. But I never made the mistake of thinking that this was a sound overarching economic policy. I knew that it led to misallocation of resources, but my students had to play the game of life with the cards they were given and according to the rules of the game set by Government. It was and is up to Government, not the players, to set the rules.
Right now, at a policy level, we need to be thinking about whether the current extent and proposals for quantitative easing are simply holding up asset prices to unsustainable levels and reinforcing economic distortions. It may well be directing behaviours in quite the wrong direction.
Perhaps we need to focus more on other policies that can reset the economy for the world ahead.
There might also be merit in asking some big questions as to whether, within the global economy, New Zealand has become a plaything of international finance. Perhaps that has been the case for a long time. What happens next in New Zealand is highly dependent on how overseas investors might respond within a risk-on environment. Short-term money flows can themselves be highly distortionary.
It would seem hard to refute that the global macroeconomic system is a complex but ‘jerry-built’ system. There was never an overarching and planned design. Rather it was built piece by piece over the last 100 years, and with many patches. It is a bit of a mess.
*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. He can be contacted at firstname.lastname@example.org