In this morning’s blog post, Brian Keeley mentioned quantitative easing (QE) as one way governments can stimulate the economy, and (in an unrelated move) the European Central Bank has just announced it is launching a QE initiative amounting to 60 billion euros a month until September 2016. But what is quantitative easing?
First we have to understand the role of interest rates, the main weapon in central banks’ armouries. The rate set by a central bank is soon followed by other banks, thereby influencing the “price of money” – how much you have to repay on a loan, how much the bank will pay you for your savings and how much the government will pay to borrow money.
Central banks set different rates, depending on the type and length of the loan. In general, the shorter the payback period, the higher the rate. The rate most often referred to as “interest rates” is the so-called base rate or prime rate used to calculate the other interest rates.
As Brian said, central banks use interest rates for two main reasons. First, rates may be raised to “cool” the economy when there are fears about inflation. The idea is that by making credit more expensive, demand will be restrained and prices will not rise so quickly. Second, when economic growth is too slow, a cut in interest rates makes it cheaper to borrow money to purchase goods or to invest in a business, thereby stimulating growth.
In April 2009, the average interest rate set by the central banks of the Group of Seven nations fell to 0.5% and has been hovering around this level since. What happens when money is so cheap it can’t get any cheaper? In other words, what can governments do when interest rates can no longer be cut because they are so low already?
Quantitative easing is one possibility. The central bank injects money into the economy by buying certain financial products, notably government bonds (also known as gilts). The sellers are expected to use the money to lend to businesses and households or to invest (although they may just leave it in bank deposits or send it offshore). The US Federal Reserve applied quantitative easing during the banking crisis that followed the 1929 Wall Street Crash, and the Bank of Japan adopted a similar approach to dealing with the crisis in the 1990s following the crash of the property market.
The media often present this as “the government printing money”. The reason is that instead of borrowing money in the usual way by issuing new bonds, the government, through the central bank, simply creates the money and uses it to pay the banks and other financial institutions it intends to help.
We’ve become so used to describing the crisis in terms of trillions of dollars that the ECB’s 60 billion euros a month, seem modest by comparison (and it is compared to the $3.7 trillion the Federal reserve spent buying bonds in the US QE programme). But to put that into perspective, in March 2009 when the Bank of England announced it was making available £75 billion to buy gilts and corporate debt as part of its QE strategy, that was one and a half times the total value of all banknotes and coins circulating in the UK at the time.
If quantitative easing succeeds in making government bonds more attractive, the interest paid on these bonds does not have to be as high as it was previously. As I write, that seems to be happening. The Financial Times’ latest headline is “Eurozone bonds on fire after ECB launches QE”, with the paper reporting drops to record lows in the interest rates on 10-year government bonds in Eurozone countries.
That’s good news for governments who have to borrow money and to finance the debt they have already accumulated. But it may not be good news for everybody, pensioners for instance. Pension funds are massive holders of government bonds, so a drop in the interest paid on them (the yield) translates directly into a loss of income to the funds. And since the pensions industry uses bond yields to calculate pension payments such as annuity income, pensioners will be affected. Company pension schemes could be affected too. The yield on government bonds is an important element in calculating the future liability of pension funds, and when yields fall, liability increases.
Few people can have been very surprised when the IMF announced this week that it was lowering its growth projections for this year. It feels like that’s been the story of the recovery in much of the OECD – a succession of disappointments and dashed hopes. Today, seven years after the financial crisis, growth remains well below where it was pre-crisis and unemployment well above.
All this begs a question: Is there something wrong with the economy? Some leading economists fear there is, and they’ve given it a name – “secular stagnation.” The expression was coined in the 1930s and famously revived in 2013 by Larry Summers, a former US Treasury Secretary. It may sound strange, but all it really means is “persistent stagnation.” Whatever you call it, it’s causing a lot of concern, including, no doubt, among the global movers and shakers at Davos this week.
What is persistent stagnation? As The Economist notes, it’s a “baggy concept” that’s hard to pin down. Still, there are a few ideas that crop up repeatedly. Most notable is the idea that it describes a period when interest rates can’t be pushed low enough to provide the economy with the stimulus that it needs.
To explain: In normal economic times, interest rates are among central banks’ most powerful weapons. When the economy’s overheating, central banks can raise rates, making it more expensive to borrow, which puts a brake on consumers and businesses; when the economy’s cooling, they can send rates back down to encourage consumers and businesses to borrow and invest more.
That weapon’s currently proving much less effective. Inflation is very low, as are real interest rates – in other words, the return on money once inflation is accounted for. Today, many economists believe the economy would need a real rate of interest well below zero in order to shift money out of what Martin Wolf calls the “global savings glut” and into productive investment. But because inflation is so low, that would require nominal (or advertised) interest rates to also go well below zero. And that, by general agreement, can’t happen.
Yes, it’s true that some national central banks, such as in Sweden and Denmark and, more recently, Switzerland, have experimented with negative nominal interest rates, as did the European Central Bank (ECB) in 2014. But the rates weren’t much below zero and usually didn’t apply to all the rates set by the bank. This “zero lower bound” limit on interest rates explains why central banks have sought other ways to boost the economy in recent years, most notably quantitative easing – a step the ECB is widely expected to follow this week.
So what’s causing this situation? There’s no shortage of theories, but broadly speaking a range of factors – often interrelated and self-sustaining – may be dragging down the economy, both in the short and longer term. Take unemployment: Despite some recent signs of improvement in the jobs market, joblessness remains worryingly high in many OECD countries. As time goes on, at least some of those without work risk seeing their skills become outdated, may lose the will to go on searching for work or may become unfairly stigmatised as “unemployable”. That robs the economy both of workers and of workers’ spending power.
Business investment is also an issue (albeit a complex one). In theory, the current low interest rates should make this an ideal time for businesses to borrow. In practice, this doesn’t seem to be happening, probably because of economic uncertainty and because many firms are already sitting on large stockpiles of cash.
There are longer-term drags on the economy, too, such as the slowdown in population growth and the ageing of our societies, which will leave a rising number of retirees dependent on a declining number of workers. And there’s widening inequality – as highlighted at Davos by Oxfam – which may play a role by reducing overall consumption, as Robert Peston notes: “The poor in aggregate spend more than the rich (there are only so many motor cars and yachts a billionaire can own, so much of the super-rich’s wealth sits idle, as it were).”
So, if interest rates won’t work to boost the economy, what will? An OECD paper released this week at Davos argues for a comprehensive stimulus package, especially in the euro area and Japan, where signs of stagnation are arguably strongest. It calls for action in four main areas: Encouraging investment by, for example, establishing public-private partnerships and reducing the incentives for firms to buy back shares; supporting SMEs and entrepreneurs; promoting trade by, for example, making customs procedures more efficient and liberalising the services sector; and raising employment by supporting job-seekers and encouraging women and older workers into the workforce.
“Secular Stagnation: Evidence and Implications for Economic Policy,” by Łukasz Rawdanowicz, Romain Bouis, Kei-Ichiro Inaba and Ane Kathrine Christensen (OECD, 2014)
What Do Company Data Tell Us?” by Adrian Blundell-Wignall and Caroline Roulet (OECD, 2014)
OECD Insights: From Crisis to Recovery (OECD, 2010)