Quantitative Easing - A Blessing or a Curse?

Posted in Finance Articles, Total Reads: 2201 , Published on 05 December 2012
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Quantitative Easing is the unconventional monetary policy that seeks to increase the money supply by injecting liquidity into the economy. The central bank\ monetary regulatory of a country increases the money in the economy by buying the assets owned by depository institutions. Such a move increases the capital available with the banks which can be further loaned to consumers and business. The aim of such a move is to promote economic growth in situations where conventional monetary policies fail to be feasible.

Conventional expansionary monetary policy involves reducing the interest rates, which would make savings in a bank less attractive. In addition it also makes the interest rate at which loans can be taken lower. This promotes consumers and businesses to use this opportunity to invest further. A by-product of Quantitative easing is inflation. Conversely Quantitative easing can also be used to increase inflation which would be useful in deflationary situations where other conventional methods of economy stimulation fail.

image:freedigitalphotos.net

I limit the discussion to the impact and effectiveness of Quantitative Easing on the US Economy only. This should be a fair indicator of the world economy given the large reliance of the world economy on the dollar.

QE1 & QE2: The US Federal Reserve held 700 – 800 billion dollar of assets on its balance sheet in mid 2008. In bid to improve economic situation, the Fed launched the QE1 and started the process of buying $600 billion worth Mortgage-Backed Securities (MBS) and agency debt. QE1 was further expanded and lasted till March 2010.

Later in the year, QE2 was launched which was a commitment for purchase of $600 billion of long dated securities at a rate of $75 billion dollars a month. This program lasted from November 2010 to June 2011.

QE3: Recently the Federal Reserve announced an open ended third round of quantitative easing that would buy $40 billion every year till substantial improvement in economic environment is seen.

Gross Domestic Product is the market value of all final goods and services produced within a country within a given period, typically one year. It is one of the best indicators of the growth of a country as a whole. It can also be represented by

Using Milton Friedman’s equation,

M * VT = P * Q

Where  M is the total amount of money in circulation on average in an economy during the period, say a year

VT is the transactions velocity of money, which is the average frequency across all transactions with which a unit of money is spent

P & Q are the price and quantity of a transaction

The P * Q is an indicator of the Growth of an economy and as an extension, the GDP.

Measuring the effectiveness of QE1 and QE2

The methodology used to analyze the phases is by comparing the Supply index of the economy, i.e. taking the ratio of GDP Index to Consumer Price Index. This ratio is compared every quarter and data extrapolated for a yearly growth. This is indicated in the graph below.

Figure 1: Gauging economy using supply index

So far, the Economic timeline can be divided in four phases, to analyze the performance of the economy with respect to Quantitative Easing. I.e.

  • QE1
  • Between QE1 and QE2
  • QE2
  • Between QE2 and QE3

The summary of the average performance during the various periods are

Period

Events

Average growth rate of GDP in comparison with previous quarters

Q4-2008 to Q1-2010

Quantitative Easing 1

99.65605

Q1-2010 to Q4-2010

Between QE1 and QE2

103.185

Q4-2010 to Q2-2011

Quantitative Easing 2

99.51884

Q2-2011 to Q3-2012

Between QE2 and QE3

101.9722

It is seen that the economy has grown during the phases when no Quantitative Easing infusion occurred whereas a negative growth during the QE. The above date questions the effectiveness the current and latest Quantitative Easing, QE3 announced by Federal Reserve in September 2012 will have on the economy in the long run. We will not look at the possible reasons for this ineffectiveness of Quantitative Easing.

Cause of ineffectiveness of Quantitative Easing.

1. Increase in Excess reserves held by banks: The excess money that was infused by Quantitative Easing was through banks, which have not passed on these reserves into the market. This can be seen in the graph below which indicates the Assets held by Federal Reserve which it acquired on purchase of the debt and mortgage backed securities from the different depository institutions. Also the increase in assets owned by Feds is to the tune of 1 $ trillion whereas the increase in excess reserves held by banks is close to 1.5 $ trillion. The excess reserves are the amount of money held by bank over and above the statutory requirement.

Figure 2: Comparison of money infused and money held by Depository Institutions.(All figures in $billions)

2. Reduction in demand of commodities by the lower segment of economy: There has been an increase in prices of various commodities. This is partly also because of the expectation by the market of an increase in inflation. This inflation has however caused an increase in prices. This increase in price has had a significant increase in the value of money earned mainly at those with low wages. However as these people are large in numbers, the reduction in the value of their money has caused them to reduce their demand for products. This is because the percentage of income used in such commodities is already high.

3. Insignificance of wealth effect: There has been a good increase in the price of stock markets. This as per economist Dean Baker should lead to the wealth effect where presence of greater valuation leads to greater consumption. An analogy of this is between two people owning 2 plots of land, everything else being the same, the person with the more expensive land valuation is likely to spend more. This effect however is very small as the data from Federal Reserve shows that the lower 80% of the population only hold 35% of the stock market shares. Also at the high income group any increase in net worth hardly leads to an increase in consumption. In addition, the report also mentions that only 18% of the population of USA trades in the stock market. Thus in effect the increase in stock market only increases the inequalities in the economy by making the rich richer.

4. Minuscule Employment Generation: Despite huge amounts of Quantitative Easing there has not been a good amount of reduction in percentage of people employed. Though it is improving, the pace for the same is very slow and gradual. It does not really show any good improvements during the periods of Quantitative Easing.

Figure 3: Population Employment Percentage

5. Ineffective Money Multiplier: The money multiplier effect is the money used to create more money. This is because to lend $100 money a bank needs to have only a fraction of the amount as reserves. This it can now lend more money that it needs to maintain as reserve, i.e.  in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves. However as the banks are maintaining a large amount of excess reserve, No money multiplier effect occurs which in the pre 2008 era was used effectively by the banks to increase money supply in the market.

Negative Effects of Quantitative Easing

  1. Inflationary Concern: Due to the large dollars being infused into the economy, when the economy starts to recover, it would lead to large scale inflation which would again impact the economy negatively. There is also the concern of rightly predicting what would be the right time to reduce the money supply in the market since which is a very difficult job. Also an incorrect timing could again push the economy back into a recession. Also is it seen historically that once an inflationary spiral gets going it is really hard to stop.
  2. Economic Inequality: The Quantitative Easing leads to a larger gain on the upper classes of the economy which increases the inequalities further. This becomes especially important since there is an already huge inequality that was created because of the capitalistic economy. Thus it makes the rich richer and poor poorer.
  3. Impact on fixed income groups: The inflation has caused a huge impact on the fixed income groups like pensioners whose inflation adjusted income reduces, making it difficult for them to sustain their lifestyle.
  4. Another asset bubble: The increase in net worth without an equivalent improvement in actual economic indicators like supply production etc could create another asset bubble. The effects of which would add the problems.
  5. Alternative Currency: A failure to get an economy upturn soon only encourages countries like China and Russia to try and further hasten the need for moving away from using the dollar as the world reserve currency
  6. More Expensive for US Government to borrow debt: QEII not only produces more dollars but it also lowers the yield that investors earn on them. This makes other countries less willing to hold dollar at current prices. Thus if the government wants to take more debt, it would have to pay a higher interest rate to increase the yield and make it lucrative.

The Quantitative Easing that has been used by the Federal Reserve using monetary policy has not been effective in satisfying the purpose of improving the economic scenario and in bringing the world back on fast track progress. The fact that a third round of Quantitative Easing is being put in place is in itself a proof that the first two QE’s failed. Thus with just the minor difference of making QE3 open ended, it is not convincing enough that this policy will have a positive effect and is more a desperate attempt to get the economy on a fast track.

This article has been authored by Abhishek Singhvi from MDI Gurgaon.


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