Friday, 30 September 2011

A doomed assessment

This is part 1 of a two-part post reviewing Finance for the Future's paper proposing so-called "Green Quantitative Easing". The paper was produced in December 2010 (although I have only just seen it) but the ideas it contains are widely promoted, so I thought a critique would still be in order.  I make no apology for the technical language I use in this review, as the concepts in the paper assume a fair understanding of finance and economics.

PART 1 of the report is an assessment of the Bank of England's Quantitative Easing programme in 2009-10.  PART 2 is a proposal for government investment in the economy specifically to further green objectives as outlined in the New Economics Foundation (NEF)'s Green New Deal. I shall follow the same structure in this review.

I would like to state before I start that this review is in no way intended to be a criticism of the authors, Richard Murphy and Colin Jones. I would also like to issue a personal disclaimer. I am neither an economist nor an environmentalist, so will not comment here on the economic usefulness or otherwise of either Quantitative Easing or the Green New Deal. My comments will be concerned entirely with the financial process.

PART 1: Assessment of Quantitative Easing

What is Quantitative Easing?

The BoE has a handy layman's guide to QE as a PDF download from their website. As this is so easy to obtain, I am surprised that the paper does not refer to it, or even to the brief definition on the BoE's website. Instead, the appendix to the paper obtains a definition of QE from an article in the Financial Times (FT). The FT's definition is consistent with the BoE's but is not as comprehensive an explanation. Perhaps because the explanation is limited, the authors of the report have completely misunderstood it.

According to the authors of the report,

"Quantitative easing is......the Bank of England granting the Treasury an overdraft".

No it isn't. It's the central bank injecting newly-created money directly into the economy, bypassing government. Here's what the Bank of England (BoE) itself says about this (from its website):

"The MPC boosts the supply of money by purchasing assets like Government and corporate bonds – a policy often known as 'Quantitative Easing'. Instead of lowering Bank Rate to increase the amount of money in the economy, the Bank supplies extra money directly. This does not involve printing more banknotes. Instead the Bank pays for these assets by creating money electronically and crediting the accounts of the companies it bought the assets from."

The central bank is able to create new money itself and does not require permission from government to do this. Because this money is created "out of thin air", it is NOT borrowing and does not increase the government debt, unlike an overdraft. What it does do is increase the size of the BoE's balance sheet. It can of course be reversed by selling a sufficient quantity of securities to eliminate the amount of new money created - this may or may not be the same quantity or type of securities as the original purchases, of course, depending on movements in market prices since purchase. The BoE's money creation process for asset purchases has absolutely nothing to do with the issuance of new government debt in the form of gilt-edged securities, or "gilts".

What assets were purchased?

From the BoE's pamphlet:

"...in March 2009, it decided to buy two types of asset – UK government bonds (known as gilts) and high-quality debt issued by private companies. Making the majority of purchases in gilts allows the Bank to increase the quantity of money in the economy rapidly. Targeted purchases of private sector assets should make it easier and cheaper for companies to raise finance by improving conditions in corporate credit markets."

The reason why gilts were purchased was because the gilt market is highly liquid, so funds could be injected into the economy quickly and easily. For some reason the authors seem to think that the QE programme was "buying back" government debt. It wasn't. The BoE bought gilts, but they were not redeemed. Those gilts, along with corporate bonds purchased as part of the same asset-purchase programme, now form part of the BoE's balance sheet.

Where did the assets purchased come from?

According to the authors of the report, the assets came from banks. Here's how they think it works:

"...the Bank of England has been issuing bonds to High Street and investment banks, which they buy.....But because the Bank of England does not want to take money away from the banks....the Bank of England then buys back gilts from those same High Street and investment banks that have bought the gilts issued by the Treasury"

Well, yes, high street and investment banks do indeed buy gilts, although they are by no means the only purchasers of that debt - major holders of gilts are pension and other savings funds. But the BoE generally did not buy gilts back from banks. On page 9 of the BoE's pamphlet we find these statements:

"Direct injections of money into the economy, primarily by buying gilts, can have a number of effects. The sellers of the assets have more money, so may go out and spend it. That will help to boost growth. Or they may buy other assets instead, such as shares or company bonds. That will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off. So they may go out and spend more. And higher asset prices mean lower yields, which brings down the cost of borrowing for businesses and households. That should provide a further boost to spending.

"In addition, banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses. So, once again, borrowing increases and so does spending. That said, if banks are concerned about their financial health, they may prefer to hold the extra reserves without expanding lending. For that reason the Bank of England is buying most of the assets from the wider economy rather than the banks."  (my emphasis)

In other words, because the BoE was concerned that High Street and investment banks might just sit on the money realised from asset sales instead of lending it out, it AVOIDED buying gilts or other securities from them.

What was the effect of this asset-buying programme?

As the authors correctly state (quoting Alistair Darling), we don't know whether QE did what was intended. The BoE, on page 13 of its pamphlet, provides a useful checklist to determine whether or not it was working. But the authors of the report produced their own checklist, so I shall use that.

Outcome 1: Recapitalising the banks

Recapitalising the banks was certainly not an aim of QE. The authors claim that "...public money has been used to reflate the banks with the benefit going to the existing shareholders and those receiving bonuses rather than reflating the broader economy to the benefit of the majority"

There are two errors here. Firstly, the money created by the BoE to purchase assets was not public money. The BoE, like all fractional reserve banks, has the capability to create new money without borrowing. The money it created had nothing to do with the government. Secondly, the money it created was not "used to reflate banks". Most of that money initially went to institutional investors. Yes, it then found its way into banks, because risk-averse investors chose to place the cash in deposit accounts rather than invest in riskier assets themselves or spend it, as the BoE hoped. And that cash did indeed inflate bank reserves. And banks may indeed have used that money placed on deposit with them to speculate on the international financial markets, from which they will have made profits which - if retained - improved their capital, or which may have been distributed in the form of bonuses and dividends.

So yes, the end result of this process may well have been that banks profited from QE. But that's not the same as using the money "to reflate the banks", is it? And if investors preferred to hoard the cash rather than spending it, well, they were only doing what in the report the authors identify as normal behaviour in a recession - saving. And if the banks speculated with that money, they were only doing what banks normally do with wholesale deposits. It was all perfectly normal behaviour. The only abnormal bit, really, was the lack of bank lending. I shall return to that.

Outcome 2: making funds available to business

From the authors:

"The stated aim of quantitative easing was to make funds from banks available to business so that they could meet the pressure on them arising as a consequence of the recession".

No it wasn't. There was no such stated aim. In fact the BoE avoided purchasing assets from banks because it was concerned that banks might not lend the funds out.

The stated aim of QE, according to the BoE's pamphlet, was to make it easier and cheaper for businesses to raise finance on the capital markets:

"Bank of England purchases of private sector debt can help to unblock corporate credit markets, by reassuring market participants that there is a ready buyer should they wish to sell. That should help bring down the cost of borrowing, making it easier and cheaper for companies to raise
finance which they can then invest in their business.

More generally, the Bank of England’s purchases of both government and corporate bonds also increase the total demand for those types of assets, pushing up their prices. This is another way in which the Bank’s actions will make it cheaper for companies to raise finance."

Outcome 3: a shortage of gilts for investment purposes

By reducing the availability of gilts, and therefore increasing the price, the BoE hoped to encourage investors - including pension funds - to move their portfolios more towards riskier assets such as corporate bonds and equities. What they actually did was place the funds on deposit at banks, which wasn't what the BoE wanted. But QE creating a shortage of gilts - yes, that was the point. It was supposed to.

So I'm a bit bemused by the authors bewailing the fact that there was a shortage of gilts for pension investment, as if QE wasn't supposed to have this effect.  However, the key to this lies in the authors' observation that "...during a recession people save more". Indeed they do. But the point of QE was to encourage spending instead of saving. So obviously QE was going to make life difficult for savers, wasn't it?  The shortage of gilts raised gilt prices and lowered yields, reducing returns to savers and therefore discouraging saving. In a recession, this is quite a sensible thing to do, surely?

Outcome 4: asset price inflation

"We suggest that is because excessive funds, being saved for the reasons noted above by both households and corporations have been moved by investment managers acting on their behalf into the UK stock exchange and other markets (such as those for commodities, including metals and foodstuffs) because those funds have not had sufficient access to the gilts market, because the government has not met the demand for gilts to be used for savings, and has instead been repurchasing gilts, so denying them to the savings market."

The authors, in that sentence, have summed up the entire purpose of QE. What a pity that they are using it to criticise QE's effect. If that has indeed happened then QE has done exactly what it was designed to do - forced investors to move funds to other types of asset.  

Oh, and the confusion between central bank and government rears its ugly head again. No, the government has NOT been repurchasing gilts. The BoE has been purchasing them.

The authors then go on:

There are important consequences of this. First, a mini asset boom has been created, maybe inadvertently....(my emphasis)

No, not inadvertent at all. Absolutely what was intended.

Given the whole problem that gave rise to the financial crisis was asset price inflation, or booms, this replicates the whole financial failing of the pre-2008 era.

The authors are comparing apples and oranges again. Commercial banks leveraging assets to the skies with derivatives is hardly the same as partial replacement of certain classes of security with cash.

"Second, because many of the assets whose prices have been inflated, such as coffee which is at a thirteen year high, or palm oil, which is up 45% in price in a year, feed (almost literally) into consumer price inflation, this policy does result in inflation, but not as a consequence of the direct printing of money, which is what economists predicted."

Well, ok, commodity price inflation on international markets probably was an unintended effect. But QE is supposed to raise inflation. Yes, in the short term it depresses yields. But the aim of the spending boost is to raise inflation to the level where normal interest rate management can take over. The BoE's stated aim for QE was to get inflation back up to the target level of 2%.

Outcome 5: deflation has been avoided

Yup, by raising inflation. Which was the point.

Outcome 6: low interest rates

"Another policy objective of the Bank of England, the government, and the quantitative easing programme was the maintenance of low rates of interest within the UK economy with the objective of stimulating economic activity. The programme has clearly helped achieve this with regard to interest rates on government debt, and on rates of interest paid by banks on savings, but the impact on the cost of borrowing to business, in particular, has been marginal. As has been widely reported, businesses have continued to pay significant premiums over bank base rates. This is because banks say that the risk inherent in such loans has increased. As a result it is not clear that the programme has delivered the new economic activity via increased bank lending to business that was intended."

I do have to agree with the authors here, except for their assertion that increased bank lending to business was an intended outcome of QE. The costs of borrowing for both businesses and households has risen massively. Yes, cost of financing on capital markets has fallen. But most businesses don't have access to capital markets, and for them, bank lending has become expensive and difficult to get. This is not because of QE, but because of risk aversion on the part of both lenders and borrowers. 

Summary of PART 1

The authors' assessment of QE was doomed from the start because of their abject failure to understand what QE is and how it works. In particular, their confusion of government and central bank, and their evident lack of knowledge of the mechanics of fractional reserve banking, mean that this is a very seriously flawed analysis.  Let's see if Part 2 is any better.

You can find my review of Part 2 by following this link: "A new name for an old game"

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