Bye to QE—for now?

It began as a response to the sclerosis that shut down the credit arteries of our economies in the wake of the great financial crisis. Quantitative easing (QE), under which central banks bought government and private-sector assets, was deployed to stabilise the financial system. It remained in place later as the principal policy tool to stimulate growth and inflation while many governments presided over restrictive fiscal policies (aka austerity) in order to lower budget deficits. The balance sheets of major Western central banks rose from less than $4 trillion in 2008 to the current level of about $14 trillion. But now, in a turbulent and often shocking year, it looks like regime change is upon us. QE seems gradually to be handing over the baton to fiscal activism. Should we bury or praise QE?

The US Federal Reserve stopped buying assets two years ago, and as is well known, is awaiting propitious circumstances in which to raise interest rates again, perhaps at the end of this year or if not, in 2017. The Bank of England had stopped, but following the Brexit referendum started up again in August, fearful that the economy might turn down. The downturn hasn’t happened, and the kind of sudden halt the Bank feared probably won’t occur for the foreseeable future. I don’t see a long lifespan for this QE round.

The Bank of Japan, whose balance sheet has exploded to nearly 90 per cent of GDP, has backed away from more aggressive QE too and substituted a zero government bond yield for quantitative purchase targets. Only the ECB remains committed to regular monthly purchases of assets through 2017, but its enthusiasm has waned too, and there is now market chatter about when it will adopt a “tapering strategy.”

So what’s happened?

Early concerns by prominent commentators that QE would lead to rapidly rising inflation, currency debauchery and financial chaos were much exaggerated, and definitely wrong. For some time, though, there has been a growing sense that QE—at least as currently constituted—isn’t working, or at least is not having the desired effects of boosting output growth and inflation. Concerns about ineffectiveness have joined worries expressed by several economists about the unintended negative consequences of QE.

One particular charge has been that persistent cheap money, low bond yields and buoyant asset prices have had the effect of benefiting the rich. In an environment of rising concern about income inequality, this does not fit well even though some central banks, including the Bank of England, have argued that the effects of QE were insignificant in this regard. Nevertheless, asset-rich individuals were unquestionably beneficiaries, and most people don’t own financial assets directly (I think the case stands even if the many hold assets indirectly in institutions). Pension funds, by the way, have hardly made out like bandits during QE, recording ever growing deficits which plan sponsors either have to make good at a cost to the company and other spending, or else pass the risk back to pensioners if the scheme is impaired or ultimately wound up.

There have been other unintended consequences. Domestically, these include excessive reliance on central banks for outcomes they are incapable of delivering because of the structural nature of our main economic ailments; misallocation of (cheap) capital that keeps zombie companies alive at the expense of new lending to and funding of newer, more productive companies; and accentuating the use of debt as opposed to equity in the structure of balance sheets when we want households and firms to delever. Globally, QE has its fingerprints on voluminous and unstable capital flows across national boundaries, compromising financial stability, and aiding and abetting competitive currency depreciation.

Recently, Prime Minister Theresa May told the Conservative Party conference that the Bank of England’s QE was having adverse side effects and that changes were needed. It wasn’t clear whether she was referring to the Bank of England’s policy goals like inflation, which the government does set, or its operational tools, which it doesn’t. It sounded as though she was referring to a more populist gripe, namely the impact of low yields on savers. Hopefully, she meant something entirely different, because economic welfare and distributional policies are most definitely not in the remit of the central bank: those are for the government to determine. Perhaps we will find out in the forthcoming Autumn Statement on 23rd November.

In any event the Bank has new things to scrutinise, including the fall in sterling, the doubling of gilt yields since August, and signs of rising inflation. Many forecasters think that the consumer price index will rise further than the Bank’s target of 2 per cent and reach perhaps 3 per cent or so by 2018. This will be no disaster, but it will matter. Governor Mark Carney has said the Bank might well look through a temporary rise in inflation, and so higher interest rates would not necessarily follow. But they might if sterling’s decline became chaotic, gilt yields rose considerably further, or if wages and salaries started to increase more rapidly. These things are possible, even if not immediately or indeed for a while.

But the changing debate about central banks and new challenges underscore why the focus is draining from QE and towards the balance sheet of the government, or more commonly, the fiscal scope for the government to use taxation and spending to manage the economy. This is a task from which they have absented themselves largely since 2008-9.

Fiscal is the new monetary

Canada kicked things off earlier this year, announcing higher public spending, including a six-year infrastructure programme, and an increase in projected fiscal deficits. The Japanese government committed to new budgetary spending initiatives to try and get Abenomics back on course. Some of its spending programmes are down payments on labour market reforms designed to boost the economy’s flexibility and responsiveness over the medium term. For example, the government is trying to get more women into the workforce, boost childcare programmes, raise minimum wages to bring irregular workers into the mainstream labour force, and increase wages for public-sector workers, such as teachers.

In the US, even though the election campaign has tilted towards Hillary Clinton, there are still over three weeks to go, and no one can be complacent in this volatile political environment. Yet whoever wins, fiscal activism is almost certain, despite the role that Congress has in policymaking, and regardless of the scant focus on both candidates’ economic policy programmes. Donald Trump wants to boost US growth to 4 per cent, cut taxes for companies and the better off, and has pledged significant increases in federal spending, both defence and non-defence. The Committee for a Responsible Federal Budget, a think-tank, reckons that Trump’s programmes would push US national debt up from about 80 per cent of GDP to almost 110 per cent by 2026. This is significantly less than its estimate for Clinton’s programmes, which are more measured and focused, even if not widely agreed as necessary. She wants to spend $250bn or more on infrastructure, capitalise a new infrastructure bank, make changes to tuition fees and childcare costs, and raise taxes on high incomes. Her programmes would raise US national debt to just under 90 per cent of GDP by 2026.

And so to Whitehall. We know the government will abandon the fiscal surplus target for 2020, pushing it to an unpublished future time. We know from May’s party conference speech that her government will be more statist and interventionist, and favours infrastructure spending, broadband expansion and so on. Yet Chancellor of the Exchequer Philip Hammond has also ruled out a “splurge” in public spending, and with sterling falling sharply and the gilt market lurching down, Brexit Britain places at least some constraints on what the government might be able to do. The Autumn Statement will doubtless reveal the government’s thinking and plans.

Next year, with crucial national elections in France, Germany and perhaps Italy taking place in the face of rising populism, it seems likely that these Eurozone giants are going to back away from the austerity mantra. Even Wolfgang Schäuble, Germany’s Finance Minister, has said there is room for tax cuts. With a budget surplus in Berlin, It would have been shocking if he had indicated anything else.

So it seems to be bye-bye QE, all things considered. More activist fiscal policy is on the way, a rise in bond yields is very likely, and we will try and wean ourselves from sole reliance on unusual or unorthodox monetary policies—and not before time. QE fulfilled its purposes when it was needed for defibrillating the financial sector, but it gradually proved to be less effective and prone to unintended negative consequences.

Bye-bye may not mean farewell. If central banks prove unable to raise interest rates much, or at all, between now and the next downturn, we will certainly ask again what central banks might do. In those circumstances, and especially if governments have already used up what the IMF calls “fiscal space,” central banks might adopt new forms of QE, colloquially called helicopter money. They wouldn’t just buy assets in the marketplace or from banks, as now, but they might be authorised to buy bonds directly from the government to finance tax cuts, infrastructure spending or other programmes. But this is for another day, Right now, the QE tide is receding, as economic policy relearns to walk on two legs.