Too much state-created money is by definition a bad thing. And so is too little. But how do we know how much is too much and how much too little? The brief dogmatic answer is that we cannot. We can only “suck it and see”. The gold standard may have been excessively maligned by would-be progressive commentators. But paper money has one advantage. While gold, silver and many other precious metals are difficult to eliminate once they have been extracted from the ground, paper can be annulled. And the edifice of bank credit that rests upon it can, at least, be tapered off.
These basics need to be borne in mind in the arcane dispute about so-called quantitative easing (QE). Old-fashioned textbooks used to talk about “open-market operations”. The theory was blessedly straightforward. Most commercial (or “clearing”) banks held reserves at the central bank which could be converted into cash on demand. These reserves, plus till money and deposits held by these banks, are often known as “the monetary base”. If the central bank wished to expand the economy, it bought marketable securities from the commercial banks. The latter were then flushed with reserves and were able to increase their lending and, in the process, expand their deposit total.
These activities were known as open-market operations. Thus the quantity of money – or, in more recent parlance, the money supply – grew and banks became readier to lend to businesses and households. The incentive for the borrower to use the available funds was the resulting drop in the rate of interest.
The process was supposed to be symmetrical. If the central bank wanted to restrict the pace of economic activity, it sold securities. The reserves of the commercial banks contracted, their available funds for lending contracted and interest rates rose. The problems on the contractionary side were political, not technical. Borrowers disliked having to pay more for their funds.
Critical mass of borrowers
The technical issues arise on the expansionary side, and they lay dormant until the onset of the recent Great Recession in about 2008. In such conditions there may not be enough borrowers to utilise potential savings, however low the nominal rate of interest. It was this problem that preoccupied John Maynard Keynes, but it had been raised before by Alfred Marshall at the end of the 19th century and by John Stuart Mill. It has to be said in favour of governments and central banks that, this time round, they decided to keep interest rates as low as possible and to go slowly in reducing their budget deficits.
It is a pity the central banks decided to use the ugly term “quantitative easing”. If they had called it “extended open-market operations”, they would have had less explaining to do.
As it is, these operations gave rise to much suspicion. The hint that the US Federal Reserve might be about to taper off its bond purchases was enough to cause tremors in financial markets, which eased somewhat when this did not materialise. For now, both the fear that this tapering- off might take place early next year and the fear that it might not are sufficient to set off new tremors.
The London-based consultancy Capital Economics has gone one by one through the fears raised by QE. The first is that it could lead to high inflation. The authors point out that it has not, even in the US and Japan, which took the lead in using this weapon. And, should the threat materialise, QE could easily be reversed.
A more subtle concern is that QE, by holding down interest rates, might reduce incentives to invest in new activities. The argument here can become complex. But the rub is that the recessionary problem only arises because of a lack of investment activity in the first place; and extra spending has to be conjured up from somewhere in compensation. A more realistic worry is that QE might stimulate energy and oil prices, and thus reduce demand.
Household vs state
The most serious objection is that overstimulated bank lending may create asset bubbles. I would argue an optimal anti-recessionary package should include fiscal as well as monetary stimulation. But political resistance to that is even greater, owing to a mistaken analogy between household and government budgets.
So as Hamlet nearly put it, it is better to bear those risks we have than “fly to others that we know not of”. – (Copyright The Financial Times Limited 2013)
