QE, European Style: Expect More Harm Than Good
A research paper featured in the 2014 Q1 Bank of England Quarterly Bulletin calls it a “misconception” that a "central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money.” It is quite clear, however, despite the research-paper authors’ protestations to the contrary, that central bankers, in practice, believe this “misconception.” Central Bankers even extoll this “misconception” with the adulatory term, “the money multiplier approach." This central bank shibboleth is at the heart of the quantitative easing (QE) policies of the U.S. Federal Reserve, the Bank of Japan, the Bank of England, the People's Bank of China and, as of last Thursday (1/22/15), the European Central Bank.
The theory of QE is easily stated: Central banks conjure money. Their black magic has succeeded, at least with electronic impulses recorded in account books, where the alchemists of old failed. Indeed, the central banks’ legerdemain is even more powerful. The alchemists at least had to start with something physical in their attempts to create gold from lesser stuff. But the central bankers create money, i.e., real purchasing power, ex nihilo, meaning “out of nothing.” And that “nothing” is exactly what backs this demon seed, but for the belief in central bankers and their omnipotence.
Once created, the new money is used by the central bank to purchase bonds (generally sovereign debt and mortgage obligations) from commercial banks. (The Bank of Japan is even purchasing stocks with their newly created yen.) Per the central banks’ theory, the commercial banks, in turn, will loan that fresh liquidity to commercial and retail borrowers. The borrowers then will deposit the loaned funds into their own bank accounts, triggering the fractional reserve “transmission system,” compounding the amount of money in circulation. The increased money in circulation is supposed to stimulate demand for both financial assets and consumer goods and services, hereby “fueling” an economic recovery, including production increases and the job creation that accompanies it.
Sounds wonderful, as the central bankers proclaim it. Problem is, it does not work.
Why? One simple reason. It is not a surfeit of credit (i.e., bank liquidity sourced from central banks) that causes good loans to be made by commercial banks. Good loans, by definition, can be made only when borrowers are able to use credit to build or purchase assets that enhance profitability, creating free cash flow with which the loans can be serviced and ultimately repaid. But a surfeit of credit, particularly credit in the hundreds of billions, shot out of central bank QE fire hoses, facilitates bad loans—and lots of them. These bad loans, or what F.A. Hayek would call “malinvestments,” ultimately result in credit bubbles that burst and wreck the economy. This is the “crack-up boom” described by Mises in his magnum opus, first published in 1949, Human Action. One need look no further than the 2008 housing bubble for proof of this chain of causation.
The genesis of the 2008 housing collapse was Federal Reserve–created, too-cheap credit forced into the economy pursuant to the political mandate of the Community Reinvestment Act (CRA). The CRA facilitated hundreds of billions of dollars in subprime home mortgages that ended up on the books of Freddie Mac and Fannie Mae, government-sponsored enterprises that had the implicit guarantee of the U.S. government. The transmission system for the guaranteed credit was the money center banks, whose managers were only too happy to push bad loans for the fees they generated, both on origination and on sale into Wall Street securitization packages. These securitized bad loans ultimately were purchased by pension funds, retirement funds, hedge funds and sovereign wealth funds worldwide.
QE, which creates bank liquidity not demanded by the real economy, is, as Keynes himself acknowledged, “pushing on a string.” The fact that banks have more fiat money to lend does not mean that firms and individuals have an economic use for that liquidity. As the late Professor Hyman Minsky pointed out, consumers and nonfinancial private-sector firms do not borrow simply because rates are low. In order to borrow, rational real businesses and rational real consumers must believe that they will be able to repay any credit they assume. In the case of businesses, they have to see the market for their goods or services as stable and likely to increase in the short to medium term. As for consumers, they have to believe that they have job security and the possibility of wage increases in the short to medium term.