Monday, November 1, 2010

Will QE work?

With the Fed set to announce a second round of quantitative easing (QE) early next week, there have been intense debate about its potential effectiveness. I have blogged a few days back about the merits of both sides in the debate. There are two plausible arguements that could lower the effectiveness of any quantitative easing

1. Since, as Paul Krugman has written, any QE only involves a maturity transformation of outstanding debt by "paying off long-term bonds (using money generated by expanding the monetary base) while borrowing short-term (through sales of new short-term debt instruments)", the net risk remains with the government (Treasury or the Fed). Further, since at close to the zero-bound, cash and T-Bills are close substitutes (both pay nearly zero interest rates), it is just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

One channel through which QE can positively influence the financial markets is by way of large-scale purchases of illiquid private financial instruments which would have the effect of repairing the battered balance sheets of those institutions holding such assets. However, the success of this channel would depend on whether the Fed purchases such assets and the quantity it purchases.

2. The other question mark is about whether a mere expansion of monetary base will automatically expand money supply. In other words, will a greater monetary base actually result in banks lending more and people borrowing (and spending) more? Though Milton Friedman had argued that quantitative easing will expand money supply and address Japanese deflation in the nineties, the actual experience was conclusively to the contrary.

The graphic above shows that even after Bank of Japan engineered a huge increase in the monetary base post-2000 (Krugman calls it "the original quantitative easing"), the money supply hardly budged. This calls to question the hypothesis that monetary expansion in liquidity trap conditions would automatically result in broad money expansion, economic growth, and even inflation. Krugman invokes the same precedent to question the oft-repeated claim that the Fed's refusal to indulge in monetary accommodation caused the Great Depression - "Why should we believe that the Fed had any more control over M2 in the 30s than the BOJ had over M2 more recently?"

This experience once again highlights the importance, even pre-requisite, of revival in aggregate demand for monetary expansion to produce the desired results. If demand is frozen and attendant expectations get anchored, no amount of QE will be able to get businesses to bring forward their investment decisions and consumers to engage in consumption, leaving banks with more cash reserves which does not leave their vaults.

See also this excellent article by David Wessel in WSJ that considers both sides of the monetary policy arguments on QE and pumps for another roaund of QE in the US. He looks at the declining money supply velocity (or lower "oomph" for each unit of dollar), declining incomes, and declining bond-market expectations to justify another round of QE.

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