Quantitative easing

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Monetary policy in a period of financial chaos:

The political economy of the Bank of Canada in extraordinary times

Presented at the Political Economy of Central Banking conference,

Toronto, May 2009

Marc Lavoie and Mario Seccareccia

Department of Economics

University of Ottawa

July 2009

“Although quantitative easing is now referred to as an unconventional monetary policy tool, the purchase of government securities is, in fact, the conventional textbook approach to monetary policy…. In practice, most central banks have chosen to conduct monetary policy by targeting the price of liquidity because the relationship between the amount of liquidity provided by the central bank and monetary aggregates on the one hand, and between monetary aggregates and aggregate demand and inflation on the other, are not very stable.” (Bank of Canada, 2009b, p. 26).

The Bank of Canada thus feels compelled to recall that monetary aggregates are very badly correlated with price inflation, and that base money is also very badly correlated with the money supply. To provide excess bank reserves, as recommended by Monetarists, central banks must decline to sterilize its liquidity creating financial operations or it must conduct open market operations by purchasing assets. As pointed out by Deputy Governor John Murray (2009), “All quantitative easing is, by definition, ‘unsterilized’. Although this is correctly viewed as unconventional, it closely resembles the way monetary policy is described in most undergraduate textbooks, and is broadly similar to how it was conducted in the heyday of monetarism”. Murray misleadingly insinuates that such a technique has been implemented before, namely during the 1975-1982 monetarist experiment in Canada. What can really be said is that quantitative easing is an attempt to put in practice what academics have been preaching in their textbooks for decades from their ivory towers. It is merely monetarism but in reverse gear. While monetarist policy of the 1970s was implemented to reduce the rate of inflation, current monetarist quantitative easing is being applied to generate an increase in the rate of inflation.

As a result, the claims of quantitative easing are just as misleading as the claims of monetarism of the 1970s and early 1980s. Bank of Canada officials claim that “The expansion of the amount of settlement balances available to [banks] would encourage them to acquire assets or increase the supply of credit to households and businesses. This would increase the supply of deposits” (Bank of Canada, 2009b, p. 26), adding that quantitative easing injects “additional central bank reserves into the financial system, which deposit-taking institutions can use to generate additional loans” (Murray, 2009). In our opinion, these statements are misleading and indeed completely wrong. They rely on the monetarist causation, endorsed in all neoclassical textbooks, which goes from reserves to credit and monetary aggregates. It implies that banks wait to get reserves before granting new loans. This has been demonstrated to be completely false in the world of no compulsory reserves in which we live since 1994. In any event, even before 1994, as argued by a former official at the Bank of Canada, the task of central banks is precisely to provide the amount of base money that banks require (Clinton, 1991). Banks do not wait for new reserves to grant credit. What they are looking for are creditworthy borrowers.

Quantitative easing is an essentially useless channel. It assumes that credit is supply-constrained. It assumes that banks will grant more loans because they have more settlement balances. Both of these assumptions are likely to be false, at least in Canada. With the possible exception of its impact on the term structure of interest rates, the only effect of quantitative easing might be to lower interest rates on some assets relative to the target overnight rate, as these assets are being purchased by the central bank through its open market operations. It is doubtful that the amplitude of these interest rate changes will have any impact on private borrowing or on the exchange rate. Indeed, in Japan, which has had experience with zero interest rates for many years, quantitative easing was pursued relentlessly between 2001 and 2004, but with no effect, as “the expansion of reserves has not been associated with an expansion of bank lending” (MacLean, 2006, p. 96). Indeed, officials at the Bank of Japan did not themselves believe that quantitative easing could on its own be of any help, but they tried it anyway as a result of the pressure and advice of international experts. As Ito (2004, p. 27) notes in relation to the Bank of Japan, “Given that the interest rate is zero, no policy measures are available to lift the inflation rate to positive territory… The Bank did not have the tools to achieve it”.


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8 Responses to Quantitative easing

  1. In as far as it is just banks that are involved in QE, I have no quarrel with Warren’s argument above. However QE involves buying securities (including tsys), not just from banks, but from the private sector generally. (And even if the Fed buys initially only from commercial banks, tsys flow between the latter and the private sector generally, so it makes little difference who the Fed initially buys from) This is a different ball game.

    In fact it’s a game nicely described by Warren himself in his parent, children and business card economy. (There’s now a model of this economy hardwired into my brain.) As Warren rightly points out, if the parents offer less interest on the cards, the children will want to hold fewer cards: they’ll dissave cards.

    Likewise, if the private sector gets monetary base in exchange for tsys, the total amount of interest that can be earned on “cash plus tsys” will decline, thus the private sector will try to dissave cash, which is reflationary.

    Of course this effect will be small if (as is probably the case) the private sector expects QE to be reversed quite soon.


    Tom Hickey Reply:

    Ralph, the Fed desperately wants reflation. They are fighting deflation and can’t get traction.


    Ralph Musgrave Reply:

    Can’t get “traction”? Never mind traction: central banks hardly know where to insert the ignition key or where the gear lever is!

    Anyway, jokes apart – yes I know the Fed wants reflation. Trouble is that having reduced interest rates to zero AND done about as much QE as is likely to have any effect, they’ve run out of options. The US government should have stimulated the economy from the bottom, rather than stuff money down Goldman Sach’s throat. The UK and Europe should have done the same. Warren’s payroll tax holiday would have done that.


    Tom Hickey Reply:

    Agreed. I guess the Fed had to learn the hard way, if they have learned at all. Some things that Bernanke has said indicate that he gets at least part of it, but Fed actions belie this, and so does Bernanke’s apparent advice to policy-makers.

    The US really needs to have a debate about how things actually work, ie., why taxes are needed (not to fund spending), why debt is used (to drain excess reserves so the Fed can hit its target rate), what government disbursements do (increase non-government NFA), and how the sectors balance in the fundamental macro equation, Y-C+I+G+NX (government deficits = non-government surpluses, and vice versa). Hopefully, Warren’s candidacy will bring this to the fore at least somewhat.

    For example, when these questions are asked, the question beomes why have a payroll tax at all when there is no need to use particular taxes to “fund” particular spending when that’s not actually what’s happening at all. The US should be asking what proportion of real resources it want to commit to public purpose based on necessities and then how to regulate nominal aggregate demand in relation to real output capacity as a separate issue that fiscal policy affects.

    Neither the voting public, nor the media that shape public opinion, nor political leaders, nor the people in charge of managing the economy get this, so the debate is largely an excericse in nonsense. Right now, ithe dog is chasing its tail.

    As Randy Wray and others have observed, the bailout was unnecessary to “save” the system. It just saved the people responsible for creating the mess, avoiding accountability, as William K Black has delineated.

    And the public has already figured this out, as well as where the money should have gone. If employment doesn’t start falling fast, the Dems are going to be in serious trouble at the voting booth, and they could lose both the House and Senate, not that the GOP would have been any better. Arguably, a McCain/Palin administration would have been worse.

  2. Pingback: News from around the web: 2009-07-25 - Credit Writedowns

  3. Hoover Printing Presses says:

    “Banks do not wait for new reserves to grant credit. What they are looking for are creditworthy borrowers.”

    We don’t even have to look to Japan, hoover couldn’t get the banks to lend with similar policies could he? We have run out of creditworthy borrowers for perhaps a generation. Every shopping machine princess that shouldn’t have got a credit card, got one anyways. Watch geithners testimony today in Congress and he readily admits to congressman hensarling and the others that many people got credit cards and mortgages that should not have got them. I have been saying that too.

    Ramanan, I too was interested on the topic of Japan bowing to international pressure against thier own best ideas. I have tried to ask Warren for a couple years now that certainly that same international chorus has now brought its weight to bear on influencing the USA. That certain policy actions by the USA that he deems as ignorance by the administration are not so, but just trying to appease global harmony.

    I personally can see the logic for it, but I don’t like that political influences from other nations can affect my national policy and I can’t vote in those other nations. For that same Reason why was it fair to japanese citizens for their government to be influenced by foreign political machinations?


  4. Ramanan says:

    That makes lot of sense (BoJ acting because of pressures from international experts). After reading some of the BoJ articles, it seems that they understand some things better than the guys at Fed.


  5. Michael says:

    From Mauer:

    That implies that there is some “public debate”. In fact, the prevailing paradigm on QE is so powerfully entrenched, that there has (until now) been no debate. I tried to explain to Bill Gross and Paul McCulley that QE was just a means for the public sector to steal income from the private sector and they didn’t seem to agree, even though it works directly against the very aggressive fiscal policy measures that both sensibly advocate in their most recent PIMCO notes.


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