Wednesday, 29 September 2010

More quantitative easing for the UK?

Now here is an interesting news article in the Telegraph:

Bank of England's Adam Posen calls for more quantitative easing
The Bank of England should restart the printing presses and pump more money into the economy to prevent a "lost decade" of low growth and high unemployment, one of its senior policymakers Adam Posen has said.
So called "quantitative easing", or QE, accomplishes one thing and one thing only; it produces inflation. So how is that any use as a policy instrument to be used to "prevent a 'lost decade' of low growth and high unemployment"? Well, it does two major things:
  1. It deflates real wages, on the premise that real wages are flexible. A fair enough assumption at the moment given that unemployment is high generally there won't be too much resistance from or bargaining power with sellers of labour who might see the true value of their time fall.
  2. It deflates the stock of debt. Governments in particular borrow over long terms at fixed rates of interest. Inflation which is higher than expected at the time of issue will mean that the amount these governments will need to repay will be smaller in real terms (they will be paying back in the future using devalued money). In fact, if inflation is high enough they might end up paying back less than they borrowed.
Now think about that second point for a moment. Astute readers understand instantly that debt is a two sided coin. One person's debt is another person's asset. So, if higher than expected inflation means that borrowers might not have to pay back as much as they thought, or even as much as they borrowed, then the person who lent them the money is losing out by exactly the same amount. All we are witnessing is a transfer of wealth, not a creation of wealth or indeed a "destruction of debt" (which in fact is impossible for the reasons noted).

So what is the benefit? Is there any benefit? Well, I'm glad you asked, because the answer is yes/probably/sometimes.

Yes, in that for an economy facing the opposite case where inflation is unexpectedly negative and large (deflation) currently extended borrowers can easily find themselves in a debt death spiral. Instead of paying back less than they planned in case of higher than expected inflation, they might find themselves paying back much much more than they expected if prices fall over time. At the moment we certainly have over extended borrowers aplenty. An extremely widespread occurrence of such a debt death spiral (debt deflation) would indeed be a potential threat I for one would prefer to not test. Think of Greek, or Irish public finances for example. What if the debt stock which looks worryingly large and is increasing turned out to be a multiple of what we currently estimate it to be because every €100 that needs to be paid back in 20 or 30 years time turns out to be a massive €150 or €200 in today's money due to deflation? Can you imagine the crippling debt effect?

So inflation is probably a benefit in these circumstance, but not unequivocally so. Consider what happens if QE is successful. Debtors avoid the debt spiral and the €100 that, say, the Irish government needs to pay back lender in 20 years time turns out unexpectedly to be more like €50 or even €20 in today's money. Huzzah, the taxpayer is saved!!! Well, hold your horses there pilgrim. Who is on the receiving end of the now devalued €50 or €20. Look no further than yourself in retirement. Yep, pensions are funded predominantly by bond assets. The unexpected inflation has robbed you of the expected value of your savings in retirement. It isn't without reason that inflation is referred to as a tax on savers. In this case it is a tax, because the benefit mostly accrues via government accounts in reduced public debt repayment.

So that is the choice that we are looking at with Posen's policy suggestion. There is no outright economic gain here, but a potential aid to adjustment (reducing the price of labour), plus a potential redistribution of wealth, as noted from government bond holders to governments (and possibly from foreign holder of those bonds to your domestic government - which is a local benefit as a type of tax on foreign lenders) and from today's savers to today's debtors. If you fear the debt spiral scenario enough (and perhaps if many of your creditors are foreigners) it becomes a policy worth considering.

1 comment:

yoganmahew said...

As I said on the IrishEconomy blog, I'm not even convinced that QE will/can generate inflation, nor indeed can fiscal stimulus. Absolute debt levels leave the hole too big with the result that an asset that was worth 100 is bought by someone at 100 (rather than the market price of 90). There is an absence of loss, but no new money creation.

For inflation to happen, less has to be paid in future, with QE masking this by suppressing long-term interest rates. But if QE is soaking up the assets, then it is money supply that is going to take the losses (i.e. money will be 'created', as no matching liability will be enforced).

So, I just don't see how QE, in particular QE that is directed at higher quality assets, is not just a game of pass the parcel. Where am I going wrong?