The good news — quantitative easing will not cause inflation.
The bad news — we need to reform the whole banking system before QE can be withdrawn.
So says Adam Posen, the newly-recruited Bank of England monetary policy member and “Lost Decade”-specialist, anyway.
Posen spoke on Monday night about British QE and the whole speech is worth a quick recap.
To begin with here are his thoughts on the unconventional policy measure and the prospect of inflation:Yet, given the extremely large scale of asset purchases by many central banks today, amounting to £175 billion in QE by the Bank of England, is there an inflationary threat? If one believes seriously in a kind of mechanistic monetarism, then the key issue is how much has (and will) money growth exceeded the required to accommodate the real development of the economy. I would like to present to you now some evidence from past periods of quantitative easing and large-scale reserve creation, when there arguably was excessive monetary growth, and how little it mattered for inflation. While one cannot prove a negative with data, it is to [my] mind the best approach to look empirically for parallel periods in order to understand and forecast from our current circumstances, rather than to rely on an unsubstantiated belief in so-called first principles, monetarist or otherwise.
And those parallel periods are, according to Posen — the Bank of Japan’s QEasing from 2001 and the People’s Bank of China from 2003 — when both central banks created large amounts of reserves to battle deflation and maintain a fixed exchange rate of the yuan against the US dollar over the period since the Asian Financial Crisis. That reserve creation resulted in money growth and inflation which looked like the below left (click to enlarge). Here’s what Posen says:
I am not trying to prove with academic rigor (which these charts admittedly do not attain) that money is endogenous or some other fundamental concept. What I am trying to do is make the practical point that there is no evidence from relevant periods of UK or other major economies’ economic history that QE will result in high or sustained inflation. That conclusion is robust to more intensive econometric investigation of the available data. That conclusion is also supported by evidence from the period of QE in Japan earlier this decade which is the closest parallel to the present situation and the QE policy pursued by the Bank of England this year. Thus, high inflation is not what we should be worrying about.
What we should be worrying about, according to Posen, is a rather different parallel to Japan — the availability of credit to non-financial companies — your run-of-the-mill SME.
Here’s Posen:
Taking all that into account, however, the major question for me going forward about the UK outlook remains the availability of credit to non-financial companies, particularly to SMEs, when the upturn comes. Absent enough credit, correctly allocated, there will be insufficient investment in the UK economy even when prospects improve, unavailability of sufficient funds for businesses’ trade and short-term liquidity needs, and a reduction in the formation of new businesses. This kind of dislocation for the real economy is what explains why financial crises have historically been so costly, beyond their direct impact on wealth and short-term demand. When there are persistent financial sector problems, there are persistent negative effects on aggregate supply and on the potential rate of growth for an economy going forward, even after the recession ends. Some of that harm is inevitable, especially when financial crises of the scale we experienced occur, but the extent of the lasting damage is far from entirely out of our hands.
. . .
I am concerned because the financial system in the UK does not seem to have a spare tire for the provision of capital to non-financial businesses when the banking system has popped a leak. QE puts this unfortunate fact into clear relief. Other central banks were able to buy a wide range of assets from the private sector, under the heading of ‘credit easing,’ as described in Bernanke (2009), to good effect.12 The Bank of England, prior to my joining the MPC, decided to purchase only gilts (essentially, being 95%+ of purchases) under the QE program. One of the primary reasons given for so doing was the relative thinness of UK markets for corporate bonds, commercial paper, and other corporate securities issued by non-banks. I appreciate the constraint, but that limitation on QE reveals a major long-term structural problem in UK financial markets which could be of potential harm as the UK economy begins to recover.
. . .
In fact, in this aspect the UK has an uncomfortable parallel with the Japanese financial system when the Japanese economy began to recover in the mid-1990s and was unable to sustain it. Severe macroeconomic policy mistakes also played a role there, and those are thankfully absent at present, so the parallels should not be exaggerated.13 The similarity between Japan then and the UK now with regards to the financial system, however, should not be overlooked either, just because other factors are not the same. The closer one looks, the more worrisome this specific parallel becomes, given the concentration of the UK banking system in a few major, mostly still troubled, banks, and the relative underdevelopment of alternative non-bank channels for getting capital to non-financial businesses in the UK.
In fact, the `structure’ of the UK financial system is shown in the below table. In it, Britain has the smallest private sector bond market capitalisation relative to GDP. When it comes to short-term private securities (commercial paper and the like) the UK markets are again near the bottom. And the UK is also far closer to Japan than the US when it comes to banking sector concentration (the last two rows in the table). All of this leads Posen to conclude:
In the coming years for the UK, it will be the ability of the financial system to support private capital formation and investment in innovative activities that matters for national economic performance, not the growth of financial sector employment or financial innovation that does not yield benefits to non-financial institutions and households.
The functioning of the UK financial system is therefore of importance and direct relevance to the work of the Monetary Policy Committee, as I understand our duties. A banking system as we have in the UK today, with large segments still in public sector hands, a high degree of concentration of assets, and still needing capital (though progress has been made on that front) is a structure that bodes poorly for the sustainability of the coming economic recovery. It also is a structure that could impede the return of trend growth in the UK to its previous rate, and which could if things worsen put on persistent deflationary pressure (as the ongoing banking structural problems did and do in Japan).
This is a completely independent reason for the critical re-evaluation of the current UK banking structure, including of having too few big banks, than that raised by financial stability concerns – though it points in largely the same direction.14 We need a financial system that is subject to sufficient competitive pressure such that it provides enough traditional lending to non-financial business, rather than one beset by too big to fail institutions who engage in relatively unproductive speculative behavior.…..
That is why in testimony before the UK Treasury Select Committee (2009c) as well as before the US Congress’ Joint Economic Committee (2009a), I have argued that that the banking system must be largely fixed before macroeconomic stimulus is needed to be withdrawn. The alternative is likely to result in a still-born recovery, a double-dip (though less severe) recession, and/or persistently slow growth. What we have learnt from the US Savings and Loan Crisis of the 1980s, the Asian financial crisis of 1997-99 and from Japan’s Great Recession of the 1990s, and what we are seeing right now, is that those economies which either fix their banking systems quickly or which have a wide range of alternative channels to impaired banks through which to provide capital to businesses, recover faster and stronger. It helps to have at least one spare tire in the financial system, as Greenspan (1999) observed.
While we’re sceptical of Posen’s views on inflation (for one thing, we suspect the monetary base expansion multiple for the UK is higher than Japan’s) — his point on corporate lending seems especially poignant given that the government’s £175bn Asset Purchase Facility, aimed at boosting lending to non-investment grade companies, has so far been completely un-utilised.
In fact, some finance providers claim to have been warning the Bank of such a difficulty since the scheme began.
How do you say “doh!” in Japanese? Or, for that matter, “further central bank action” ?
Related links:
Bank’s business lending scheme falters – FT
Why the US won’t lose a decade – FT Alphaville
That’s not quantitative easing… – FT Alphaville
Managing expectations, central bank edition – FT Alphaville