by Ann Pettifor, 8 March, 2009. There is much confusion about the meaning and impact of QE. This is an attempt to summarise what it means, what it does not mean, and how it can be effective in preventing insolvencies by lowering interest rates.
I am indebted to Graham Turner of GFC Economics for sharing his knowledge and experience of Japan’s use of QE with me. Graham spent time in Japan during the years of that country’s Credit Crunch which began in 1990, and is also knowledgeable about the 1930s when QE was adopted by policy-makers. Japan adopted QE eleven years too late – in 2001, but has since then kept interest rates below 2%.
Graham notes that Ben Bernanke’s book “Essays on the Great Depression” ‘contains no reference to Quantitative Easing…there is astonishingly little analysis of the monetary policy response that secured recovery (in the 1930s) in any of Mr. Bernanke’s essays.’
First lets remind ourselves that a bond is like a loan. The issuer is the borrower, the bond holder is the lender. So when I buy a bond from the Federal Reserve or BoE, the governors of these banks are issuing a bond (‘I promise to repay on this date…at this rate…’) and I am trusting their word with my money. Bonds, like loans, usually have a fixed term, or maturity. The interest rate on the bond is known as the ‘coupon’, and is what the issuer pays to the bond holders.
Rates on company or corporate bonds are important because they determine whether companies can afford to borrow to invest, to pay wages or to manage cash flow. They determine whether entrepreneurs can take risks – and invest, e.g. in green technology. If they can’t do any of these things they declare bankruptcy, and lay off their employees.
Above all interest rates determine whether companies can afford to repay the huge debts dumped on them by lenders, so-called ‘private equity’ companies and other financial institutions during the inflation of the credit bubble.
Interest rates on government and corporate bonds can be lowered by QE – purchases of government bonds by central banks and the shifting of these bonds out of the market, and on to the balance sheets of central banks.
The first myth to dispel is that interest rates are currently low. Base rates may be low, but the rates that companies pay, as Warren Buffett has argued is at ‘record levels’. He tells shareholders that “highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Though Berkshire’s credit is pristine – one of only seven AAA corporations in the country – (its) cost of borrowing is now far higher than competitors with shaky balance sheets but government backing.”
Graham Turner shows that ‘average yields on loans for non-investment grade companies in the UK rose to 31.66% on the 4th March, 2009.’ These are bankrupting rates.
The second myth to dispel is that QE is about ‘printing money’. QE is not about directly using liquidity injections to boost the supply of money. As we have learned to our cost, plenty of liquidity has been injected into banks, but this has not slowed the pace of bankruptcies. As Turner notes: ‘money supply (M) is entirely endogenous, and depends on the structure of borrowing costs being secured through bond purchases. ‘ It will be vital for the Bank of England to set a long term interest rate target, and to use the purchase of government gilts to reach that long-term, and low target.
QE is about preventing debtors from defaulting. This is done by the Central Banks targeting lower rates of interest e.g. for 30-year bonds (or loans), and achieving this by purchasing government bonds and taking them on to their balance sheets, (It can be used to purchase corporate bonds, but is more effective in bringing down all rates, if used to purchase government bonds.)
These purchases are known as ‘open market purchases’. By purchasing government bonds, central banks increase the price of the bonds, but damp down the yields, or rates of interest, on these bonds. It is particularly important that rates on e.g. 20-year bonds should be driven down low.
Within a month of the Federal Reserve starting large scale open market purchases of government bonds in April, 1932, corporate bond yields had started to fall decisively.
By buying up government bonds, the Federal Reserve or the Bank of England will increase the price of government bonds, and lower the yield – effectively the interest rate on these bonds. By lowering the rate on government bonds, central banks will help suppress rates across the board.
By lowering rates, they will begin to help companies, and stop the spread of insolvencies – the economic ‘virus’ at the heart of the crisis.
Two additional points: QE has to be applied early on in the crisis. If insolvencies are allowed to spread and engulf the whole economy, there comes a point when QE just cannot help. Second, in a highly synchronised, global economy, it is vital that central banks co-ordinate and co-operate to apply QE across the board. If applied in just one or two economies, the measure will not work. If it is not applied in the United States soon, then US insolvencies will cause unemployment to spiral higher, and will exacerbate global economic failure.
So the stakes are high, and the timing of QE measures vital.