Quantitative Easing (QE) Explained: What It Is, What It Isn’t
Is QE an Effective Way to Generate More Demand Within the Economy or – as MMT States – Ineffective and a Driver of Inequality?
“Under quantitative easing, central banks flood the banking system with masses of money to promote lending.” NEW YORK (Reuters) Tue Dec 16, 2008
“Since lending is in no case ‘reserve constrained’, the ‘extra’ reserves do nothing for lending…The lower borrowing rates may or may not alter aggregate demand.” Warren Mosler – Quantitative Easing for Dummies
What you will learn:
What Quantitative Easing (QE) really is; how the Bank of England explains QE’s role; why orthodox economics supports QE as a demand stimulus; how MMT economists view QE as an asset swap; why QE doesn’t increase bank lending through reserves; QE and inflation in theory versus practice; why QE tends to increase wealth inequality and why fiscal policy is a more effective and direct tool to support the economy.
Technical Terms/Jargon Used in This Article
You will find definitions of all of the technical terms/jargon used in this article in my series of MMT Economic Jargon Buster articles. Paid subscribers can also download my MMT Dictionary.
A Guide to Quantitative Easing – From an MMT Perspective
In this article my intention is to explain the basics of Quantitative Easing (QE). What it is, how it works and what it’s (purportedly) for. I will set out the orthodox explanation of the role of QE and then follow up with a critique from an MMT perspective.
In summary, I might say something like, “it’s an awful lot of faff for not much effect - other than to increase wealth inequality” or, I might agree that it’s a useful policy tool to turn a failing economy around. If I was you, and you’ve read any of my previous articles, I’d put my money on the former.
First we need to know what it is. Here’s an explanation from the Bank of England (BoE):
“Quantitative easing is a tool central banks can use to meet an inflation target…we can buy bonds to bring down longer-term interest rates on savings and loans. This is sometimes called quantitative easing (QE). When we need to support the economy by boosting spending, we lower interest rates. That also causes inflation to go up. QE is one of two tools we can use to lower interest rates, particularly when Bank Rate is very low and there is limited scope to lower it further. “
To paraphrase – QE is a tool used to boost the economy when interest rates can’t be cut any further: for the BoE it is the policy tool of last resort. It works by pushing up bond prices, lowering bond yields, bringing down long-term interest rates and - if the wind is blowing in the right direction - boosting spending in the economy. The BoE also says it is a tool it can use to meet it’s 2% inflation target: a claim I will address later in this article.
Orthodox economists support the BoE story with theoretical underpinnings: cutting interest rates, combined with providing more ‘liquidity’ in the financial system, will directly lead to more investment. In layman’s terms – cheap loans lead to more business investment and will allow banks to provide those loans. Because, in the conventional story of banking, banks create loans based on a multiple of the reserves they hold at the central bank. In this article I examien both of these assumptions - and as you would expect – they are found wanting.
But first, what is QE and how does it works in practice?
If you have any questions or if you disagree with anything I write in this article, I want to hear from you. Please add your comments in the discussion area. Contrary views are welcome.
What is Quantitative Easing (QE)?
Here’s how MMT economist Bill Mitchell describes the mechanics of the process:
“Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. The aim is to create excess reserves which will then be loaned to chase a positive rate of return. So the central bank exchanges non-or low interest-bearing assets (which we might simply think of as reserve balances in the commercial banks) for higher yielding and longer term assets (securities).” Bill Mitchell - Quantitative easing 101
In layman’s terms, the central bank – in the UK, that’s the BoE – issues new money in order to purchase bonds from commercial banks (and other financial institutions). These bonds (in the UK they are called gilts) are held by commercial banks in their securities accounts, which are located at the central bank.
In practice, here is what happens:
The BoE creates new money and deposits it into the commercial bank’s reserve account.
At the same time, it removes the commercial bank's gilts from their securities account.
QE doesn’t increase the value of private sector assets
Commercial banks (and other financial institutions) now have more reserves but less gilts. Note, that the total value of assets held by the private sector hasn’t increased. What has happened is that gilts have been swapped for newly created reserves. This is an important point as it refutes the popular belief that QE is about pumping huge amounts of money into the private sector. In practice no additional value has been created or added to the private sector.
In other words, QE is not ‘a fiscal stimulus’. Its primary aim is to bring down long-term interest rates, increase bank lending and – through this circuitous route – increase demand within the economy.
Isn’t QE just ‘money printing’?
It’s easy to see why the headline story about QE is that it just a case of ‘the government indulging in endless money printing’, i.e. QE is about pouring money into the private sector. According to ‘Yale‑affiliated Program on Financial Stability’ in January 2019 (as a response to Covid), the BoE’s asset purchase facility (i.e. QE) expanded by a further £300bn (bringing the total to £745 bn). £300bn is a big number and big numbers make good news stories - as we can see in this Guardian article from 2020:
"Ever since the central bank began to print money and inject it into the financial system after the 2008 financial crash, its answer to any and all economic problems has been to print a bit more. Interest rates have moved up and down a little over the last 10 years, but in such a narrow range – from a high of 0.75% in 2018 and 2019 to the current 0.1% – that it has had only a limited impact. Quantitative easing on the other hand has expanded from £200bn in 2009 to £745bn today.” The Guardian – June 2020
And from the quote I added to the top of this article:
“Under quantitative easing, central banks flood the banking system with masses of money to promote lending.” NEW YORK (Reuters) Tue Dec 16, 2008
However, as we know, this is not ‘printing money’, in fact it’s not really spending at all it is merely an ‘asset swap’ (swapping reserves for gilts). An asset swap used, in the first instance, to manipulate longer term interest rates.
QE Isn’t Magic — It’s Just More Monetary Policy
QE is just monetary policy by another name, i.e. the go-to policy of the BoE and - as recommended by orthodox economists - it’s the policy that will fix all ills. MMT advocates point out (as is their want), that the evidence that monetary policy is the best way to stimulate demand or to control inflation is ‘thin on the ground’ and that there is a much more effective and direct route to increasing demand within the economy: and that is, to spend and tax, i.e. fiscal policy.
So why does the BoE persist in using the monetary policy approach? I can think of two main reasons. Firstly, manipulating interest rates is the only tool the BoE has control over. They have no power over spending and taxing. And secondly, orthodox economists (and thus the governments they advise) tend to be allergic to using fiscal policy. They just aren’t keen on using spending and taxing as a policy tool. They’re happy to leave that approach in the past – before neoliberal economists discovered how the economy really works (sarcasm in an article about QE?).
So, today when it comes to stimulating the economy or controlling inflation, the answer is the same as it was yesterday: more monetary policy.
“I don’t think quantitative easing is a sensible anti-recession strategy. The fact that governments are using it now just reflects the neo-liberal bias towards monetary policy over fiscal policy. What will motivate consumers to borrow if they are scared of losing their jobs? Why would a company borrow if they expect their sales to be depressed? The problem is a failure of demand which has to be addressed via demand measures – that is, fiscal policy. Overall, you can only take a horse to water ….!” Bill Mitchell
Before an examination of why this is not an effective approach, I’ll take a step back to explain why bond purchase will result in lower long term interest rates.
Why BoE buying bonds brings down long term interest rates
When the BoE buys bonds, it increases demand for those bonds — and that pushes up their price (standard supply and demand behaviour). Bonds pay interest, i.e. a fixed percentage of their original price (the original value of a bond is called the ‘face value’ or ‘par value’). For example, if you bought a bond with a face value of £100 and a 10 percent interest rate (this is called the coupon — the fixed annual payment based on the original price), you’d expect to get £10 a year for your investment. But if the price of the bond goes up, the return you get on what you paid goes down. If you bought the bond for £110, you’d still only get taht £10 back every year (until the bond ‘matures) — i.e. a smaller return on your investment.
The return on your investment is called ‘the yield’. So the higher the price you pay the lower the yield is on that bond: which is why these BoE bond purchases push down yields. Hang on to that idea - it’s connected to my next point.
How or why does the yield on government bonds affect general interest rates within the economy?
Yields on bonds affect general interest rates within the economy because banks and other financial institutions compare the return they get from holding safe government bonds to what they can earn from lending to customers.
Government bonds are risk-free so they act as a benchmark. For example, if the return on bonds is 2%, then banks will only lend to customers if they can get more than that — otherwise, it’s not worth the risk to provide the loan. They are in business to make a profit so they set their interest rate accordingly.
Banks have to compete for customers with other lenders, which puts downward pressure on the rates they charge. So, when bond yields are low, the rates they offer to customers fall.
In summary, when the BoE pushes down bond yields, it is also pushing down retail interest rates.
MMT advocates agree on one thing: QE can bring down long-term interest rates but little else – other than create more wealth inequality
MMT advocates agree that QE is a tool to bring down long-term interest rates but they don’t agree that it’s a good tool to control inflation (in this case, the BoE is trying to push it up to reach their 2% target) or that it’s the appropriate tool to increase demand within the economy.
MMT on QE: If That’s What You Want to Get To, I Wouldn’t Start From Here
The BoE outlines a chain of events that they say will boost the economy, i.e. buy bonds, because that will lower long-term interest rates and that will boost the economy because it allows banks to provide more loans. MMT sees several issues with this and point out that:
Banks don’t need reserves in order to make loans. The level of reserves banks hold is not related to their ability to provide loans.
QE has a weak impact on boosting demand within the economy as in practice it results from increased asset prices. Fiscal policy is a more direct approach and more effective. I refer you to‘Fiscal policy is effective, safe to use, and markets know it’ by Bill Mitchell and 'QE is a Tax‘ by Warren Mosler.
QE has little impact on inflation, as I explain below: historical data doesn’t support the idea that QE is inflationary.
MMT also points out that some of the assumptions behind the justifications for the use of QE are themselves spurious. For example, the idea that adding reserves enables banks to increase their lending is incorrect. I briefly examine this assumption below.
Banks don’t need reserves in order to make loans
“Available funds are not a constraint for the banking system. The constraints are regulated asset quality and capital requirements that are expressed in the rates banks charge. Not the total quantity of funds available” Warren Mosler - ‘Quantitative Easing for Dummies’
The idea that banks can only make loans based on the amount of reserves they hold. This is the 'fractional reserve banking' myth — the idea that banks can only lend a multiple of the reserves they hold.
This isn’t how banking works. When a bank gives someone a loan, it simply types the numbers into the customer’s account. (If it needs reserves to ensure it’s not breaking any banking regulations or to settle payments, that comes later.) What really matters is whether the bank thinks the business or individual it’s lending to has a sound plan, is trustworthy and has the ability to repay the loan.
When a bank makes a loan it’s not handing over something it already has. It creates a loan (an asset) and a matching deposit (a liability) by typing the value of the loan into the customer’s account.
If the bank does need reserves – for example, to settle up with another bank or meet a requirement – it can obtain them afterwards. It might borrow reserves from another bank or from the central bank.
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QE has very little effect on inflation
One of the stated aims of QE is that it allows the BoE to reach and maintain its target inflation rate of 2%. This is based on the idea that the use of QE will be inflationary, because:
BoE assumes that lower private sector interest rates will encourage businesses to invest rather than save.
BoE assumes that sellers of bonds now have more spending money.
BoE assumes that lower long-term interest rates will encourage spending rather than saving.
BoE assumes, and MMT advocates agree, that institutions, having sold their bonds, will invest elsewhere: in property, corporate bonds and equities. This will raise asset prices thus the stock market goes up and house prices go up, increasing household and business wealth.
Orthodox economists tell us that these activities increase demand, and that it is this demand that will push up prices. However, in practice there is little evidence that this is the case.
For one thing, those who hold bonds tend to be already wealthy and the wealthy have ‘a lower propensity to spend’, i.e. they spend a smaller proportion of any additional income they receive compared to those with lower incomes. And for another thing, evidence from the history of those countries that have used QE does not support the argument that it can be causes inflation. As Steven Hail points out:
“There’s no reason to expect QE to be inflationary. As far as the economy is concerned, if you understand that the banking multiplier is a myth and that lending by banks is not constrained by the amount that they’ve got in their exchange settlement account balances, you will understand this clearly. You will also understand this from experience. There’s been massive quantitative easing in a number of countries since 2008, and in the case of Japan it was going on before then. And quantitative easing on its own has never been shown to be inflationary. “ Economist Steven Hail – Foundations of Modern Money, Institutions and Markets
So, if QE is not good at generating demand within the economy and not good at managing inflation, what is it good for? MMT points out that one of the main things it is good for is increasing wealth inequality.
QE Exacerbates Inequality
The Bank of England itself admits that QE has a negative impact on equality - finding that on balance – it exacerbated wealth inequality within the UK. ‘The distributional impact of monetary policy easing in the UK between 2008 and 2014’ – Staff Working Paper No. 720 by Philip Bunn, Alice Pugh and Chris Yeates. See also ‘Quantitative Easing has increased inequality' By Rob Dix.
QE raises asset prices, which mostly benefits the rich who already own those assets. As I mentioned earlier, those individuals or businesses having sold their bonds, will look to put their money elsewhere. This will raise asset prices, for example, in property, corporate bonds and equities.
In conclusion QE isn’t the most effective way to generate demand within the economy - and in practice increases wealth inequality
While quantitative easing (QE) is promoted as a tool to boost economic activity by lowering long-term interest rates, in this article I have argued that, in practice, it has, in practice, a limited effect. What QE does well is push up asset prices, which primarily benefits financial markets more than the broader economy.
As Stephanie Kelton points out (The Deficit Myth) QE does little to directly increase spending in the real economy. What it does is redistribute existing financial assets rather than create new purchasing power for households and businesses.
In contrast, fiscal policy (government spending funded by its own currency issuance) directly injects money into the economy by paying for goods, services, and wages. This directly supports demand and economic growth without relying on a trickle-down effect from increased asset prices.
Warren Mosler and other MMT advocates point out that government spending is a more straightforward way to put resources to work and to boost demand. Mosler argues that relying on monetary policy tools like QE is a roundabout, inefficient approach, inflating asset prices without guaranteeing more jobs or production.
Fiscal policy, through targeted government spending and taxation, allows for a more direct control over where and how demand is created. Investing in infrastructure, healthcare, education, renewable energy and other related areas will have a more immediate and inclusive impact on economic wellbeing.
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Do you agree with my critque of quantitative easing? Add your comments below. I want to hear from you whether we agree or not.
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Resources
The distributional impact of monetary policy easing in the UK between 2008 and 2014 – Staff Working Paper No. 720 by Philip Bunn, Alice Pugh and Chris Yeates.
Quantitative Easing has increased inequality By Rob Dix
Kelton, Stephanie. The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, 2020.
Mosler, Warren. The 7 Deadly Innocent Frauds of Economic Policy 2010.
Mitchell, Bill, and L. Randall Wray. Macroeconomics, 2019 (Chapter on monetary vs fiscal policy).
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Thanks for sharing this and a must read. Its important to have an understanding of what QE is and how in reality it has done very little to grow the economy and instead has caused wealth inequality.
Richard Murphy has a slightly different take: Understanding QE https://share.google/SsnZw7HGEEuYwak6u.
He explains that it was largely a subterfuge to obscure the reality that the government was simply running a large overdraft at the BoE. In 2008 we were in the EU, and EU rules forbid govts borrowing from their CBs, so it was a piece of smoke & mirrors. That link offers text or a YouTube talk.