Understanding the Effects of Quantitative Easing
1. Overview of Quantitative Easing
Quantitative easing is a tool that central banks have used over the last decade to inject money into the economy where it is needed. The vagueness of both the means of injection as well as the destination of the “new” money is exactly why QE has become so popular: it is very dynamic. QE can be utilized in a multitude of economic situations, many of which this paper will cover. A more technical definition of QE is that when a central bank practices quantitative easing, they initiate large-scale asset purchase programs of either mortgage-backed securities (MBS), corporate bonds, or government bonds, and in return, they provide money or reserves to these institutions either as a form of liquidity in times of crisis or to incentivize lending during periods of slow activity.
- “The Swap:”
QE is often referred to as the swapping of assets for cash. This does capture most of what QE aims to accomplish, but there are other elements. The reason why it is a swap is that commercial banks, financial institutions, and sometimes companies are in dire need of money, whereas central banks do not need the MBSs or corporate or government bonds. Thus, the central bank allows a swap to happen where they take on the risks or consequences attached to the aforementioned assets while gaining little in return. The question then becomes, why do banks resort to QE and not other forms of open market operations or other monetary policy tools? Quantitative easing is highly effective during a liquidity crisis because unlike lowering the federal funds rate, which becomes ineffective as it approaches zero, QE can result in a direct swap without speculating the direction of the money, especially when people are not showing any signs of increased consumption despite low interest rates.
2. Brainstorming Consequences
Quantitative Easing is intimidating to many. The manipulation of trillions of dollars in the economy can arouse fears of inflation, interest rate changes, or excessive power from the Federal Reserve. On the contrary, many might see benefits to this unconventional monetary tool by examining its aid in liquidity, its role in easing distressed assets, or its effectiveness compared to other open market operations. Both sides will be thoroughly examined with descriptive and quantitative data.
- Liquidity and Distressed Assets
As monetary economists often say, there exists a point at which monetary policy becomes ineffective because interest rates have reached near-zero levels, and consumption is still not rising. At this point, a “liquidity trap” has seemed to occur, and monetary policy is then disregarded. Quantitative easing seeks to emerge out of this liquidity trap by adding liquid assets or credit to distressed institutions. Liquidity is critical during an economic downturn because firms need liquid assets that can be converted to cash to pay off debts or invest in new capital expenditures for future growth. During these downturns, firms’ assets can severely depreciate if they are overvalued.
The prices of these assets crashed amid the bubble popping, but QE was able to take these distressed assets off the balance sheet of the financial institutions who held them and replace them with liquid assets or reserves to increase their liquidity. The Federal Reserve added MBSs to their assets on their balance sheet and credited reserves to the banks that previously held those distressed assets. Alongside distressed assets, it is critical to consider the effect on liquidity that QE had. In a paper on QE’s effect on liquidity creation, academic researchers in Dublin, Ireland, constructed a model that depicts the liquidity creation-to-total asset ratio before and during the three rounds of QE. Interestingly, QE was unable to lift this measurement to pre-2008 levels, possibly hinting at limits to what QE can accomplish during a liquidity crunch. This may show that like many other monetary policy tools, QE can only do so much to bring market conditions back to normal.
Perhaps the most notorious effect associated with QE is a change in the price level. Most people who do not grasp the idea of asset swapping would like to think that QE is simply printing money. This is an easy conclusion to come to, but it is critical to correct. The notion of printing baseless money to inject into the economy in hopes of spurring consumption is “helicopter money,” which is a concept that Milton Friedman wrote about in 1969, but unlike QE, helicopter money would entail simply growing the money supply without compensating for this increase on the other side of the balance sheet. Helicopter money is important because if all else remains unchanged, increasing the money supply via direct payments to individuals will lead to more money circulating, thus bidding up the price level. Simply put, all else equal, helicopter money will lead to inflation. Quantitative easing follows a different pattern. Because QE is an asset swap, the money that is given to the financial institutions or companies after they exchange their assets (MBSs, corporate bonds…), is used for liquidity or to pay off debts. It has a role that it must fill before becoming freely circulating cash that can bid up the price level.
Another reason that commercial banks in particular prevent inflation after QE is a policy tool known as “interest on reserves” and also “interest on excess reserves.” This tool is a new way for the Federal Reserve to keep member banks’ reserves high so that they would not be lent out excessively, which could cause inflation. After the QE rounds following 2008, the additional reserves that banks carried totalled up to $2.7 trillion, and in May of 2020 following QE rounds for COVID-19, that same metric reached $3.2 trillion. The Fed used these tools as a way to finance more lending measures during the crisis of 2008 by creating new reserves that they knew would not be drastically lent out. Peter Ireland of the Cato Institute explains this rationale perfectly.
However, by paying IOER, the Fed hoped to place a floor beneath which the funds rate could not fall, since no bank will lend reserves in the federal funds market at rates below what it can receive on its deposits at the Fed.
This clears up the myth that QE sparks hyperinflation, or any sort of drastic price level change. Another aspect to consider when discussing price levels is that QE is generally applied during times of significant deflation, which usually occurs during a recession. If by some measure lending substantially increased, then the worst that could happen is that prices level off to pre-crisis values, or if they exceed, they could remain below the two percent target rate that the Federal Reserve and other central banks practice. The point is, an asset swap is not pure money creation, and especially during a time of low liquidity, deflation, and distressed assets, inflation in the general price level is one of the last effects to be concerned about when QE is enacted.
- Moral Hazard
The aforementioned consequences of QE, both positive and negative, were quantitative and involved real economic variables. Moral hazard is an entirely different consequence. This effect demonstrates the political power that comes with such impactful tools. If they are used irresponsibly, how will our economy and the firms that make it up behave? When the Federal Reserve assisted the purchase of Bear Stearns from J.P. Morgan, or bailed out AIG, what message did they send to the typical American company? Is the message of competitive capitalism and free markets that your reckless lending, ignorance of necessary liquidity, and indulgence in uncontrolled greed can earn you billions of dollars from the Federal Reserve? Quantitative easing, when used as a tool to bail out distressed companies, poses a significant threat to the free enterprise protocol in market economies. Markets incentivize proper lending behavior, and if firms willingly deviate from this order and suffer immense losses as a result, they simply go bankrupt and face the consequences of their own risk. Irresponsibility leads to consequences, and these consequences should incentivize responsibility. When the Federal Reserve flips this equation, why should we expect companies to adhere to free market standards of business? This is one of the chief concerns of QE as a means of advancing political goals. The Federal Reserve and its monetary policy have been independent from Congress and other legislative power for decades, but after regulations and laws like Dodd-Frank, that independence has been reduced. Left-wing members of Congress like Alexandria Ocasio-Cortez (D-NY) have championed ideas like the Green New Deal and universal healthcare, all of which require massive spending initiatives. Quantitative easing offers a tempting means of payment, but this should not be the future of QE. This tool was not created to fund government expenditures, but rather to act as a last resort way of spurring liquidity and consumption during an economic downturn.
3. Historical Lessons
Even though we have examined countless data to understand liquidity, interest rates, inflation, and more, we have yet to construct a clear view of the historical success or failure of QE. In the United States, QE substantially grew household refinancing activity after the Fed initiated QE1, which led to increased household net worth because by financing at an even lower rate, the house pays less for their mortgage and has more money to delegate to other forms of consumption. Other studies show that by QE3, the U.S. finally saw positive changes in employment, but QE1 and QE2 were ineffective for the labor market. Other economists and historians like Brian Domitrovic have scrutinized QE because of the length of recovery. Growth rates from 2009-2017 were barely higher than 1929-1939. This comparison is critical because Ben Bernanke, the central banker who orchestrated QE, famously criticized the ineffective policy following the Great Depression. Perhaps QE will be looked at as a semi-effective monetary policy tool that spanned half a decade only to score marginally higher growth rates when compared to the worst depression our economy has seen. Thus, the general success story of QE in the U.S. is still incomplete. There needs to be other unconventional tools to compare it to in order to truly see its value. We should also wait until a decade has passed since QE was activated during the COVID-19 pandemic to also analyze its effects. The age of QE makes it significantly harder to genuinely appraise.
4. Conclusion: QE - A Tool or Weapon?
Quantitative easing is unique. In his final weeks as Chairman of the Federal Reserve, Ben Bernanke joked that QE works in practice but not in theory. The balance sheet dynamics, variety of asset classes that it involves, and countless economic variables that it impacts makes QE truly one of a kind. There are conclusive benefits in terms of liquidity structuring, the handling of distressed assets, and risk tolerance. There are inconclusive consequences, especially with regards to inflation, stock market increases, and interest rates. There are definitely drawbacks regarding moral hazard and the independence of the Federal Reserve.
This prompts the question of if QE is a tool or a weapon. After analyzing the effects, it seems as though QE is a tool with spikes. If you swing it the wrong way, you can hurt yourself. The benefits outweigh the drawbacks because any negative consequence has ways of mitigating those effects. Quantitative easing possesses the power and flexibility to mediate future economic downturns, and as we monitor the impact of past QE initiatives, it is critical to understand the effects for a variety of economic variables so that policymakers can maximize its effectiveness and minimize its drawbacks.
1) Ospina, Juan & Uhlig, Harald. “Mortgage-Backed Securities and the Financial Crisis of 2008: a Post Mortem” Becker Friedman Institute, no. 2018-24, 2018, Accessed 29 June 2021.
2) Kapoor, Supriya and Peia, Oana, The Impact of Quantitative Easing on Liquidity Creation (April 28, 2020). Available at SSRN: https://ssrn.com/abstract=3587467 or http://dx.doi.org/10.2139/ssrn.3587467
3) Nickolas, Steven. “What Is the Difference Between Helicopter Money and QE?” Investopedia, 2020, www.investopedia.com/articles/personal-finance/082216/what-difference-between-helicopter-money-and-qe.asp.
4) Chen, James. “Excess Reserves.” Investopedia, 2021, www.investopedia.com/terms/e/excess_reserves.asp.
5) Heller, H. Robert. “Will Paying Interest on Reserves Endanger the Fed’s Independence?” Cato Journal, vol. 39, no. 3, 2019. Crossref, doi:10.36009/cj.39.3.6.
6) How Quantitative Easing Works: Evidence on the Refinancing Channel; The Review of Economic Studies; vol. 87, Issue 3; May 2020; Accessed 4 July 2021
7) Stephan Luck and Thomas Zimmermann, “Ten Years Later—Did QE Work?,” Federal Reserve Bank of New York Liberty Street Economics (blog), May 8, 2019, https://libertystreeteconomics.newyorkfed.org/2019/05/ten-years-laterdid-qe-work.html.
8) Domitrovic, Brian. “QE Was A Failure.” Forbes, 15 Dec. 2020, www.forbes.com/sites/briandomitrovic/2019/05/01/qe-was-a-failure/?sh=3beb5124518a.