Sunday, 25 January 2015

Quantitative impotence

For all of my 50 year career as a teacher of economics I have  taught that a central bank can control the quantity of money in its economy by a process called Open Market Operations.  If the central bank  wants to increase he quantity of money in the economy it buys (government) bonds on the Open Market: if it  wants to contract the quantity of money it sells bonds.  In order t  help students remember which way round the process works I used to point out that LESS is more or less  SELL backwards, so to make the money supply LESS the Bank SELLS bonds.

For some reason totally beyond me this well established process is now called Quantitative Easing (QE) and many commentators seem to think it is something new.

Keynes acknowledged the importance of "monetary policy," to give it another of its names: after all, the great work is called "The General Theory of  Employment, Interest and Money " (my emphasis). But he was sceptical about the effectiveness of expanding the money supply to stimulate demand in a recession. He famously compared it to "Pushing on a piece of string."  For further and better particulars see

The reasons for the ineffectiveness of monetary expansion are that:

a)  households are not inclined to borrow (unless desperate) when, in a situation of unemployment or job insecurity, they are not confident of being able to pay back, and
b)  businesses are not inclined to borrow for investment if they see no or little demand for the products they would like to sell.

This was the experience in the Great Depression of the 1930s, when a loose monetary policy coupled with very low interest rates were ineffective in stimulating demand and thus reducing the level of unemployment.

Hence Keynes argued that the most effective method of influencing the level of economic activity was through fiscal policy: taking demand out of the economy through higher taxes and lower government spending to curb a boom, and injecting demand through lower taxes and higher government spending to stimulate demand in a slump.

A third problem with monetary policy is that the government has no control over what, if anything, is going to happen to the extra money.  My memory is now vague, but I seem to recall that when Edward Heath's Conservative government relied on monetary expansion way back in the 1970s the result was not a recovery of the whole economy but a boom in the price of commercial property. The recent bouts of QE in both the US and the UK have been used to shore up the reserves of the banks, and a cause  booms in asset and house prices.  Investment in the productive parts of the economy has been minimal, for reasons a) and b) above.

Consequently I doubt  that the QE programme now initiated by the ECB will do much to revive the European economy.

It is extremely frustrating to have to spell out, metaphorically in words of one syllable, reasoning that has been so commonplace that way back in the 90s even 18 year old pre-university students were asked in an examination to comment on the assertion that "relying on monetary policy alone to revive an economy  is like "playing golf with one club."  For further and better particulars of the source of that simile click here.

Expansionary fiscal policies are  what are needed to revive the economies of the Euro-zone.  What such central economic authority as the Zone has should be calling in finance ministers to discuss  the varying degrees on which borrowing rules can be relaxed  to facilitate public investment  and allow the more depressed economies to recover.

What is most frustrating is that we in the UK, not being in the Eurozone, have no need to ask anyone's permission. We could "just do it" if one of our political parties had the guts to put the option forward.

Step forward the Liberal Democrats, heirs of the  party of Keynes.

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