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Saturday, 23 August 2014

Trickle-down quantitative easing

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(Reuters) – Some boats are lifted a good bit higher than others, it seems, when it comes to the effects of quantitative easing. A Bank of England study, released last week, showed that its £325bn of bond purchases have disproportionately benefited the wealthiest, driving up the value of the assets they own.

James Saft, Reuters Columnist

Standing as we are on the eve of what many expect to be another round of QE – in the US and possibly elsewhere – it makes somewhat depressing reading; yet another example of crisis mitigation in which advancing the interests of the well-off plays a central role.

QE drove a 26% rise in shares above where they otherwise would be, in turn fuelling a nominal increase of almost a trillion dollars in household wealth in Britain, though with the richest 5% owning 40% of financial assets those gains were hugely slanted towards the wealthiest.

Quantitative easing, as distinct from simply lowering interest rates, acts on the economy through channels several of which tend to push asset prices higher. First, most simply and most powerfully, when a central bank creates money and buys a government bond the person selling it is faced with a question of what to do with the money. Many will elect to plow the money back into shares and corporate bonds, boosting prices.

As well, the liquidity created by QE - ie. the money sloshing around the markets – will tend to support prices by artificially raising confidence that the market will be there if and when an owner wants to sell an asset.

There are good reasons to suspect that both of those types of gains are at least in part illusory, though in the here and now it is real money which owners can access, borrow against or swap into other assets like houses.

While QE will improve the earning power of corporations, via the wealth effect from higher asset prices and more generally through higher overall economic growth, it seems unlikely, to cite the BOE’s figures, that it has raised the long-term value of corporate earnings by the 26% it has raised the price of a share in those earnings. That very well may leave shares vulnerable; in need of either more QE, which may show diminishing returns, or, less likely, an actual economic recovery.

Assumptions that the market would always be there and welcoming were in part what got financial institutions – and savers – in trouble in 2008

The so-called liquidity premium may also not last forever. Remember, assumptions that the market would always be there and welcoming were in part what got financial institutions – and savers – in trouble in 2008.

A real, if unequal, boost

None of this is to say that QE doesn’t boost economic growth: it clearly does. What it also does, however, is to favour some over others. It is also unclear, at best, if financial markets-based QE will, over the long term, produce a good risk-adjusted return.

Charles Evans, of the Chicago Federal Reserve, is part of a minority advocating for much stronger policy. Evans, speaking on Monday in Hong Kong, called for the Fed to start buying bonds and keep buying them until unemployment shows an extended improvement, a tactic which would, if followed, perhaps reduce the upward skew of benefits. Cleveland Fed President Sandra Pianalto, in contrast, was much more circumspect, arguing that there were limits to what monetary policy can achieve.

The final say will doubtless be made by the Federal Open Market Committee when it meets in September, but Ben Bernanke’s speech this Friday at the Jackson Hole conference sponsored by the Kansas City Fed should give an idea of the likely outcome.

The other, and ironic, impact of QE not covered in the Bank of England report is that it acts, in essence, as a subsidy for financial intermediation. The big winners, almost certainly, are not just those with assets that rise in price due to QE but also those who make their living out of financial markets. Very much like the special treatment given to the banking industry, this is another example of reward for bad behaviour and market failure.

The way out of the debt crisis is two-part. First, reduce debt, preferably gently. QE obviously has a useful role here. The real point, however, is to increase the productive capacity of the economy, preferably of things which can be exported

This must be especially bitter for the BoE which seems, overall, well aware that Britain is far too dependent on its financial sector.

Ultimately, the way out of the debt crisis is two-part. First, reduce debt, preferably gently. QE obviously has a useful role here.

The real point, however, is to increase the productive capacity of the economy, preferably of things which can be exported. QE may well retard this process as it continues to give primacy to financial intermediation, which itself has a strong track record of mis-allocating capital away from export industries and towards where the greatest rents can be extracted by, you guessed it, those in finance.

Even those who benefit may someday regret quantitative easing.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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