Quantitative Easing and its dangers in an inflationary environment

Does a large budget deficit and the associated public debt burden really matter that much if the Bank of England finances it through asset purchases?

 

It is generally agreed during this pandemic that the government should spend vast sums of money to maintain income levels and prevent unemployment rising as much as possible so avoiding potential “scarring” of the economy ie a permanent reduction in productive economic output. There are also times dependent on the state of the economic cycle but also when investment in infrastructure and other forms of capital spending including on humans that means it may be appropriate to run a significant deficit.

 

If a budget deficit is financed through the issuance of government bonds which are purchased by investors (pension funds, insurance companies, households and overseas investors) then the degree to which one can do this successfully will depend on the existing policy credibility of the country, how much more is to be borrowed, the potential growth rate and the global background including the level of world long term interest rates. If a country has to borrow at very high interest rates (whether it is from abroad or not) then the debt burden could escalate and the interest payments will account for an ever higher portion of government spending so potentially squeezing out other spending.  Indeed a simple equation used in economics proves the debt burden will likely “snowball” ever higher if the (real) average interest rate of borrowing is greater than the (real) GDP growth rate.

 

In the UK, the government was in a very strong position to borrow coming into the pandemic aided by strong policy credibility thanks in part to its actions to tackle the deficit previously as well as by the very low global long term interest rates. Moreover, it has not had to borrow from abroad, and the borrowing has been very long-term so avoiding any rollover risk, reducing interest rate sensitivities and maximising the use of low borrowing rates now. Average debt maturities are around 13 years albeit on the decline.

 

It was conventional theory (as I learned it) that a country should borrow to fund any fiscal deficit (i.e. debt financing) if it can rather than finance it by printing money (ie monetary financing). Printing money was a sure way to generate inflation and lead to all the adverse consequences associated with inflation. The extremes of such a path which resulted in hyperinflation were of course seen in the Weimar Republic and in more modern times in Zimbabwe and Argentina.

 

However there are now new arguments which are complex and controversial, that says Bank of England purchases of assets, principally government bonds, known as Quantitative Easing (QE) may be a sort of free lunch. It is also referred to as “unconvential” monetary policy. As a result, increasingly, the UK deficit (and elsewhere) is being financed by QE. It still entails the creation of (electronic) money known as Reserve Money which is part of MO base or narrow money. However, it might not translate into M2 broad money (i.e. remaining largely within the financial sector) preventing it from largely entering the real economy and which is used to buy goods and services, and therefore affecting inflation. Such funding is approaching one-third of the gross public debt burden and being in the form of central bank reserves they only pay an interest rate of some 0.1% much lower than gilt yields.

 

The empirical evidence from the first big wave of QE after the global financial crisis (GFC) is that QE was not inflationary with M2 growth not growing excessively. However, the GFC was a deflationary phenomenon. And particularly important was that banks did not create new bank loans so preventing the operation of the classic money multiplier – they preferred to shore up their own balance sheets and regain profitability. 

 

However, there are real dangers that this will not be the case this time after the pandemic. The world is a potentially much more inflationary place after the initial deflationary impact of the pandemic itself. This reflects explicit coordination of expansionary monetary and fiscal policies (led by the US, but also the UK and the EU), the increased bias it seems of  central banks towards inflation including higher inflation targets (underpinned by a reluctance to raise bank rate given the massive amount of QE), the move back to de-globalisation (and no favourable China deflationary effect) and the disruption of international production chains. Indeed evidence is already concerning. Most notable and most importantly is the US, where M2 growth exceeds 20%yoy, input prices and commodity prices have surged, there are supply constraints and shortages (even in the labour market), and retail price inflation is also now picking up markedly. Nevertheless, some prominent economists still think inflation will not persist with classic “wage-price spirals” not taking off. I am not convinced.

 

So to sum up QE is really an experiment. Under the right circumstances it looks like it can play an important positive role, but we are now in different times than after the GFC and there is a real risk that inflation will not only rise to higher levels but stay there without tough action.