Money-printing caused muddle and mess
Central banks’ quantitative-easing programmes (buying bonds with newly created money to bolster growth) have failed and left taxpayers with a huge bill, says Philip Pilkington. Policymakers are in denial
Inearly February, to almost no fanfare, the Treasury Committee released an extensive report on the Bank of England’s quantitative tightening (QT) programme. QT was the Bank’s attempt to reverse the quantitative easing (QE) programmes it had pursued intermittently over the last 15 years. QT aimed at removing some of the money that the Bank had pumped into the broader banking system by selling some of the large quantities of assets that they had accumulated throughout QE. While the Treasury Committee’s report was nominally about QT, it also had to consider the QE programme itself and its long-term effects.
The report found that the unwinding of QE was proving extremely costly and that these costs were being borne by the Treasury – and, through the Treasury, by the taxpayer. The Committee estimated that “annual losses in each of 2023 and 2024 will amount to £40bn, eroding the cumulative £124bn positive cash flow that was generated up until September 2022”.
In only two years, 65% of the gains that the assets had accumulated in the previous 13 years would be lost. At this rate, all the gains would be wiped out by 2025 and thereafter the programme would be incurring major losses. And all of this is based on the rosy assumption that inflation does not make a comeback in the coming months and years. If it does, the losses will be even larger.
The Committee expressed concern about this situation: “Notwithstanding the operational independence of the monetary policy… it strikes us as highly anomalous that decisions have been and are being taken concerning huge sums of public money without any regard to the usual value-for-money requirements”.
This is a pertinent criticism indeed. Recall that in 2022 Liz Truss announced tax cuts in her mini-budget that would cost £30bn. When the new prime minister announced this the bond markets had a heart attack; the Treasury and the Bank of England then leaned on the prime minister and she was out of the door shortly after. Yet the year after this debacle, the Bank itself would be costing the Treasury £40bn annually until at least 2024, and not a whisper.
“BEN BERNANKE REFERRED TO HIMSELF AS A ‘GREAT DEPRESSION BUFF’”
Furthermore, the Committee uncovered evidence from expert testimony that the Bank’s QE programmes that had created these problems were ill-defined. Experts could not really agree on what goals QE had achieved. Some stated that the first round of QE was good for the economy, but subsequent rounds were not. Economists admitted in testimony that it was next to impossible to gauge the impact of the programme. The Bank itself seemed unable to offer a coherent, testable narrative about what the programme that was now costing the country a small fortune had achieved.
A JAPANESE DISEASE
Quantitative easing is now almost a quarter of a century old. Shortly after the terrorist attacks on New York City on 11 September 2001, the Bank of Japan announced that it would increase the intensity of a new monetary policy it was experimenting with: quantitative easing, or QE for short. For many years, the Japanese economy had been experiencing falling prices and economic stagnation. It was hoped that this new type of monetary-policy intervention would lift the economy from its slumber.
At the time in the Western world few were paying attention. There was little time to consider an obscure operation being undertaken by the Japanese central bank when the prospect of major terrorist attacks on Western countries was looming. Yet in the bowels of the Western central banks, many economists were paying attention. In a note written in November 2001, for example, the Federal Reserve Bank of San Francisco (FRBSF) considered the measures undertaken by the Japanese with some scepticism.
“A modest expansion in the growth rate of the money supply is likely to have a limited expansionary impact unless it is accompanied by the public’s expectation of higher future inflation rates,” the note stated, “and quantitative easing is not likely to change inflation expectations.”
While Western banks were sceptical about the Japanese central bank’s attempts to fight deflation with QE, they were nevertheless forming a theoretical picture of what was going on – a theoretical picture that would be applied to the Western economies less than a decade later. The FRBSF argued that the Japanese economy was in a “liquidity trap”. This is a situation in which “interest rates on short-term assets have been driven to zero”. Monetary policy had effectively run out of juice.
Since rates could not obviously be lowered below zero, the central bank was unable to stimulate the economy further. This is where QE came into the picture: rather than simply aiming at lowering interest rates, the central bank could flood the banking system with cash balances to try to force the banking system to extend more loans.
A year after the FRBSF put out its note, an economist from the US Federal Reserve’s board of governors gave a speech in Washington DC. “The US government has a technology, called a printing press,” the economist said. “By increasing the numbers of US dollars in circulation the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising prices in dollars of goods and services.”
This was a much more aggressive interpretation of how QE worked and what it could do than the one put out a year earlier by the FRBSF. The economist who gave the speech, whose name was Ben Bernanke, considered himself a disciple of Milton Friedman’s monetarism.
BEN BERNANKE’S BIG BET
Bernanke was an expert on the US economy during the Great Depression, referring to himself as a “Great Depression buff in the same way some people are Civil War buffs”. Described by Reason magazine as a “libertarian-leaning Republican”, Bernanke was convinced that his favourite economist was correct in his interpretation of the Great Depression.
Friedman had argued that the key cause of the Great Depression was that the money supply in the United States had fallen precipitously. He reasoned that if the Fed had been less cautious as the Depression had started to set in and flooded the banking system with newly issued money, the economy would soon have recovered.
When the banking system started to go into meltdown in 2008, Bernanke was well placed to observe and diagnose events. In 2006, he had been appointed chairman of the Fed by George W. Bush. From the beginning of the crisis Bernanke viewed it, correctly, as a historic moment; the closest America had come to having another Great Depression since World War II.
“We have learned from historical experience with severe financial crises that if government intervention only comes at a point at which many or most financial institutions are insolvent or nearly so, the costs of restoring the system are greatly increased,” Bernanke said in the speech in Washington DC in October 2008.
What started as an effort to save the banks soon transformed into an aggressive and proactive QE programme by the Federal Reserve. One month after Bernanke’s speech in DC, the Federal Reserve started by buying $600bn in mortgage-backed securities. By March 2009, the central bank had bought $1.75trn of bank debt, mortgage-backed securities, and Treasury notes. Bernanke had received the opportunity to experiment with the policies advocated by his hero Friedman, and he had done so with gusto. After Bernanke’s foray into QE, no serious economist could any longer say that the policy had never been tried.
As the years rolled on, so too did the QE programmes. The second round, QE2, came in November 2010 and the third, QE3, in September 2012. By the time a fourth round had been launched by Bernanke’s successor in response to Covid in 2020, the policy was no longer an innovative and experimental monetary policy. Rather, it had become standard operating procedure. For a man with only a hammer, everything looks like a nail – and QE was now being used for everything from cleaning up banking crises to tackling global pandemics.
Along the way, the policy had picked up no shortage of critics. We will never know what Friedman thought about the endless iterations of Bernanke’s QE policy, as he died in 2006, but his co-author Anna Schwartz was still alive and perfectly willing to voice her opinion. In a 2009 op-ed published in The New York Times and entitled “Man Without a Plan”, Schwartz argued against Bernanke being reappointed Federal Reserve chairman.
She argued that Bernanke had indulged in aggressive monetary easing without a clear plan of how large it would be, what its goals were, and when it should be reined in. Rather, she wrote, Bernanke stumbled from one QE programme to the next while each round led to ever more disruption in the financial system.
HERDLIKE BEHAVIOUR
As is so often the case, other central banks around the world did not do their own homework when it came to post-crisis policy. Instead, they copied the homework of the United States. The international economics community has an awful tendency to move slowly and in a herd, with specialist journals suggesting which direction the herd should go in next. The Bank of England’s QE programme kicked into gear in March 2009. The Bank accumulated an enormous hoard of purchased assets: £175bn by the end of October 2009.
Bernanke’s interest in the Great Depression had by now spread to the rest of the economics profession. In a speech explaining the rationale for the Bank of England’s QE, David Miles, a member of the Monetary Policy Committee, the very first paper cited was from Bernanke’s book on the Great Depression. Miles went on to lay out a monetarist argument that would have made Friedman proud.
Miles’ presentation was no doubt his own, but in terms of his ideas he was copying his homework. If Bernanke was a man without a plan, as Schwartz said, then the Bank of England had simply copied the actions of a man without a plan. They outsourced their policy to the Americans and assumed that the Americans knew what they were doing.
“BY THE TIME COVID ARRIVED IN 2020, QE HAD BECOME STANDARD OPERATING PROCEDURE”
The never-ending QE programmes implicitly assumed that inflation would never return. In the wake of the 2008 financial crisis, and the slow economic growth that followed, it became fashionable to say that the economy was in permanent stagnation owing to various imbalances – from trade imbalances to income inequality. This metanarrative allowed central bankers to ignore the awkward question of what might happen when QE had to be reversed. It also allowed them to avoid the awkward matter of what might happen to the value of the assets that they held if inflation appeared.
Sadly, for the proponents of QE, inflation did indeed appear. In Britain inflation emerged on the scene in 2021 in response to pressures placed on the supply side of the economy by the lockdown policies. Most economists and central bankers did what they thought was the sensible thing to do: they buried their heads in the sand. They simply denied that inflation was a problem and insisted that it was transitory and would pass. It did not pass. In Britain inflation peaked at the end of 2022 above 11%. Inflation was not transitory.
This explains why the Treasury Committee report has revealed both large losses accruing to the government and a lack of ability on the part of economists to clearly explain what the point of 15 years of QE actually was. The basic model of the economy that the Bank’s economists held in their head – one that would be perpetually in deflationary stagnation – was wrong. The stagnation has largely remained, but the deflation has given rise to inflation. Although they will not admit it in public, the economists who promoted QE did not believe that this would happen – indeed, many probably did not believe that it could happen. But it could happen, and it did happen and now they do not know what to do.
That is the dirty little secret that the Bank does not want to get out: no one really knows what to do. The model of a perpetually deflationary economy that most policymakers and commentators adopted in the past 15 years is dead and there is nothing to replace it. This is not discussed in polite company because there is nothing to replace this model. That explains, to a large extent, the otherwise surprising lack of attention that journalists are giving to the shocking Treasury Committee report.
The report has revealed not just that the emperor, in this case the Bank of England, has no clothes, but that his entire entourage is also naked. And in this entourage is everyone from financial-market players to academic economists to financial journalists. In such an embarrassing situation it is in everyone’s self-interest simply to pretend not to notice the rampant nudity.
BOND INVESTING AMID UNCERTAINTY
While the shenanigans at the Bank of England have ramifications for the whole country, they also have more immediate consequences for those who hold part of their wealth in British government debt. Rising interest rates have meant falling bond prices. These declines in the value of bonds are particularly extreme because of the effects of the QE programmes.
As interest rates get closer and closer to zero, their impact on bond prices increases. This is known as “convexity”. This means that when QE pushed interest rates ever lower, the sensitivity of the bond price to future interest rates increased. It is also as if central banks that engage in QE are pulling on an elastic band and the moment they stop pulling, the elastic band snaps back, stinging their fingers.
In 2022 especially we saw the elastic band of very low interest rates snap back in dramatic fashion. A recent report by the pensions regulator found that British pension funds lost around £425bn in that year. This represented an overall fall in asset value of nearly a quarter. The financial press has been keen to blame this on Truss’s mini-budget, but the reality is that the main driver is the Bank’s QE and QT programmes. Since bond holdings are supposed to be the more stable component of investors’ portfolios, this raises the question of whether savvy investors might be able to offset this risk.
“THE ECONOMISTS WHO PROMOTED QE DID NOT BELIEVE INFLATION COULD RETURN”
QE is not just a British problem. Central banks across the developed world pursued these policies in lockstep. Still, diversifying your portfolio away from simply holding British government bonds makes sense. You will be better insulated from major market volatility, such as we saw after Truss’s ill-fated mini-budget. It also insulates an investor from the ever-present risk of the decline of sterling. In 2023 Britain ran a current-account deficit of nearly 5%, all of which is financed by capital inflows that can easily reverse in a recession, so building protections into your portfolio is wise.
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