By Chaahat Khattar
The tulipmania has been known as the mother of all economic bubbles. It happened much before the Great Depression of 1929 and it was the beginning of legalisation of greed. Tulips were brought from Turkey by the Dutchmen because of their intense petal colour, which to the Dutch, became a status symbol. One bulb of tulip became so precious in Netherlands that people exchanged their complete estates and acres of land for it. Soon some prudent men started selling tulip which created a domino effect and the price of tulip crashed. At the peak of the market, a person could trade a single tulip for an entire estate and at the bottom, one tulip was the price of a common onion.
Back then, taxpayers’ money had little effect and the economy usually corrected itself. However, with time, the pace of industrialisation multiplied and now we have trillion dollar economies.
The economic recession of 2008 was all about moral hazard. In a moral hazard, you hold no responsibility for any wrong that you commit. The United States of America’s central bank, the Federal Reserve (the Fed) allowed Lehman Brothers to collapse in the hope that other large investment banks would learn from their mistakes and eventually stabilise. However, the amount of risky (or toxic) assets that these large investment banks were carrying in their books of accounts was monumental. It was too late for the economy to correct itself and the Fed needed to immediately take corrective action.
Money is an essential part of any modern economy. We do not function under a barter system and the unit of measurement for goods and services is money. Today, money is also the mechanism to measure an economy. In a stable and free economy, the central bank of a country gives money to banks and these banks allow the public to borrow from them. The public then uses that money to buy goods and services from the firms/industries which produce them. These entities invest their surplus with banks, thereby creating a flow of money in the system. Such free flow of money leads to economic growth.
During the economic recession, the system of free flow of money was completely blocked. People were not borrowing from banks, banks stopped borrowing from each other (leading to highest ever inter-bank interest rates), people stopped spending and the growth of the firms/industries started contracting. From an economic perspective, the Gross Domestic Product (GDP) of the economies started to suffer. GDP is equal to the money supply in the economy multiplied with the velocity of that money supply.
For this, the Fed initially decided to go for a capital injunction (heavy increase in the money supply) into the banks so that they could lend it further to the people. The problem here was that for a capital injunction, the banks would have to make the Fed a shareholder. This would give the Fed a significant say in the operations of the bank – a situation that the banks wanted to avoid. The whole process was nothing less than nationalisation and for a capitalist economy like the USA, it was not a sustainable solution.
Also, the Fed brought down the interest rates (to as low as 0%) to make borrowing cheaper. This flooded the banks with too much liquidity and the system failed. The cheap money did not lead to higher spending or investment. Instead, the banks borrowed heavily to invest in high-risk assets, not allowing the money to reach the average spender.
The other route available with the Fed was to buy the assets from the banks, that is, government banks, mortgage-backed securities etc. By doing so, the Fed intended to ease the capital injunction into the economy without leading to speculative activities by the financial institutions.
This came to be known as Quantitative Easing (QE).
QE was initiated to increase the money supply and to restore confidence in the individuals.
In a QE cycle, the central bank buys assets, usually government bonds, with money it has or, more accurately, created electronically. It then uses this money to buy bonds from investors such as banks or pension funds. This increases the overall amount of funds in the financial system. Making more money available is supposed to encourage financial institutions to lend more to businesses and individuals. It can also push interest rates lower across the economy, even when the central bank’s own rates are just about as low as they can go. This, in turn, should allow businesses to invest and consumers to spend more, giving a knock-on boost to the economy. Such digital creation of money prevented the recession of 2008 from becoming a mammoth, irreversible one. However, QE is not the printing of money but creation of it through electronic ledgers (mere entries in the books of accounts). To understand it better, let us take a look at the balance sheets of the actors involved. Here is what the balance sheets of each institution, showing the assets on the left and the liabilities on the right, look like before quantitative easing:
Now, as part of QE the central bank buys up all the bonds that Bank ABC holds. What do the balance sheets look like now?
Bank ABC has only shuffled the composition of its portfolio around. It has exchanged bonds for reserves in just an asset swap. There is no increase in the size of its balance sheet. The central bank’s balance sheet, on the other hand, grows substantially. On the asset side, it gains 40 bonds and on the liability side, reserves increase by the same amount. What is important to note here is that there is no change in cash (what we know as money) in the hands of the public. The whole operation leaves the Treasury’s balance sheet unchanged. No new bonds are issued, no revenues are received. Quantitative Easing therefore simultaneously increases, a) the amount of central bank money which is used by banks use to pay each other, and b) the amount of commercial bank money (deposits of people and companies). Of the two, only the deposits can actually be spent in the real economy as central bank reserves are just for internal use between banks and the central bank.
So we can see that while the central bank’s balance sheet does expand, the only impact in the private sector is the change in the composition of the banks’ balance sheets, which is, exchanging bonds for reserves. QE swelled the Fed’s balance sheet enormously. Its vast bond-buying programme took the balance sheet from about USD 870 billion in August 2007 to USD 4.5 trillion in 2015. However, the total assets of the private sector did not change. Hence, no money is being created any more than, say if someone sold their stocks and put the money into bonds.
The background of the QE is more interesting. When the central bank announces that it is going to buy the bonds, the banks run to buy the same (this is known as front running) from wherever possible. Then banks sell the same to the central bank at a higher price and get more money. This leads to a win-win situation. The central bank enjoys high demand for its debt and ultra-low interest rates. This is particularly critical for a country like the USA where the debt is to the tune of trillions of dollars. The financial institutions, on the other hand, enjoy high profits at very low risk. The central bank gets a lot of money into the system further driving down the interest rates. The QE also lowers the income which an investor may get from safe assets (risk-free securities such as government bonds). They become less interactive in the market.
The investors, therefore, invest in riskier assets such as shares, other bonds and real estate. The stock markets shoot up restoring confidence into the industries and the people.
The other side of QE is little worrisome. After all, when you are artificially pumping money into the system, you are bringing down the value of the currency. It can upset a lot of people. Especially the ones who have large stakes in the assets of an economy. China has a lot of dollar-dominated assets in its kitty and if the dollar goes down, they will have a tough time calculating the losses. Also, as part of QE, the commodity prices go up leading to inflation.
On the other hand, the QE boosts the government and consumers to import new goods and services from other countries. These goods and services are more or less coming in for free. The problem is that sooner or later, other countries end up getting sick of exchanging goods and services for, what they feel, are worthless sheets of paper. In other words, the value of the importer’s currency decreases, which can discourage exporters. China stopped exporting valuable minerals to the USA due to its quantitative easing program.
And what if the central bank stops QE? The simple direct relations explained above would be reversed and the consequences may be worse. The central bank would start selling bonds to the banks, the bond prices will go down, interest rates will rise and the stock prices will become less attractive. Industrialisation will again be destabilised. QE is also not the solution for all types of economies. Japan ran a QE regime from 2001 to 2006 and is still in deflation. The reason their QE didn’t work was because even with interest rates at zero, nobody wanted to borrow. There was no demand for loans. Bank lending started falling on a year-on-year basis in November 1998 and was consistently negative until September 2005.
What is more important to note is that QE has no impact on the real growth of an economy. The prosperity of an economy is unchanged. Real wealth comes from real work and real people and not artificial money. Money is not wealth, it is merely a claim on the wealth which, if created artificially, can to lead to inflationary periods.
Studies suggest that QE did raise economic activity marginally and avoided a meltdown which could have put a full stop on various economic activities globally. But some worry that the flood of cash has encouraged reckless financial behaviour and questioned the ability of the emerging economies to handle cash. Others fear that QE may choke off recovery. It also creates over dependence on the fact that someone is holding your back and you can continue to be speculative. Last spring, when the Fed first mooted the idea of tapering, interest rates around the world jumped and markets wobbled. Prudent central bankers around the globe are adopting other methodologies to boost the economy. Some are granting money directly to the government and allowing it to invest directly into the real economy, thereby creating real wealth. While some others are reducing their dependence on QE and allowing the institutions to correct themselves.
Chaahat Khattar is an ardent economist and is working with an international consultancy firm. He is an MBA and pursuing Masters in Business Laws. He is also a Harvard University alumnus and a certified financial modeller. He has keen interest and experience in authoring research papers and case studies and have contributed to various renowned journals. Chaahat can be reached at [email protected]