Commentators like former US Treasury minister Lawrence Summers argue that instead of QE, governments should be spending our way to a stronger recovery by running higher deficits. But since there is little political will for this, others believe that QE is effectively the only game in town. The ECB, which was fiercely criticised from within the institution for resuming QE, has pointed to the benefits from the previous programme.
We could add that the concerns about speculative bubbles overlook the fact that a shift in demand towards riskier assets was precisely the objective behind QE. We intend to continue reinvesting in full the principal payments from maturing securities purchased under [the QE programme] … for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.
It is usually overlooked that QE has also led the central banks into an industrial role that is normally restricted to governments except the Fed, which works hand in hand with the US Treasury in this regard. Why were those firms and sectors targeted? The selection criteria are not always clear. Unsurprisingly, the investments have raised some political criticism.
Some have argued, for example, that the money should prioritise green energy firms and not the bonds of companies that trade in fossil fuels. At any rate, these central banks are now in the business of picking winners and losers in the corporate world.
As the Bank of Italy has admitted , the possibility of some of these companies going insolvent creates financial risks for the whole eurozone system. It should be said that there are echoes of the past in these interventions. The likes of the Bank of England and Bank of Japan have been involved in salvaging firms or entire industrial sectors after economic downturns before. Pensioners and those near retirement, facing low income from interest, may cut back further on consumption, weakening the economy.
Bolder pensioners, desperate to generate higher returns, may take undue risks — for example, investing in junk bonds — that could jeopardize their nest eggs.
And, unfortunately, such financial risk-taking may have little impact in terms of spurring corporations to assume more risk by investing. Similarly, a potential downside to quantitative easing is that low interest rates send capital to higher-growth, high-interest-rate countries. In practice though, as investors make money on their trades, they bring in yet more money, forcing further currency appreciation. All too often, the process does not end smoothly but in a crash.
No wonder recipient countries resist inflows of hot capital. We also know little about how smooth the exit from quantitative easing will be. In theory, as the economy picks up and interest rates begin to climb, central banks will simply pay higher interest rates on their reserves, so that they can finance their holdings of long-term securities and shrink them slowly.
Even if some of these losses are offset for the government as a whole as the central bank loses on its holdings of government debt, the treasury gains in equal measure, because the debt it owes is worth less , the losses on long-term private debt holdings are real.
Moreover, the argument that losses are offset is not easy to explain to the public. Will opinion be sympathetic to the Fed when politicians like Ron Paul excoriate it for losing tens of billions of dollars monthly on its asset holdings?
Will bond markets fall sharply and interest rates rise as markets fear that the Fed will be pushed to sell its enormous holdings in short order? By creating the impression that something beneficial is being done, unconventional monetary policy relieves pressure on politicians. So, when central bankers argue that they are the only game in town, they are ensuring that outcome.
Central bankers nowadays enjoy the popularity of rock stars, and deservedly so: their response to the difficult and uncertain environment during and after the financial crisis has been largely impeccable. But they must be able to admit when they are out of bullets. After all, the transformation from hero to zero can be swift. Please enter your email address and click on the reset-password button. If your email exists in our system, we'll send you an email with a link to reset your password.
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