The Failure of Central Banking: Quantitative Easing

Commentary The world economy has been on a perilous road for over a decade. The Global Financial Crisis (GFC) that hit the world in full force in September 2008 led central bankers and the government to issue extra-ordinary measures to stop the financial sector from melting down. Governments, for example, issued blank guarantees to bank debt and deposits, re-capitalized banks, and the Federal Reserve setup liquidity-swap operations with other central banks to guarantee the availability of dollars. However, the most drastic innovation was the asset purchase programs of central banks named quantitative easing, or QE. The Bank of Japan ran a first-ever QE-program from March 2001 till March 2006. The program was deemed unsuccessful and canceled, but this did not stop central banks from enacting such programs during the GFC. During the first round of QE, launched on Nov. 25, 2008, the Federal Reserve bought bonds issued by Government Sponsored Enterprise and mortgage backed securities. In March 2009, the program was extended to include the US Treasury debt. Seemingly, the aim of the Treasury purchases was to stimulate investments by lowering the long-term rates and to support consumption by boosting the asset prices (bonds and stocks). While the theory and reasoning for the QE came later than the actual onset of the program, it seems that the Fed also wanted to artificially rise the prices of assets to create a wealth effect. The Fed thus assumed that by making people feel more rich, they would spend more, which would grow the economy. When a central bank buys assets through QE, it operates only through so called Primary Dealer banks which, however, are not often banks, but broker dealers. The central bank buys the assets, usually Treasuries, with newly created central bank reserves, which are ‘excess reserves’ to a bank. So, the central bank does not buy the assets with money, but with reserves, i.e., deposits at the central bank. If the seller is a bank, it ends up holding the excess reserves (in exchange for the assets). However, if the seller of the asset is a non-bank, e.g., a corporation, a hedge fund, a pension fund, another trader, etc., the reserves end up to the central bank account of the bank of the non-bank. These will be balanced with new deposits, which are owed to the non-bank. That is, assets are bought from non-banks with deposits. So QE programs force both excess reserves as well as new deposits into the banking system. These may have very different effects in the economy, as excess reserves flow only between financial institutions (banks), while new deposits are money entering the economy. From who did central banks buy the assets: banks or non-banks? Seth Carpenter, Selva Demiral, Jane Ihrig, and Elizabeth Kleea found in their paper, “Analyzing Federal Reserve asset purchases: From whom does the Fed buy?’” that, during QE1 and QE2 which ran between November 2008 and December 2012, the Fed bought Treasuries mostly from households, including hedge funds, and pension funds. Essentially what happened, during Q1 and Q2, was that the Fed pushed vast amounts of cash assets into commercial banks. When the Fed has shrank her balance sheet by selling the assets, in a program called quantitative tightening, QT, the opposite has happened. More on QT later. A figure presenting the time periods for QE- and QT -programs of the Fed and cash balances at the commercial banks of the U.S. (GnS Economics, St. Louis Fed) Where have the excess cash and bank deposits of households and investors gone then? According to research, “On the international spillovers of U.S. quantitative easing,” by Marcel Fratzscher, Marco Lo Duca, and Roland Straub, published in 2016, the first round of quantitative easing by the Fed led to flows towards U.S. assets, especially equities. The second and third rounds of QE led to capital flows outside the United States. Essentially this means that the cash, pushed into banks by QE programs, was used to speculate in the financial markets both in the United States and abroad. How did the excess reserves forced into the balance sheet of commercial banks change their behaviour? John Kandrac and Bernd Schlusche found in their research—“Quantitative easing and bank risk-taking: evidence from lending”—that excess reserves led to higher total loan growth and increased risk taking. That is, the QE program altered the net interest margins (between deposits and loans), the liquidity profile and the duration of the assets held by the commercial banks. These changes induced the banks to increase lending and to move their portfolio towards riskier lending activities. So what the programs of quantitative easing managed to do, was They led to massive speculation in the financial markets, and They led to increased risk taking in the banking sector. To summarize, QE programs have made both the banking and the financial system more fragile. Moreover, it can be argued that the massively

The Failure of Central Banking: Quantitative Easing

Commentary

The world economy has been on a perilous road for over a decade. The Global Financial Crisis (GFC) that hit the world in full force in September 2008 led central bankers and the government to issue extra-ordinary measures to stop the financial sector from melting down. Governments, for example, issued blank guarantees to bank debt and deposits, re-capitalized banks, and the Federal Reserve setup liquidity-swap operations with other central banks to guarantee the availability of dollars.

However, the most drastic innovation was the asset purchase programs of central banks named quantitative easing, or QE. The Bank of Japan ran a first-ever QE-program from March 2001 till March 2006. The program was deemed unsuccessful and canceled, but this did not stop central banks from enacting such programs during the GFC.

During the first round of QE, launched on Nov. 25, 2008, the Federal Reserve bought bonds issued by Government Sponsored Enterprise and mortgage backed securities. In March 2009, the program was extended to include the US Treasury debt. Seemingly, the aim of the Treasury purchases was to stimulate investments by lowering the long-term rates and to support consumption by boosting the asset prices (bonds and stocks). While the theory and reasoning for the QE came later than the actual onset of the program, it seems that the Fed also wanted to artificially rise the prices of assets to create a wealth effect. The Fed thus assumed that by making people feel more rich, they would spend more, which would grow the economy.

When a central bank buys assets through QE, it operates only through so called Primary Dealer banks which, however, are not often banks, but broker dealers. The central bank buys the assets, usually Treasuries, with newly created central bank reserves, which are ‘excess reserves’ to a bank. So, the central bank does not buy the assets with money, but with reserves, i.e., deposits at the central bank.

If the seller is a bank, it ends up holding the excess reserves (in exchange for the assets). However, if the seller of the asset is a non-bank, e.g., a corporation, a hedge fund, a pension fund, another trader, etc., the reserves end up to the central bank account of the bank of the non-bank. These will be balanced with new deposits, which are owed to the non-bank. That is, assets are bought from non-banks with deposits.

So QE programs force both excess reserves as well as new deposits into the banking system. These may have very different effects in the economy, as excess reserves flow only between financial institutions (banks), while new deposits are money entering the economy. From who did central banks buy the assets: banks or non-banks?

Seth Carpenter, Selva Demiral, Jane Ihrig, and Elizabeth Kleea found in their paper, “Analyzing Federal Reserve asset purchases: From whom does the Fed buy?’” that, during QE1 and QE2 which ran between November 2008 and December 2012, the Fed bought Treasuries mostly from households, including hedge funds, and pension funds. Essentially what happened, during Q1 and Q2, was that the Fed pushed vast amounts of cash assets into commercial banks. When the Fed has shrank her balance sheet by selling the assets, in a program called quantitative tightening, QT, the opposite has happened. More on QT later.

Epoch Times Photo
A figure presenting the time periods for QE- and QT -programs of the Fed and cash balances at the commercial banks of the U.S. (GnS Economics, St. Louis Fed)

Where have the excess cash and bank deposits of households and investors gone then?

According to research, “On the international spillovers of U.S. quantitative easing,” by Marcel Fratzscher, Marco Lo Duca, and Roland Straub, published in 2016, the first round of quantitative easing by the Fed led to flows towards U.S. assets, especially equities. The second and third rounds of QE led to capital flows outside the United States. Essentially this means that the cash, pushed into banks by QE programs, was used to speculate in the financial markets both in the United States and abroad.

How did the excess reserves forced into the balance sheet of commercial banks change their behaviour?

John Kandrac and Bernd Schlusche found in their research—“Quantitative easing and bank risk-taking: evidence from lending”—that excess reserves led to higher total loan growth and increased risk taking. That is, the QE program altered the net interest margins (between deposits and loans), the liquidity profile and the duration of the assets held by the commercial banks. These changes induced the banks to increase lending and to move their portfolio towards riskier lending activities.

So what the programs of quantitative easing managed to do, was

  • They led to massive speculation in the financial markets, and
  • They led to increased risk taking in the banking sector.

To summarize, QE programs have made both the banking and the financial system more fragile. Moreover, it can be argued that the massively increased cash and lending in the economy have, finally, led to increased demand and thus the programs have fed inflation that is now ravaging on. In a word, QE programs have been an utter menace to the economy.

What makes the situation even more problematic, is that central banks cannot really wind them down without bringing the financial markets and the economy down with them. The Fed tried this through the asset selling, or QT programs in 2018 and 2019, which led to the near-collapse of asset and credit markets, and the near-implosion of the repurchase agreement, or repo market. Now, the Fed is poised to try again, and we really cannot expect any other result.

Moreover, QE programs of the European Central Bank, ECB, have been the main reason, why the heavily indebted eurozone countries can borrow at very low rates. Or would lend to the government of Italy for 10 years with a yield of little over two percent? QT of the ECB would thus lead to the collapse of the sovereign bond markets in the eurozone, and to the unraveling of the European common currency.

Alas, central bankers have painted themselves into a corner with no way out. Now, due to hastening inflation they are forced try, which will, most likely, not go down well with the financial markets and the economy. Brace.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.


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Tuomas Malinen is a CEO and an associate professor of economics. He spent 10 years in academia studying economic growth, income inequality, and economic crises. Currently, Tuomas works at GnS Economics, a Helsinki-based macroeconomic consultancy specialized in scenario forecasting and analyzing and educating the populace on the various risks to the world economy and global financial markets.