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Tilting at windmills: the Faustian folly of Quantitative Easing


In a recent Real World Economics Rev blog [1] Prof Steve Keen argued, using simple accounting principles, that banks are not able to “lend out their reserves” under any circumstances. And in a subsequent blog [2] he stated that this inability undermines a major rationale given by central bank economists for undertaking Quantitative Easing (QE).

According to Keen: “Large increases in bank reserves brought about through central bank loans or purchases of securities are a characteristic feature of the unconventional policy approach known as quantitative easing. The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets. (Bernanke 2009, ‘The Federal Reserve’s Balance Sheet: An Update’) “

Keen makes the point that the only thing banks can do with the excess reserves provided by QE is to “buy other assets”. They cannot use that liquidity for lending in any direct sense. However:

“.. rather than rescuing central bankers from folly, this escape clause [buying financial assets] is an unwitting pact with the devil: they are now caught in a Faustian bargain. Any attempt to terminate QE is likely to end in deflating  the asset markets that it inflated in the first place, which will cause the central banks to once more come “riding to the rescue” on their monetary Rocinante.

“While central bankers can personally still join Faust and ascend to Heaven — thanks to their comfortable public salaries and pensions — the rest of us have been thrust into the Hell of expanding and bursting speculative bubbles, hoisted on the ill-designed lance of QE.

“Bernanke’s QE instead maintained the symptoms of the crisis, but did nothing about its cause. It generated rampant inequality, drove asset prices sky-high, and caused frequent financial panics — while doing nothing to reduce the far too high a level of private debt which caused the crisis. “Keen then comments that: “Banks come out of [the exercises in QE] as rather innocent: they can’t do what Ben Bernanke (and now Prof Joe Stiglitz) are berating them for: not only can’t they lend out excess reserves, they can’t get rid of them either. It’s not their fault that the only way they can individually attempt to do so amounts to playing “hot potato” — trying to reduce their reserves while simultaneously boosting another bank’s reserves — by buying assets, since this is what .. Bernanke .. intended them to do in the first place. However, these misunderstood institutions are nonetheless ‘crying all the way to the bank’ with the risk-free earnings given them by QE. ”

In other words, commercial banks have been given a free lunch, in the form of interest paid to them by the central bank on their excess reserves.

Moreover, “the only ways in which reserves can be reduced are (a) by the central bank taking them back or (b) by the public’s withdrawal of money from deposit accounts as cash. Under the dynamics of QE in itself, reserves can only increase (i.e. so long as the interest on excess reserves is positive – – which may be one unstated reason why central banks are now implementing negative rates, if anyone inside them has actually worked this out).”

Keen then states that “QE increases the money supply — not via lending, which is impossible, but via asset purchases, which far and away benefit rich households more than poor ones. Rich households also benefit from the income that share transactions generate. And finally, some of that money will get to poor households when the rich ones — made richer still by QE — buy some services off them.”

In summary, Keen believes that the real economy has received some impetus from QE, but that only a relatively trivial amount of the money created by that process has found its way into circulation within Main Street. This is consistent with the analysis of U.S. economist Prof Michael Hudson, who has repeatedly stated that Bernanke’s “helicopter” has dumped money onto Wall Street, not Main Street.

Keen’s concluding remarks are indeed unsettling: “The bubble before the financial crisis had already exaggerated income inequality past what is sustain- able in a capitalist society.

Central bank meddling via QE has made this problem worse, and without the illusion of a boom (like the internet and subprime bubbles) to make it seem somehow palatable. It has done this, not only by giving money to the super- rich, but by inflating [financial] asset prices, driving them well above the increase in consumer prices and wages. Now stock markets worldwide are falling again, partly in response to the Fed’s tentative and foolish attempts to unwind its original bold and foolish intervention into inflating asset prices. But it will be dragged back in again if it attempts to unwind QE, because all the dynamics … works in reverse as well. So long as it continues to believe that sky-high asset prices are actually good for the economy, it can’t afford not to continue meddling in them. ”

Readers should consult the two blogs listed for the accounting analysis which underpins the above statements.

Dr Steve Keen is Professor of Economics and Head of the School of Economics, History and Politics at Kingston University in London.




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