Uncharted Territory

March 17, 2009

Lex Share Quantitative Easing Misconceptions

Filed under: Concepts, Credit crisis, Economics — Tim Joslin @ 8:55 pm

Lex, let’s – get it? Oh, never mind.

It’s one thing when the Guardian, BBC and Indy worry about quantitative easing funds “leaking” abroad, it’s another when the FT’s Lex does it. Here’s what they’ve written today:

“…the most subtle and perhaps most pernicious leak comes from monetary policy. This is most evident in the UK’s quantitative easing policy, which involves chucking some £75bn at the gilt market to bring down yields. This will supposedly push investors to look for returns further along the risk spectrum, first by buying top-rated corporate debt, then even riskier loans. But QE might just as well push pension fund managers, constrained by mandates, to buy highly-rated foreign corporate bonds where yields have not been compressed by QE. This is more than an intellectual leak in the UK’s policy framework. It’s a hole.”

But, by engaging in quantitative easing, the Bank of England isn’t increasing the UK’s money supply, it is increasing the supply of sterling. And sterling can’t possibly “leak”. A country’s currency and the economy within its territorial borders are different, usually closely overlapping, things. Quantitive easing affects the currency, not the economy directly. Any transactions – investments or tourist spending – undertaken in dollars or euros will be entirely unaffected by QE until a conversion is made to sterling (which will be worth less than would otherwise be the case because there’s more of it).

How can I explain this? Maybe we should consider the example of physically printing more dollars. This will increase the supply of dollars everywhere in the world, not just in the US, but also, for example, to Ecuador (which uses the dollar rather than its own currency), to Zimbabwe (which has started to use the dollar), to middle-class Russians distrustful of the rouble, to a million tourists around the world carrying dollars rather than their own currency, and, for that matter, to Colombian drug-dealers.

Lex says “QE might … push pension fund managers … to buy highly-rated foreign corporate bonds.” Sure, but to buy those bonds, the pension fund will have to sell pounds to someone else (assuming the corporate bonds are denominated in a foreign currency) who will then have to do something with the sterling. It’s impossible to control what is bought, but certain that more sterling will be circulating. Worst case, it will be left on deposit in a bank, but this will support lending and spending that way.

It’s entirely erroneous to imagine that pounds created by the Bank of England can “leak” away.

Btw, the misconception that QE can “leak” is similar to that behind the under-estimation of the problem of trade imbalances. It arises from a misunderstanding of the nature of money. It’s now (mostly) not gold, not even paper, and can no longer be passively stored. It is always put to use.

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