Quantitative Easing Redux
A couple of weeks back, I posted on the topic of “quantitative easing,” the policy of having the central bank aggressively purchase government (and possibly corporate) debt in the open market ostensibly to increase the money supply.
I argued that at best, quantitative easing was a pricing operation that worked at the margin by increasing demand for a given asset class. Since then, the Bank of Canada has more or less announced that it will engage in this policy, with details forthcoming in its April 23 Monetary Policy Report.
Now, Bill Mitchell — a fellow traveler in the Post-Keynesian world (from Australia) — has posted a more comprehensive analysis of quantitative easing which makes the point that the very term “quantitative easing” implies a misunderstanding of how money and monetary policy work in a modern economy.Â Â I don’t want to pre-empt Dr. Mitchell because he does a bang-up job of making everything crystal clear, but I do want to emphasize four points that are absolutely crucial for understanding this issue:
Proposition 1: Banks create money every time they make a loan.Â They worry about reserves (or settlement balances in Canada) later (again, see the excellent Baumol and Blinder textbook (canadian version by Marc Lavoie and Mario Secceraccia) for a detailed analysis).Â Even the Bank of Canada acknowledges as much, when it notes: “Commercial banks and other financial institutions provide the greater part of assets used as money through loans made to individuals and businesses. In that sense, financial institutions are creating money.” Contrary to what you read almost everywhere in the media and from the industry itself, banks don’t “borrow first and then lend (so-called “on lending”).Â They lend first, then if need be (and this is a settlement balance and liability management issue), borrow.
Proposition 2: The Bank of Canada — and most modern central banks operating in sovereign currency environments — are quantity takers and price setters.Â That’s why they’ve stopped measuring esoteric versions of the money supply. That’s why they gave up on monetarism in the 1980s — they couldn’t make the definitions do what they said they should.Â That’s why they call money supply “a residual.”Â Incidentally, this proposition follows from, and is integral, to the first.
Proposition 3: If the Bank of Canada is contemplating “quantitative easing,” that means it is also contemplating a zero target for the overnight rate, as Bill makes clear.Â I should have insisted on this point in the previous post.
Proposition 4: The financial system has not matched the Bank of Canada’s price declienes (i.e., lowering of interest rates) because of default risk and, to a limited extent, because their cost of borrowing on international markets for foreign currency– and perhaps as well, their liability management efforst — have gone up (and, incidentally, a big chunk of the increase in chartered bank lending — of which the Canadian Bankers Association is so proud — is due to lending in foreign currency to Canadians, presumably exporters who are struggling — see the Bank of Canada’s Weekly Financial Statistics for details).Â The international interbank lending market is a mess, as any look at LIBOR reveals (although things have improved of late). Quantitative easing won’t change either fact except perhaps through some secondary effect on expectations.