quantitative easing

By John Richards

Does quantitative easing work? Does it have unforeseen
consequences? Japan is the only economy in recent times to have tried a
full-scale version of quantitative easing for a significant period.

The
Bank of Japan lowered the policy rate to zero in February 2001 and then went to
quantitative easing the next month. It ended both quantitative easing
and its zero interest rate policy only in 2006.

In Japan’s
case, the mechanics were simple. The BoJ added reserves to the banking
system through open market operations and by directly purchasing government
securities from the secondary market.

The size of the
bond-buying operation (Rinban) became the policy tool to target the level of
reserves rather than the policy rate, which was fixed at virtually zero.

The BoJ’s monetary policy committee voted on the desirable level of
reserves and the size of the Rinban, much as it had previously voted on the
level of the policy rate.

And, when the economy deteriorated further,
the BoJ increased the Rinban, pumping up reserves. At its peak, reserves
reached around Y35,000bn of which only around Y8,000bn were required.

It is a matter of debate whether or not quantitative easing had
much impact on the Japanese economy, even though it coincided with the longest
expansion in Japan’s post world war two history (2002-2007). But, I think not.

Quantitative easing was nearly irrelevant to the expansion of
real economic activity that began in 2002. The expansion was largely
self-financed by corporations’ free cash flow and therefore not constrained by
an absence of banks’ lending.

Neither were there big liquidity problems
in Japan to be solved by quantitative easing. Capital injections and
guarantees to the banks had largely cured them well before the process began.

Money market rates were already low and their spreads were tight to the
policy rate. High oil and other input prices ended headline consumer price index
deflation, but the CPI less food and energy continue to be nearly flat even now.

This makes it hard to argue that quantitative easing ended
deflation; high oil prices did that. Meanwhile, the economy cured on
its own most of the structural problems such as excess capacity and too much
debt associated with the deflationary environment.

However, the
bond market during quantitative easing was anything but smooth. The process
ignited a bond bubble, whose eventual collapse destabilised financial markets,
even threatening Japan’s hard-earned economic recovery. Long- term interest
rates began to plummet in the spring 2002, with 10s reaching 0.48 per cent in
June 2003, down 120 basis points over the year.

The yield curve experienced a rolling flattening in which
successively longer maturities tightened down on the zero policy rate.

When the bond-bubble burst in June 2003, rates soared and the
curve steepened sharply. This created what in Japan is still known as
the Var-shock because of the sudden rise in yields and
the accompanying jump in volatility triggered when banks, which were using
similar risk management models, tried to dump Japanese government bonds at the
same time.

The effects on banks’ earnings were so severe that it raised
concerns that the economy would be plunged back into another 1990s-style period
of economic stagnation.

About all quantitative easing did on the
positive side for Japan was to help the BoJ keep its independence from the
politicians by giving the appearance of action.

The costs were the
shutting down of the money market, although it revived fairly quickly when QE
ended, and a dangerous bond-bubble, whose popping threatened the recovery and
destabilised the financial system.

One of the lessons of this
episode for policymakers is that while quantitative easing may help to solve the
short-run liquidity problems that arise in times of extreme financial duress, it
is not a substitute for some of the harder choices governments must make.

These include underwriting of systemic financial risks, e.g. by
guaranteeing bank deposits, the re-capitalisation (forced or voluntary) of the
banks, regulatory pressure on banks to disclose and write down the bad assets,
or the pressures on businesses directly via their banks to restructure and
deleverage or shut down.

A worst-case current scenario is that
policymakers rushing to quantitative easing fail to understand this, giving us a
bond-bubble but no permanent fixes of the underlying structural problems.

In that case, when the bond-bubble bursts, paradoxically, quantitative
easing will have increased systemic financial risks instead of decreasing them.