Bill Jamieson: Danger of becoming addicted to QE

Over the past year the view has taken hold that the emergency action taken by central banks in the wake of the 2008 Lehman Brothers crisis has finally set us on the road to sustainable recovery.

It was five years ago this month that the giant US investment bank collapsed and sparked a credit panic and stock market slump worldwide.

The US Federal Reserve, quickly followed by other central banks, embarked on emergency measures on a scale without precedent. Hundreds of billions of dollars were deployed to buy bonds and mortgage loans and flood the system with ready cash. It followed this up in 2010 with the launch of quantitative easing. By June 2010 the Fed held bank debt, mortgage-backed securities and treasury notes totalling $2.1 trillion (£1.3 trillion).

But this proved not enough. Concerned that the US economy was not growing as robustly as hoped, the Federal Reserve embarked on further rounds of QE, culminating in September last year with a $40 billion a month debt purchase programme (nicknamed QE3) to help keep interest rates at near-zero levels. This was raised last December to $85bn (dubbed QE Infinity).

Encouraged by signs – at last – of economic improvement, Fed chairman Ben Bernanke signalled in June of this year he would scale back the QE bond purchases to $65bn a month. It was not well received. Money market interest rates rose, money was pulled out of emerging markets and stock markets dropped sharply round the world. Now the Fed has decided to hold off on scaling back QE. Its concerns are twofold: first, that America’s recovery is still tepid, with persistently high unemployment; and second, that a resort to tapering now would trigger renewed financial volatility undermining growth, job creation and global financial stability.

Monetary easing may have helped to calm markets in the immediate aftermath of Lehman, but has it really worked to effect a longer term economic uplift to the degree expected?

US GDP has fallen consistently relative to the pre-crisis trend and in the second quarter of this year was still running 14 per cent below this level. In the UK, the economy is running 18 per cent below its pre-2008 trend.

And fears that financial market instability may return suggest that QE has provided no sustainable reassurance that we are clear of the legacy of Lehman and the debt- fuelled bubble that preceded it. Indeed, concern that QE could even be moderately tapered – less spiking of the credit punchbowl – has caused interest rates on US Treasury bonds to rise by 100 basis points.

This matters here. The Bank of England has committed a total of £375bn to its own QE programme since it began its asset purchases in January 2009. The express aim of all this was to keep interest rates at their ultra-low level of 0.5 per cent. New Bank governor Mark Carney sought to underpin this with a “forward guidance” statement designed to give assurance that rates would not rise until unemployment had fallen to 7 per cent, a level that the Bank’s Monetary Policy Committee does not expect to be reached for some two years.

But this reassurance has barely lasted a few weeks. There are growing signs that financial markets are not persuaded of this guidance, and that rates may start to rise as soon as next year.

Is our recovery yet strong enough to contend with a change in the interest rate cycle? In addition to the impact this may have on demand for loans for house purchase, it is unlikely to encourage business investment, or a recovery in bank lending to business, particularly to SMEs.

And has QE really been as benign as its apologists claim? One immediate effect has been to heighten inequality, already a contentious feature of our economy.

It has done so by turbo-charging the prices of assets such as bonds, property and shares, delivering windfall gains for the owners of such assets but has done little for those who do not hold them. Indeed, it has thus widened the gap between the “haves” and “have nots”.

For developing countries, the effect of QE has been, first, to encourage a flow of money into risk assets as investors scrambled for returns, and more recently a rush for the exits as US Treasury yields have risen. It has also, through rock-bottom interest rates, made it more difficult for workers to accumulate a decent pension pot for retirement.

All told, there may have been too much of a rush to judgment on the benefits of QE and a readiness to assume that its withdrawal could be effected smoothly and without risk to the underlying economies. Of course, it may work in time to effect a sustainable recovery in the UK and in the US.

But the longer our reliance on it and the greater our dependence, the more it takes on the toxic dynamics of an addictive drug: we can only sustain a feeling of wellbeing by increasing resort to it.

Far from being followed by a retreat from excessive financial risk-taking, the danger is that such highly experimental policies have numbed our sensitivity to risk, an outcome likely to contribute to resource misallocations and ultimately to undermining the functioning of markets.

In a reaction that was both readily understandable but still bizarre, the US stock market marked the continuing reliance on artificial stimulus last week by surging to a new high. Debt-fuelled growth, it seems, far from being cauterised by Lehman, has been given a boost.

In truth, no credible judgment can be passed on whether QE has been a “success” until we have achieved a smooth exit from it and that growth is seen to be achievable without permanent reliance on a central bank standing on the street corner supplying the little black bag of goodies. And it is on the outcome of this that our fortunes in the period ahead critically hinge.

Twitter: @Bill_Jamieson