Steve Keen on the Tapering of Quantitative Easing

This is old, but still an interesting talk on quantitative easing and the end of that policy.



The graph of US private debt since 1830 that can be seen from 29.05 is particularly interesting to me, even though I do not know what data sources were used for the pre-1945 period. You can see the graph below.

As an aside, there appears to be a large fall in the level of private debt as a percentage of GDP from about 1915 to about 1919, which is very interesting since this must have preceded the recession of 1920 to 1921.

UK Deficit Spending, QE and Inflation: A Short Analysis

A commentator called “George” on the Cynicus Economicus blog has asked some questions about an earlier post of mine called
“Projections of the UK’s Interest Burden on Gilts as a Percentage of GDP”.

He states:

You merely state a percentage of interest payment against government spending but fail to acknowledge that this becomes unaffordable when lenders demand higher interest rate for the increased risk.

In fact, I have pointed out in the previous post that yields are low now precisely because the government has the tools at its disposal to control yields and hence the cost of its additional borrowing. These tools are open market operations and regulation of the portfolios of banks.

Bill Mitchell of Billyblog has shown how in a fiat currency with a floating exchange rate, the government has the power to control the yield curve:

Bill Mitchell, “Operation Twist – Then and Now,” March 31st, 2010

My views are entirely in line with his. George asks what will happen when lenders want to charge governments higher interest rates. The answer is that governments can decide for themselves what the coupon rate and yield rate will be.
The new Tory-Liberal Democrat government might refuse to use these policy tools, and that would be a foolish mistake on their part, and, if yields surge to a problematic level, then they will be responsible for it. But then again their austerity might reassure the markets – so it is difficult to know what will happen. And only yesterday there are indications that the new government will still use loose monetary policy this year:

Alan Clarke, U.K. economist at BNP Paribas .... tipped the BOE to announce £25 billion of extra bond purchases in August, and a further £25 billion in November.

Natasha Brereton, U.K. budget measures point to loose policy, Wall Street Journal, June 22, 2010

Furthermore, if my plan to nationalize the banks that accepted bailout money were implemented, then they could also purchase the issuance of new government bonds with the excess reserves they have at the Bank of England. This would help to keep yields down. The Bank of Engand’s £200 billion quantitative easing policy ended in February 2010, but there are still a lot of excess reserves in the system. These reserves are sufficient for new loans to be given to creditworthy borrowers as well as additional purchasing of government bonds when the private sector does not take them up.

It should be noted that in May 2010 the total UK public sector net debt was £903 billion, or 62.2% of GDP.

Since the public sector debt is £771 billion or 54% per cent of GDP if we exclude the bailouts and financial interventions, then nationalizing banks will be a good way to bring down the debt as a percentage of GDP in the future.

For the figures on debt, see here:

UK National Debt

The commentator “George” also claims that I

“previously have stated that governments can print without limit.”

But this is entirely false. I have repeatedly stated that there are real limits to money creation and budget deficits.

The level of money creation and stimulus for one country will depend entirely on its particular available resources, capacity utilization, unemployment, credit growth, external balance, and inflation rate.

George then asks what is the limit of UK money printing before inflation kicks in.

Most deficit spending is naturally inflationary, so presumably George means what is the limit of UK money printing before serious and very high inflation kicks in.

In 2009/10 the budget deficit will be about £178 billion or 12.6% of GDP.

My guess is that if the deficit rises to 15% or even 20% of GDP without austerity but with more stimulus, then this would cause serious higher inflation, which might be problematic. In the Weimar Republic, it is estimated that budget deficits were 50% of GDP, and in an economy suffering severe output shocks and crippling reparations.

Yet it is obvious that the UK is nothing like Weimar Germany.

For excellent analysis of Weimar hyperinflation, see here:

The Richebächer Letter, Number 417 June 2009 (p. 3 following).

George refers to the term “money printing.” It should be noted that this could mean (1) more open market operations (or the radical version of this called quantitative easing) or (2) budget deficits indirectly funded through QE and borrowing from private markets.

The fact is that QE is not inherently inflationary since in the present environment most of the new money just goes back to the central bank in the form of excess reserves, as is shown here:

Bill Mitchell, “Building Bank Reserves is not Inflationary, December 14th, 2009

Since credit growth is weak, a highly inflationary injection of money by this route is unlikely.

Direct central bank creation of money used to fund a budget deficit is undoubtedly inflationary. But this is not happening in the UK. At most, you could say that QE allows indirect funding of deficits. But a significant amount of the government borrowing is coming from private markets too, so money is withdrawn to match the money spent in the latter case.

The inflation figures for May 2010 show disinflation in the UK: the inflation rate slowed from 3.7% in April to 3.4% in May.

So clearly deflationary forces are at work, despite the budget deficit.

The projection for 2009/10 is that the government needs to borrow £178 billion or 12.6% of GDP. But austerity will cause deflationary forces.

Japan’s Quantitative Easing (QE), the Yen Carry Trade and QE in the US

I have recently seen two short essays comparing QE in Japan with that in the US:

"Quantitative easing in US and Japan".

Paul Krugman, “Way off Base”.

The monetary base in Japan rose by 70% from 2001–2006 and by 140% in the US from 2008–2010.

The Bank of Japan increased the base money from about 65 trillion yen in March 2001 to 110 trillion yen by 2006.

In the article above, Paul Krugman points out that, just because the monetary base rises rapidly, this does not necessarily mean that higher inflation must occur or is likely to occur – and Japan’s case proves it, as Japan continued to experience deflation down to 2006 despite its QE.

Needless to say, when QE was adopted in the UK and the US in 2009, we had many predicting hyperinflation for 2009 or the near future.

To take one example, the investment analyst and entrepreneur Marc Faber was interviewed by Glenn Beck on 28th May, 2009, and predicted that hyperinflation would happen in the US and that this was 100% certain.

It is obvious that there was no hyperinflation in 2009 and no signs of it now.
Many have correctly pointed out that Japan engaged in QE in the early 2000s, and no hyperinflation ever resulted. One response to this is that much of the money created by the Bank of Japan during QE was simply lent out for the yen carry trade.

The blogger Cynicus Economicus, for example, has argued that Japan did not experience high inflation because the printed money (that is, the excess bank reserves) went to the West via the carry trade (See “Getting carried away…” Trade & Forfaiting Review, 3 Dec 2009; "Easy money?" Trade & Forfaiting Review, 9 April 2009).

However, the view that all or most of the excess reserves created by Japan's QE were simply lent out in the carry trade is actually false.

First, the initial phase of the yen carry trade occurred from 1995 to October 1998 – before Japanese QE even began.

In addition, the second phase of the yen carry trade went from 1999 (again before Japanese QE began) to 2008:

despite the carry trade’s importance, no one knows for sure how large it really is. Mr. Kanno [an economist for JPMorgan Securities] estimates that about 7 trillion yen, or about $58.39 billion, flowed overseas last year [2006] alone. Another way to measure the trade is by the amount of assets now held overseas by all those involved in the trade since it began in 1999, when the Bank of Japan first cut rates to near zero. Mr. Kanno estimates those holdings are worth about 40 trillion yen, or around $330 billion …. Policy makers also seem aware that the carry trade is mostly driven by Japanese individuals trying to improve the return on their savings. Mr. Kanno of JPMorgan estimates that these individuals’ holdings overseas have grown to about 30 trillion yen since 1999, making up about three-quarters of all carry-trade-related investments. Most of the rest is held by foreign investors, he said.
Martin Fackler, “Bank of Japan Raises Short-Term Interest Rates,” New York Times, February 22, 2007.

So in fact that vast majority of all yen carry trade investors were Japanese savers, who were investing their own money that they had saved, not newly created money from QE.

Furthermore, the Bank of Japan rapidly drained the excess reserves and ended QE in March 2006, yet the yen carry trade continued. With the end of QE the Bank of Japan also ended its zero-interest-rate policy, and lifted interest rates slightly, though again the yen carry trade simply continued.

Tadashi Nakamae, in a 2007 article in the International Economy magazine, explains what happened:

The Bank of Japan undertook drastic steps to lower interest rates to save domestic banks and non-financial companies after Japan’s bubble burst. Easing the interest payment burdens of [banks] … was the most effective measure to rescue them. The victim of this policy was the household sector. Their interest income was wiped out. After peaking in 1991 at 39 trillion yen in returns from 600 trillion yen in interest-bearing financial assets (mostly bank deposits), households’ interest income has nose-dived to less than 5 trillion yen from 860 trillion yen in interest-bearing assets …. Zero interest rates also triggered a significant change among Japanese savers. An increasing number, who had traditionally favoured domestic bank deposits, are now looking abroad for better returns …. Japanese households have some 1,500 trillion yen—triple the size of Japan’s GDP—in financial assets (including the 860 trillion in interest-bearing instruments). The 15 trillion yen flowing overseas is just 1 percent of the total.

Tadashi Nakamae, “Weak Yen Conundrum: Why Japanese households love foreign financial assets,” International Economy, Winter 2007.

Thus there was more than enough money in Japanese household savings to fund most of the yen carry trade (and in 2010 Japanese savers still have about $15 trillion US in savings).

Even foreign investors probably could have borrowed yen for their carry trade operations from the Japanese money markets and the banks' own deposit base rather than massively drawing on excess reserves.

As an aside, the carry trade also caused significant depreciation in the exchange rate of the yen, as you can see in this graph of the trade weighted value of the yen (1980–2009). The fall was very steep.

It is likely that the fall in the yen’s value had a major role in the recovery of Japan’s economy in the 2000s by making its exports much cheaper on international markets. This factor was no doubt important, given that Japan is an export-led growth economy (Lok Sang Ho, “The Moral of Japan's Lost Decade”).

So the yen depreciation was actually beneficial.

With respect to the carry trade and the fall in the yen's value, the relevant policy instrument was the interest rate, which was driven down to zero by the Bank of Japan through QE. The expanding monetary base did this, but those reserves were not all suddenly lent out. When QE ended in 2006, the short term interest rate rose from nearly 0% to 0.25% – which was still a very low rate.

But, during the time of QE, the monetary base had been increased to 110 trillion yen by 2006, so the banks had more than enough money to lend into Japan’s domestic economy if they wanted to, yet domestic Japanese bank loans actually fell during most of the time in which QE was conducted and the broad money supply growth was slow.

The claim that the yen carry trade prevented the injection of the newly created bank reserves into Japan’s economy is obviously false. There were other factors that prevented a rise in bank loans.

Hyperinflation never resulted because bank lending is determined not simply by reserves, but by the number of creditworthy businesses and individuals and the willingness of banks to lend. In the uncertain environment of the lost decade and the slow recovery that followed it, Japanese business confidence was not that high, so borrowing and lending was not either.

Much the same thing has happened in the US. As of February 2010, the US banks were still not lending much:

David Rosenberg from Gluskin Sheff said lending has fallen by over $100bn (£63.8bn) since January, plummeting at an annual rate of 16pc. "Since the credit crisis began, $740bn of bank credit has evaporated. This is a record 10pc decline," he said ... The M3 broad money supply – watched by monetarists as a leading indicator of trouble a year ahead – has been contracting at a rate of 5.6pc over the last three months. This signals future deflation.

Ambrose Evans-Pritchard, “US bank lending falls at fastest rate in history,” The Telegraph, 17 February 2010.

In other words, the situation is similar to what happened in Japan during their experiment with QE.

You can get excellent graphs of the various US money supply measures and growth rates at Shadowstats.com (Monetary Base and Money Supply).

These confirm that the broadest US money supply measure (M3) is falling.

The most recent data from Forbes.com suggest that “for the three weeks between Feb. 24 and March 10, outstanding loan balances were flat. That represents the first three-week period without a decline since early 2008.”

But this doesn’t mean that lending will significantly increase any time soon, as there is still a lack of creditworthy borrowers and non-performing loans are a serious issue, as pointed out in the Forbes article.

One can also point out that even in an upturn banks are likely to return to conservative lending principles – and even if they did increase lending greatly they still only have a limited demand for credit from over-indebted borrowers, not enough to cause hyperinflation.