by Ann Pettifor, 8 March, 2009. There is much confusion about the meaning and impact of QE. This is an attempt to summarise what it means, what it does not mean, and how it can be effective in preventing insolvencies by lowering interest rates.

I am indebted to Graham Turner of GFC Economics for sharing his knowledge and experience of Japan’s use of QE with me. Graham spent time in Japan during the years of that country’s Credit Crunch which began in 1990, and is also knowledgeable about the 1930s when QE was adopted by policy-makers.  Japan adopted QE eleven years too late – in 2001, but has since then kept interest rates below 2%.

Graham notes that Ben Bernanke’s book “Essays on the Great Depression” ‘contains no reference to Quantitative Easing…there is astonishingly little analysis of the monetary policy response that secured recovery (in the 1930s) in any of Mr. Bernanke’s essays.’

First lets remind ourselves that a bond is like a loan. The issuer is the borrower, the bond holder is the lender.  So when I buy a bond from the Federal Reserve or BoE, the governors of these banks are issuing a bond (‘I promise to repay on this date…at this rate…’) and I am trusting their word with my money. Bonds, like loans, usually have a fixed term, or maturity. The interest rate on the bond is known as the ‘coupon’, and is what the issuer pays to the bond holders.

Rates on company or corporate bonds are important because they determine whether companies can afford to borrow to invest, to pay wages or to manage cash flow. They determine whether entrepreneurs can take risks – and invest, e.g. in green technology.  If they can’t do any of these things they declare bankruptcy, and lay off their employees.

Above all interest rates determine whether companies can afford to repay the huge debts dumped on them by lenders, so-called ‘private equity’ companies and other financial institutions during the inflation of the credit bubble.

Interest rates on government and corporate bonds can be lowered by QE – purchases of government bonds by central banks and the shifting of these bonds out of the market, and on to the balance sheets of central banks.

The first myth to dispel is that interest rates are currently low. Base rates may be low, but the rates that companies pay, as Warren Buffett has argued is at ‘record levels’.  He tells shareholders that “highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels.  Though Berkshire’s credit is pristine – one of only seven AAA corporations in the country – (its) cost of borrowing is now far higher than competitors with shaky balance sheets but government backing.”

Graham Turner shows that ‘average yields on loans for non-investment grade companies in the UK rose to 31.66% on the 4th March, 2009.’ These are bankrupting rates.

The second myth to dispel is that QE is about ‘printing money’. QE is not about directly using liquidity  injections to boost the supply of money. As we have learned to our cost, plenty of liquidity has been injected into banks, but this has not slowed the pace of bankruptcies. As Turner notes: ‘money supply (M) is entirely endogenous, and depends on the structure of borrowing costs being secured through bond purchases. ‘  It will be vital for the Bank of England to set a long term interest rate target, and to use the purchase of government gilts to reach that long-term, and low target.

QE is about preventing debtors from defaulting. This is done by the Central Banks targeting lower rates of interest e.g. for 30-year bonds (or loans), and achieving this by purchasing government bonds and taking them on to their balance sheets, (It can be used to purchase corporate bonds, but is more effective in bringing down all rates, if used to purchase government bonds.)

These purchases are known as ‘open market purchases’.  By purchasing government bonds,  central banks increase the price of the bonds, but damp down the yields, or rates of interest, on these bonds. It is particularly important that rates on e.g. 20-year bonds should be driven down low.

Within a month of the Federal Reserve starting large scale open market purchases of government bonds in April, 1932,  corporate bond yields had started to fall decisively.

By buying up government bonds, the Federal Reserve or the Bank of England will increase the price of government bonds, and lower the yield – effectively the interest rate on these bonds. By lowering the rate on government bonds, central banks will help suppress rates across the board.

By lowering rates, they will begin to help companies, and stop the spread of insolvencies – the economic ‘virus’ at the heart of the crisis.

Two additional points: QE has to be applied early on in the crisis. If insolvencies are allowed to spread and engulf the whole economy, there comes a point when QE just cannot help. Second, in a highly synchronised, global economy, it is vital that central banks co-ordinate and co-operate to apply QE across the board. If applied in just one or two economies, the measure will not work. If it is not applied in the United States soon, then US insolvencies will cause unemployment to spiral higher, and will exacerbate global economic failure.

So the stakes are high, and the timing of QE measures vital.

Readers of this blog are astute and fully briefed on this, the first, fully synchronised global financial crisis in history. You are all aware that yesterday, in an unprecedented move, the Bank of England created £75 billion – out of thin air -  to revive the deflating body that is the British economy. You will know that the US banking system is falling apart, and the stock market is spiralling downwards. That the US Labor Bureau has just released unemployment figures showing that more than 650,000 Americans lost their jobs in February.

However, these facts appear to have escaped the attention of the convenors of the Royal Economic Society’s Annual Conference.  Here is the agenda for that prestigious event – hot off the press.

Top of the bill is one Pinelopi K. Goldberg (Princeton) who is going to deliver a keynote address on: “Trade and Growth: What can we learn from Micro data?”  Next up is David Laibson (Harvard) who will address the assembled conference of economists on “Behavioral Finance, Behavioral Mechanism Design, and Optimal Defaults”.  Gilles Saint-Paul (Toulouse, Birkbeck) aims to hit the spot with a lecture on “Endogenous indoctrination”. While Professor Sir John Vickers (Oxford, Presidential Address) will enlighten policy makers around the world with a keynote address on, wait for it: “Competition Policy and Property Rights”.

To be fair to the Royal Society, NIck Stern is on the bill too, and will discuss climate change – a threat greater even than this financial crisis. Sadly, he has not been offered a plenary slot, but instead will be sharing his analysis at a side ’session’ – the equivalent of a workshop at a civil society gathering.

The ‘generals’ of the Royal Economic Society (complete with medals, see above) march onwards with heads held high. Like their First World War predecessors, they plod doggedly on with micro data , endogenous indoctrination and optimal defaults – regardless of the economic corpses strewn across the landscape or of their relevance to a world crashing down around their ears.

by Ann Pettifor, 1st March, 2009

This week we were asked by the Guardian to address the Queen’s question: “Why did no one see it coming?”

I tried to answer the question by sharing some of the seriously flawed analysis and advice provided by orthodox economists -  those that dominate both the economics profession, but also the economics commentariat.

I found these economists guilty of providing the Queen, prime ministers and chancellors, but also the citizenry – including millions of investors – with dangerously misleading guidance.

The accused include advisers to the Club of Rich Countries – the OECD – Professors at prestigious business schools, and writers for the Economist. The ones I cited offered very little forewarning of the catastrophe that has befallen the highly synchronised global economy – and millions of ordinary people.

A key exhibit in my case against the economics profession is a letter written by Prof. Richard Portes and Prof. Fridrik Már Baldursson to the Financial Times, as recently as July 4 2008.  They were responding to an earlier article by Prof. Robert Wade, headed “Iceland pays the price for financial excess” (2 July 2008 ).

This letter is of some significance, because as Guardian readers will know Iceland experienced the deepest and most rapid financial crisis recorded in peacetime when its three major banks all collapsed in the same week in October, 2008.

Since then the Queen’s ministers have combined with ministers of the Dutch government to demand massive compensation  – equalling 100% of Iceland’s GDP – from the largely innocent taxpayers of Iceland.

The victims of Iceland’s catastrophic economic failure include thousands of the Queen’s citizen investors and many of her own civil servants – including the Audit Commission, 100 local governments, police forces, charities and the universities of Oxford, Cambridge, and Manchester.

In their letter of 4 July 2008, (“Criticism of Iceland does not square with the facts”) the above-named professors cite a great deal of evidence to contradict Prof. Wade’s claim that Icelanders had borrowed as if there were no tomorrow, and that “Iceland’s external liabilities swamp the central bank’s ability to act as lender of last resort.”

The letter from Professors Baldurrson and Portes claims that while ‘gross debt of Icelandic households..was high…their assets….were over 750 per cent of disposable income.”  These assets were, as we have since discovered, as solid as bubbles and burst dramatically in the week of  7th October, 2008.

The letter asserts that the Icelandic “Financial Services Authority is highly professional….with higher capital ratios than their Nordic peers.”  Furthermore, they had “virtually no exposure to the toxic securities that almost all other banks did buy.”

Because the Financial Times is trusted by thousands of investors, I have no doubt that this letter comforted and reassured civil servants in the various organisations that had invested in Iceland’s banks, as well as thousands of the FT’s readers.

Today these investors are obliged to rely on the British government’s use of Part 2 Article 4 of the Anti-Terrorism, Crime and Security Act to obtain redress from Iceland’s government – if not from the FT and Professors Baldurrson and Portes.

Now, any reasonable person might argue, these professors were just two of many that shared a blind commitment to economic and financial orthodoxy. It is unfair, some might say malicious of me to single them out.

But my point is this: Professor Portes was until recently, the Queen’s economist.

As well as being a professor of economics at the London Business School, and holding many other important governmental advisory positions, he has for sixteen years acted as Secretary General of the Royal Economic Society.

The Royal Economic Society grants its imprimatur to economists, and is therefore a powerful driving force in the field of academic economics.

Under the leadership of Professor Portes, the Royal Economic Society was disdainful, even contemptuous of economists that challenged the orthodoxy he championed. This was most clearly expressed in his Valedictory Report to the Society in April, 2008 where he dismissed heterodox economists for their ‘mediocrity’. http://www.res.org.uk/society/pdfs/newsletter/apr08.pdf

I have no doubt that the Queen is consulted about the appointment of the Secretary General of the Royal Economic Society.

Which is why I blame the Queen for the catastrophe that orthodox economists have helped inflict on her citizens.

Ann Pettifor. 1st March, 2009

Its been a hectic week. There was the Guardian’s debate on the Queen’s Question with Lord Skidelsky (author of the three-volume biography of John Maynard Keynes) Vince Cable MP, Will Hutton and Larry Elliott, the Guardian’s economics editor.  I wrote up a note on one aspect of my comments that evening, and will post it here separately, as it is hard to find on the Guardian’s site…

Then on Friday Nick Raynsford MP (Labour)  David Willets MP (Conservative) and I debated on the BBC’s World Tonight whether we could expect house prices to rise again, once the economy recovers. I argued that it depended on whether we were willing to regulate credit-creation, as there is a direct correlation between rises in house prices and the de-regulation of credit by Edward Heath in 1971. In particular his Competition and Credit Control Act – widely dubbed the ‘all competition and no control’ credit act. David Willetts took umbrage at this, but it happens to be true.  Indeed ‘easy money’ helped fuel the inflation in house and other asset prices….the inflation of the 1970s which is always blamed on Keynesianism, and never on the neo-liberal economists and their financial de-regulation…Its a bad old world.

And then I have posted another blog on Huffington Post, this time on ‘the dawdling’ of President Obama’s economic team.  You can find it here.