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.

I wrote a piece on Keynes and monetary policy for the Standard, which appeared on Thursday, 23rd October, 2008. You can read it below. Today a group of monetarist economists , supported by a range of bankers, have written to the Telegraph objecting to a public works programme to help economic recovery. They are right that excessive liabilities on the government’s balance sheet could cause interest rates to rise, but government spending has a multiplier effect, and very quickly pays for itself. They seem unaware of this economic fact. There is some overlap between our views on monetary policy as an effective tool, but I disagree with their view that UK government spending has been excessive.

Nor do I share their complacent view that: “Occasional slowdowns are natural and necessary features of a market economy”. First, this is not a slowdown. This is a hugely destructive and likely to be prolonged global economic failure, unprecedented in history. Second, there is nothing at all “natural” or God-given about this failure. It is man-made and these letter-writers are largely to blame for the economic policies of financial de-regulation that have led to the biggest financial meltdown “since the First World War” to quote Mervyn King of the Bank of England.

From the Evening Standard, by Ann Pettifor

“JohnMaynard Keynes suddenly finds himself in favour with all those enamoured of fiscal policy. These range from governments and central banks trapped in economic orthodoxy to free marketeers in the private banking sector benefiting from taxpayers’ largesse. However, bail-outs will not prevent individuals, households, small and big businesses going bust because of onerous borrowing costs.Keynes’ advice would first and foremost be to cut interest rates to the bone; that is all rates, short and long, real, safe and risky.

Keynes laid far greater store by monetary policy than fiscal policy.He believed it is both sustainable and cost-effective to manage financial crises by sharply lowering borrowing costs.This remedy involves neither tax payers’ funds nor burdening the balance sheets of central banks or governments.Today the governors of the Bank of England and the European Central Bank stand firmly in defiance of this key pillar of Keynesianism. Contrary to his advice they prefer to keep interest rates high and periodically lose control over the Libor rate set by the private banking sector.

Keynes did not believe that the burden of economic renewal should be carried overwhelmingly by the public sector.Indeed he was against excessive public spending primarily because it caused long-term interest rates to rise.Instead he wanted to diversify the process of economic renewal by ensuring the private sector played a full part.For the private sector to be able to do that, requires extremely low rates of interest.Only by easing monetary policies will Alistair Darling and Mervyn King be said to be reflecting Keynes’ true priorities.”

Central banks’ obsession with inflation is stopping them from tackling a far more pressing threat.

Read more here…

Is Warren Buffett right? If this bail-out had been passed by congress, would it have halted the meltdown?

I don’t believe so. Here’s why…

First, this is a bail-out of a small number of shareholders and creditors with stakes in Wall Street financial institutions – people like investment guru Warren Buffett – and potentially some foreign banks.

Almost as an aside, Section 23 of the Act requires that Treasury Secretary Henry Paulson “take into consideration…..the need to help families keep their homes and to stabilize communities”.

He may well take their plight into consideration, but Congress has given him full discretion, and he is under no obligation to act.

But to understand why the bail-out is framed in this way, and why it will not work, let’s delve a little deeper into the economic policies that got us into this mess.
Reckless lending

The reason banks have excessive debts lies with government and Federal Reserve policies to de-regulate credit creation – policies introduced from the 1970s onwards.

This made it easy – and highly profitable – for banks to lend recklessly. The Fed and other central banks turned a blind eye to the terms on which banks, and the growing shadow banking sector, lent.

Second, the Fed, as with other central banks, effectively gave up its powers to control the rate of interest across the board, for safe and risky, and short and long-term loans. Instead interest rates – the price of credit – were effectively privatised.

Next the government’s policies ensured that the share of the national cake (GDP) going to employees in the form of wages and other compensation, fell for the three decades after the 1970s. That too, was no accident.

Third, all that ‘easy money’ or credit acted like a giant pump, and inflated the price of assets e.g. property. The rich on the whole own assets, and could use their assets to borrow even more ‘easy money’, flip condos, move up the property market, buy stocks, race horses, works of art etc.

So asset prices rose higher, and higher. This helps explains why the rich became richer and the poor, poorer.

Easy credit

The less well-off, those without assets, but with falling incomes, were not so lucky. To put a roof over the heads of their families, to go to college, they had to borrow. They even took to using credit cards to pay everyday food bills etc. The very poor – sub-primers – were given loans, but at very high, and very profitable, rates.

While the credit pump inflated asset prices, it also encouraged consumption. People used easy credit to go shopping – on a grand scale.

Anglo-American governments gave up on other sectors of the economy – i.e. manufacturing – and believed foolishly, that we could all live by shopping or by services, like hairdressing and financial services, while the Chinese manufactured our goods.

Now the credit pump is broken, and the bubble has burst. Asset prices are falling, and people are not shopping on the same scale.

What broke the pump? First and foremost, the very high, real rates of interest that had to be paid on these debts. Because of the privatisation of interest, these rates were high (eg: the rate charged on your credit card), even when official (i.e. central bank base rates) were low. Secondly, falling real incomes made it hard to repay rising debts. So people began to default.

These defaults began to expose the reckless lending of banks, and these institutions too began to fail. The rest is history.

Overhaul needed

What would it take to fix the system. A bail-out of banks?

No, what is required is an overhaul of the whole economic system; a system-wide fix.

• That means, first, dumping the orthodox free-market zealots responsible for the policies that got us into this mess. Frederick Hayek’s and Milton Friedman’s de-regulation policies have already been dis-credited, with Republicans obliged to disown Margaret Thatcher and Ronald Reagan’s contempt for government.

• Second, it will be vital to restore to the Federal Reserve and other central banks the power to set the rate of interest – across the whole spectrum of lending, so that all rates can be lowered on the massive debts incurred across the board in countries that followed the Anglo-American economic model.

• Third, we must abandon the policy of holding down wages and other forms of compensation, especially if we want people to repay debts, and help salvage the banks. Jobs will have to be protected, or even created by government, and incomes must rise.

• Fourth, we have to simply write off the debts of those poor people who cannot ever repay. Just as we write off the debts of companies or governments that can no longer pay, so we must recognise that many citizens are effectively insolvent. The refusal to acknowledge this truth lies at the heart of Mr Paulson’s plan – and that is why his plan will fail.

Only a system-wide fix of economic policies will help restore stability to the Anglo-American economies. But with orthodox economists like Mr Paulson and Fed chairman Ben Bernanke still at the helm – expect Anglo-American economies to keep lurching down the long road to Depression.