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VANDERBILT UNIVERSITY

QUANTITATIVE EASING:

AN EASY FIX?

A PAPER SUBMITTED TO PROFESSOR TIMOTHY LOGAN

CORPORATE FINANCE: 240

BY

CHARLES W. CURRY

NASHVILLE, TENNESSE

APRIL 7, 2011

I have neither given nor received any unauthorized information on this

assignment:

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Alan Greenspan once described the dotcom bubble as an episode of “irrational

exuberance that unduly escalated asset values,” and led to a dramatic loss of capital in

in financial markets. 1 Arguably, the most recent economic decline is attributable to

similar exuberance. A failure on behalf of Congress, financial institutions, and countless

individuals resulted in the largest loss of production since The Great Depression.2

Obviously, it is of concern to examine the events leading up to the meltdown in

order to prevent similar circumstances in the future. However, this paper will not focus

on the events leading up to the crash. Rather, it will provide a brief overview of these

events in order to demonstrate the response of the Government and financial

institutions. It is the manner of the solutions and the economies response to the

solutions that will be the focus of this essay.

The paper will provide a framework from which to assess the ramifications of

Government policy. Specifically, it will introduce a concept known as quantitative easing

(QE), define this concept, and explain its uses and direct implications. Additionally, it will

also examine the historical use of QE. In particular, the financial crisis in Japan at the

end of the twentieth century offers a useful case study from which to assess QE.

Therefore, juxtaposing the similarities of historical QE to current policy will

demonstrate historical solutions and future difficulties. Recent articles and texts offer

useful information on which to critique the Government’s decisions and assess their

1 Remarks by Federal Reserve Chairman Alan Greenspan on December 5, 1996. Washington D.C. http://webcache.googleusercontent.com/search?q=cache:rDL7f4GyUIIJ:www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm+irrational+exuberance+speech+by+greenspan&cd=1&hl=en&ct=clnk&gl=us&source=www.google.com 2 BBC News. (2009). Fed pumps $1.2tn into US economy. Retrieved from http://news.bbc.co.uk/2/hi/business/7951493.stm

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justifications for implementing quantitative easing policies. Some difficulties arise in

quantifying the distant effects of QE policy but some early signs may appear. Therefore,

this paper will base its judgment of QE only on the immediate effects and will posit its

suggestions based on historical trajectories of QE in Japan.

What is Quantitative Easing? Quantitative easing is a specific government policy

that aims to reduce the difficulties associated with contractions of the money supply. Or

more formally,

“A government monetary policy occasionally used to increase the money supply

by buying government securities or other securities from the market. Quantitative

easing increases the money supply by flooding financial institutions with capital in

an effort to promote increased lending and liquidity.”3

QE is a conscious government initiative to increase the availability of funds in the

economy. QE also implies a certain type of government action. Investopedia explains

that QE comes about “when interest rates have already been lowered to near 0% levels

and have failed to produce the desired effect.”4

QE takes the form of an advanced use of monetary policy. Specifically, “With

quantitative easing, the central bank expands the money supply by directly increasing

the quantity of reserves in the banking system. Normally, the Fed would increase the

amount of money in circulation by lowering the Fed funds rate, thereby lowering the

return on holding reserves and thus encouraging bank lending.”5 It also has severe

implications or that near 0% interest rates do not have enough influence to stimulate the

3 Definition of Quantitative Easing by Investopedia, http://www.investopedia.com/terms/q/quantitative-easing.asp. 4 Ibid 5 J. D. Foster, The fed’s QE2 and the economy: Sailing to safety or a ship of fools?, The Heritage Foundation. Washington, DC. (2010).

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economy and that President Obama’s stimulus failed. As a result, QE is the last resort

of the Federal Reserve.

However, the dramatic degree of easing is not without ramifications. In fact, QE

has the potential to cause more problems than it solves. Specifically, “The major

risk of quantitative easing is that although more money is floating around, there is still

a fixed amount of goods for sale. This will eventually lead to higher prices or inflation.”6

Assuming that QE leads to inflation, then government policy creates a new unwanted

problem that hampers economic recovery. The excerpt states that inflation results from

there being a fixed amount of goods and a surplus of loanable funds. A disconnect

exists between applying the excess amount of loanable funds to increasing production.

As a result, in order to make QE more effective and less harmful, policies should be

oriented around increasing production as well as the availability of loanable funds.7

But have initial QE efforts produced the desired results? A recent article on

CNNMoney suggests that QE was ineffective in stimulating the economy. In fact, the

article relayed that the Fed announced a decision to purchase $900 billion dollars in

treasury bills by the end of the third quarter of 2011.8 This initiative is being termed

“QE2” or the second round of easing. Its implementation suggests that the first round of

easing was ineffective in aiding economic recovery. Therefore, QE1 did not bring about

the desired results, and it is yet to be determined if QE2 will suffice.

In order to better predict the results of QE in the U.S. it is necessary to examine

the actions of the Japanese government. Volker Wieland establishes three questions of 6 Explanation of Quantitative Easing by Investopedia, http://www.investopedia.com/terms/q/quantitative-easing.asp. 7 Gail Makinen, Money,The price Level, and Interest Rates, (Prentice Hall, Nre Jersey: 1977). 8 CNNMoney.com, http://money.cnn.com/2010/11/03/news/economy/fed_decision/index.htm

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concern in his article scrutinizing expansive monetary policy by the Bank of Japan. In

particular, he asks “Did the Bank of Japan increase base money sufficiently so that it

implied an expansion relative to nominal income, that is, an expansion in the

Marshallian k?9 Did it succeed in creating an overall greater supply of money as

measured, by M1, and was the quantitative monetary expansion ultimately followed by a

return of inflation?”10

9 Wieland asks this question as a result of macroeconomic theory. In Money Inflation (A Monetarist Approach) by J. Huston McCulloch he asserts that “monetary policy that lets the money supply grow at about the same rate as real income could result in runaway inflation.” Where runaway inflation is akin to hyperinflation. As a result, Wieland examines whether these growth rates were equivalent as a means of qualifying the theory and assessing the degree of inflation. 10 Volker Wieland, Quantitative Easing: A Rationale and Some Evidence from Japan, (The University of Chicago Press (2009).

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Wieland’s work suggests that the answer to the first questions he asks is yes. As

the Bank of Japan increased the monetary base through treasury purchases, the

interest rate declined.

11

Figure 1 above demonstrates that as the monetary base increased as a ratio of nominal

GDP, interest rates fell. Generally a fall in interest rates forecasts an increase in the

availability of loanable funds. And an increase in the availability of loanable funds

encourages spending in the economy through cheap debt.12 In fact, Wieland argues that

“the expansion of base money engineered by the central bank induced additional

deposit creation by banks and led to an even greater expansion in the broader

monetary aggregate.”13

11 Graph from Volker Wieland’s article, Quantitative Easing: A Rationale and Some Evidence from Japan 12 C. A. E Goddhart, Money, Information and Uncertainty, (The MIT Press, Massachusetts: 1989) Intro. 13 Volker Wieland, Quantitative Easing: A Rationale and Some Evidence from Japan, (The

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Wieland’s research also supports this assertion. In Figure 2 at the top of page 7,

he demonstrates the effect that low interest rates had on borrowing relative to

categories of the money supply.

Base money and M1 relative to nominal income in Japan, 1981–2008, quarterly observations.

14

M1 is traditionally defined to include demand deposits and other next to liquid accounts

such as savings and checking accounts.15 The Monetary Base or M0 is defined as the

most liquid form of money, such as cash. Notice that during the years the Bank of Japan

carried out QE that deposits grew, especially in proportion to M0. The growth in M1

coincides with the years of low interest rates and suggests that QE helped stimulate

borrowing.

University of Chicago Press (2009). 14 Graph from Volker Wieland’s article, Quantitative Easing: A Rationale and Some Evidence from Japan 15 www.investorglossary.com/m1.htm

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Most importantly, it appears to have stimulated growth in M1 without increasing

the consumer price index (CPI). Wieland’s work exhibits that as QE increased the CPI

remained within 3-5% of the beginning of QE. In fact, as figure 3 exhibits below, for

approximately a year at the height of QE the CPI actually realized deflation. At the end

of easing, inflation returned approximately to its pre-QE levels in a relatively short time

span. This research is counter to intuition that suggests QE would stimulate inflation.

Wieland notes that “The return of price stability coincided with the sustained shift of the

Bank of Japan to quantitative monetary policy and direct asset purchases.”16 As the

CNNMoney article relayed the U.S. Federal Reserve is involved in “direct asset

purchases,” and assuming the Japanese and U.S. experiences are comparable, then

price stability should coincide with direct treasury purchases.

Figure 3 -Base money and CPI inflation in Japan, 1981–2008, quarterly observation

17

16 Volker Wieland, Quantitative Easing: A Rationale and Some Evidence from Japan, (The University of Chicago Press (2009). 17 Graph from Volker Wieland’s article, Quantitative Easing: A Rationale and Some Evidence from Japan

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The United States is currently implementing quantitative easing policies. The

Federal Reserve Chairman, Ben Bernanke, openly discussed monetary policy,

economic concerns, solutions, and risks at a recent reserve conference. He relayed the

specifics of the process, stating

“to stabilize the quantity of securities held by the Federal Reserve we reinvested

payments of principal on agency securities into longer-term Treasury securities.

We decided to reinvest in Treasury securities rather than agency securities

because the Federal Reserve already owns a very large share of available

agency securities, suggesting that reinvestment in Treasury securities might be

more effective in reducing longer-term interest rates and improving financial

conditions with less chance of adverse effects on market functioning.18

He explains that the Federal Reserve is purchasing long term treasuries in order to

reduce long term interest rates. He suggests that by reducing these rates, businesses

and consumers will be more inclined to increase consumption or investment

borrowing.19

However, there is inflation risk with Bernanke’s approach. He continues to add

that “Another concern associated with additional securities purchases is that substantial

further expansions of the balance sheet could reduce public confidence in the Fed's

ability to execute a smooth exit from its accommodative policies at the appropriate time.

Even if unjustified, such a reduction in confidence might lead to an undesired increase

18 Bernanke, B. S. (2010). The economic outlook and monetary policy. Speech at the Federal Reserve Bank of Kansas City Economic Symposium 19 David Gowland, Money, Inflation and Unemployment, (Wheatsheaff Books Limited New Jersey:1985) Intro.

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in inflation expectations.”20 Generally, an expected increase in inflation leads to

inflation.21 Inflationary conditions in the economies delicate state could prove damaging

to the recovery.

Still, in a later delivery Bernanke tried to console those with inflation anxieties. He

explained that the Fed has “tools” in place in order to combat inflation if it should occur.

He said, “To mitigate the [inflation] concern, the Federal Reserve has expended

considerable effort in developing a suite of tools to ensure that the exit from highly

accommodative policies can be smoothly accomplished when appropriate.”22

Unfortunately, he was quite vague as to what tools he was referring. This vagueness

has many market participants concerned that the Fed will not be able to exit QE quick

enough to avoid inflation.23

J.D. Foster is one of those concerned with inflation risk. In his article, The Feds

QE2: Sailing to safety or a Ship of fools?, he relays his concern. Specifically, he raises

the point that already next to zero interest rates have failed to stimulate the economy to

the necessary degree. As a result he questions the Fed’s decision to reinstate an

already “tried and failed” policy.24 In addition, he dispels the belief that a stagnant

economy wards off inflation by offering the example of stagflation present during the

1970’s under the Carter Administration. Therefore, the current slow economy is no

hedge against rising future inflation.

20 Bernanke, B. S. (2010). The economic outlook and monetary policy. Speech at the Federal Reserve Bank of Kansas City Economic Symposium 21 David Gowland, Money, Inflation and Unemployment, (Wheatsheaff Books Limited New Jersey:1985) Intro. 22 Bernanke, B. S., Reinhart, V. R., and Sack B. P. (2008). Monetary policy alternatives at the zero bound: An empirical assessment. 23 J. Hilsenrath, (2010). Fed fires $600 billion stimulus shot. Wall Street Journal 24 J.D. Foster, The Feds QE2:Sailing to Safety or a ship of fools?, 2010

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Worst of all, Foster asserts that extremely loose monetary policy could lead to

another “Great Recession.” He illuminates the fact that loose monetary policy can

“trigger asset price bubbles in the equity markets as a precursor to resurgent inflation.

Asset price bubbles are common consequences of excessively loose monetary policy.

These asset price bubbles would give the economy a welcome dose of levitation—until

they popped, leaving a weaker economy [in its wake].” In other words, low rates may

encourage excessive lending in speculative ventures that could result in another

setback for the economy. Obviously, this risk is real and needs to be regulated in a

manner that provides investors with incentive without jeopardizing the economy as a

whole. The only question that remains is how to implement this ideal in practice, and

this paper cannot provide that solution.

In light of all the research provided in this essay where is the U.S. heading? It is

possible to posit some theories of direction given certain perimeters. In particular, the

Fed should examine the Japanese experience with QE. Volker Wieland’s research

showed unexpectedly positive yields from their policy. Clearly, more work needs to be

done in this field before any solid conclusions form, but initial views are promising. More

than likely, as the CPI already shows, the U.S. will experience inflation.25 In order to

quell this threat the Fed should reign in its loose monetary policy until budget deficits

come under control. If it continues this policy into QE3 or QE4 price stability will dissolve

and the U.S. could see hyperinflation or even deflation. Especially if the Japanese and

U.S. economies diverge substantially in there likeness, then Wieland’s work may be

25 Wall Street Journal Article, Inflation Slowly Showing Signs of Life, http://blogs.wsj.com/economics/2011/03/18/inflation-slowly-showing-signs-of-life/

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less applicable to the U.S. Therefore, the Fed needs to ascertain the extent to which the

economies resemble one another before embarking on an identical path.

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Bibliography

Benford, J., Berry, S., Nikolov, K., and Young, C. (2009). Quantitative easing. Bank of

England Quarterly Bulletin, 2. Bernanke, B. S., Reinhart, V. R., and Sack B. P. (2008). Monetary policy alternatives at

the zero bound: An empirical assessment. Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board. Washington, D.C.

Bernanke, B. S. (2010). The economic outlook and monetary policy. Speech at the Federal Reserve Bank of Kansas City Economic Symposium. Jackson Hole, WY.

Retrieved from http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm BBC News. (2009). Fed pumps $1.2tn into US economy. Retrieved from

http://news.bbc.co.uk/2/hi/business/7951493.stm Foster, J. D. (2010). The fed’s QE2 and the economy: Sailing to safety or a ship of

fools? The Heritage Foundation. Washington, DC. Goddhart, C. A. E, Money, Information and Uncertainty, (The MIT Press, Massachusetts: 1989) Intro.

Gowland, David, Money, Inflation and Unemployment, (Wheatsheaff Books Limited New Jersey:1985) Intro.

Greenspan, Alan At the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C.December 5, 1996

Hilsenrath, J. (2010). Fed fires $600 billion stimulus shot. Wall Street Journal. Retrieved from http://online.wsj.com/article/SB10001424052748703506904575592471354774194.html

Hoenig, T. M. (2010). The Federal Reserve’s mandate: Long run. National Association of Business Economists Annual Meeting. Denver, CO: Federal Reserve Bank of

Kansas City. Gail Makinen, Money,The price Level, and Interest Rates, (Prentice Hall, Nre Jersey: 1977).

McCulloch, J. Huston: A Monetarist Approach

Wieland, Volker Quantitative Easing: A Rationale and Some Evidence from Japan, (The University of Chicago Press (2009).

Definitions www.investorglossary.com/m1.htm CNNMoney.com, http://money.cnn.com/2010/11/03/news/economy/fed_decision/index.htm

Wall Street Journal Article, Inflation Slowly Showing Signs of Life, http://blogs.wsj.com/economics/2011/03/18/inflation-slowly-showing-signs-of-life/