In my humble bid to respond to Martin Wolf's post in FT, I must de-clutter the arguments. But first let us look at the questions:
- Why suddenly does QE have to be of this large magnitude?
- When does QE work? What are different types of liquidity problems that QE can solve?
To answer these questions we must understand how the asset bubble phase worked. Let us take two important policies that aided the previous boom.
Two policies that aided the boom
First, we were in era of low interest rate and low inflation. Second, inflation, everywhere is measured by estimating changes in the price of basket of goods and services, no matter how exhaustive or qualitatively superior the basket is.
The question really is - what happens to a person who has a lot of money but he cannot put in a basket which is watched closely? Logically, he puts it into another basket. What if there is no other basket? Well, he creates another basket. This is exactly what happened over past three decades.
People wanted to invest in assets that were included in inflation basket because the goods and services in the basket comprised important daily items. However, they realised that too much investment makes the central bank tighten the money supply by increasing interest rates or calling for higher reserve requirements.
So these people started investing in other baskets - let us call them basket 2. In many countries real estate was in this basket. This created substantial bubble in these asset classes. The level of bubble was so high that these investors baulked at the prices and were reluctant to invest. Some internal value compass was indicating a diversion from reality and presence of unprecedented risks.
So these people had money and no where to invest. So they created a new basket - basket 3. This comprised derivative of assets in basket 2. This reduced the risk associated with assets in basket 2 and calmed the frayed nerves of investors reluctant to invest directly. Now these people can invest, because the risk was, supposedly, reduced.
The basic rule was to created tradable assets where this excess money can go to without stoking inflationary fires. This is what I call Asset-creator boom.
Two type of Assets
The asset creators initially scouted for most promising of productive assets. However, once all the investable assets were exhausted, they started creating paper assets. These paper assets are not productive and have same utility as coins or chips from a gambling house.
To complicate matters, the developments in this asset class were creating winners everywhere. Traditionally, the gambling house always wins, but here was a gamble where the clients were winning big. Naturally, the paper assets had same problem as that of gambling house chips. They are good enough till the gambling house is good enough to pay money for them. Once the doubts about gambling house start creeping in, there is bound to be trouble.
Since the economic policy remained in this zone for long time, the quantum of these paper assets grew to large order of magnitude. In comparison, genuine productive assets grew at a modest pace - as they usually do.
The essence of QE
Usually, QE or infusion of liquidity, or asset purchase, is done when there is no buyer for assets and that stalls the economy. When this mechanism was invented or discovered, assets usually referred to productive assets. So even when the central banks buy these assets, the assets do produce something of value. Over time, people tend to appreciate the value of these assets and buy them back from the central bank. Thus QE works when the system has more good productive assets than bad assets.
This time, the central bankers are buying paper assets leading to two major issues. First, the quantum of purchases is going to be substantially large sometimes as much as the real economy itself. Second, no one is going to purchase these assets back from central bank later as they will realise that these are worthless. So, for all practical purposes these assets are destroyed or taken out of the system. Thus, the central bank asset purchase schemes put out a lot of money in the market while reducing the quantum of assets in the system. This is what leads to talk of inflation.
Problem of inflation
Now, we have too much money, pumped in by the central bank, chasing too few productive assets. Note that no one wants to hold the dummy assets any more.
In our basket-3 type assets, there was a micro-thread connecting these assets to the productive assets. The thread was too weak and too thin that it escaped perception of investors. Hence there was no effect of basket-3 asset bubble on basket-1 goods and services.
Today, investor want assets strongly linked to productive assets. Naturally, there is a good deal of impact on underlying goods and services. Thus price of these goods and services are becoming increasingly volatile. Inflation is all about changes in prices of these goods and services.
To have sane pricing of goods and services, we will need some equitable relation between total money in the system and total number of productive goods, services and assets. It means this excess money will have to be destroyed. To counter this excess money chasing core, productive assets, central banks have decided to pay interest on money it created, so that this excess money simply sits in a bank account doing nothing. This incentive prevents money from chasing any assets. Further, the central bank knows where the money is sitting so that it can quickly destroy it when it becomes troublesome. Alternatively, the currency will lose its value and adjust to new price equation.
The problem of sovereign debt
The ideal solution to our crisis was thus. The central bank creates excess money and gives it to investors. These investors, worried of the risk in the system, invest in government securities. This gives government enough money to deploy in programs that can promote real, productive growth of the economy. Meanwhile, as the growth returns, investors are more confident of what are good assets. They buy these assets from central bank thus returning the excess money.
This time, the excess money available with investors was truly large. The government could not come up with a credible list of projects that will build long term advantage of the country. Hence, investors have started demanding that the government either tighten their belts to meet their obligations or show how their spending will create future returns. Government has been able to do neither. Therefore, we see substantial demand that government undertake austerity measures. Government, on the other hand, believes that since the central bank purchased assets no questions asked, the investors should also purchase government bonds no questions asked. A sort of quid-pro-quo. But investors have not kept their end of the bargain.
One wonders, if this conditionality should have been embedded at the time of central bank asset purchase and if it was wise to believe that investors will uphold their end of the bargain. The question therefore remain, why did the central bank have to purchase bad assets at all? Why QE?
Nevertheless, that is the story of QE. Those are the reasons QE will not work. It is said that false money created from casinos should have been destroyed at the hands of the gamblers. By purchasing these gambling chips for real money, the central bankers have, in effect, sold the tax-payers and citizens short. Hence, QE is, for all practical purposes a bad idea.