Wednesday, February 15, 2012

Confirmation that Quantitative Easing lowers demand

Over a year ago, your humble blogger first wrote on zero interest rate policies (see Random observations that drive economists and regulators nuts).

While freely admitting that I do not hold a PhD in Economics, I laid out an argument for why Quantitative Easing would reduce demand.

The short form of the argument is that individuals with jobs or who had retired and lived off their savings would cut back on the consumption to offset the decline in earnings on their savings.

In the last 24 hours, this argument has been confirmed by two different sources.

First, Naked Capitalism ran a guest post by Philip Pilkington on "QE actually kills demand".  This post looked at the reduced consumption by retired individuals living off their savings triggered by zero interest rate policies.

Second, the Telegraph ran an article on Sir Mervyn King's discussion of the UK economy.

Sir Mervyn said that savings were effectively acting as a brake on the economy: “One of reasons for slow growth in the last year was weakness of consumer spending and higher savings by household.”
Confirmation that increased saving reduces demand.

According to the Bank’s latest Inflation Report, ... saving may yet rise again, because “households may want to increase the amount that they save due to other factors, such as the need to save more for future retirement provision.” 
Confirmation that a primary driver of increased savings is to offset the decline in earnings on the funds already saved.

There is something quite wonderful about having the Bank of England endorse one's analysis of why Quantitative Easing lowers demand.

The question now is how to restore the demand that Quantitative Easing is destroying.

My suggestion is to turn to Walter Bagehot, the man who literally wrote the book on central banking and an editor of the Economist magazine.   Mr. Bagehot observed that 2% was the minimum interest rate required by savers.

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