Looking at QE in context of economic backdrop at times it has been implemented

In an interesting column in the Telegraph, Mark Gull, co-head of asset-liability management at Pension Corporation, argues that quantitative easing must be looked at in the context of the economic backdrop when it was implemented.

Context, as they say, is everything, which is why the increasingly polarised debate over the benefits of the Bank of England’s policy of quantitative easing (QE), under which UK government debt is bought with printed money, ... should be reviewed in the context of the economic backdrop at the time the specific actions were taken....

This also applies to QE as practiced by the Federal Reserve.

When the policy was introduced in early 2009, credit supply was non-existent as the banks clammed up in the wake of the Lehman Brothers collapse, deflation worries were high, 15-year gilt yields stood at 4.4pc and the UK had not yet achieved its status as a safe haven for investors. 

Within that context, QE’s first-order aim to push gilt yields down signalled that policymakers were prepared to take extraordinary measures, in extraordinary times, to expand lending and keep the economy moving. It was the right thing to do.

Actually, it was already clear that policymakers would take extraordinary measures.  The question is were these measures necessary.

To answer this question, it is instructive to look at Iceland.  Iceland did not take these extraordinary measures.  Instead, Iceland implemented the Swedish model for handling a bank solvency led financial crisis and made its banks absorb the losses on the excess debt in the financial system.

As they say, the rest is history as Iceland's economy is growing again and unemployment is shrinking.

Today, some things are very different, with inflation, not deflation, the risk; the UK now seen as a safe haven investment, and 15-year gilt yields standing at only 2.27pc at the time of writing. 

Yet despite this, lending to small and medium-sized enterprises (SMEs) remains well below levels seen even at the end of 2009, according to the Bank’s report, “Trends in Lending”, published in April. 

With gilt yields marking historic lows, how much lower does the Bank think they can go before the effects it wants to see take hold? Having bought almost 40pc of the gilts in issuance, how many more can it realistically purchase? 

To answer this question, it is instructive to look at Japan.  Like the EU, UK and US, Japan elected to take extraordinary measures like Quantitive Easing.  Japan implemented what I call the Japanese model for handling a bank solvency led financial crisis that focuses on protecting bank book capital levels.

The result of protecting bank book capital levels is to shift the burden of the excess debt in the financial system from the banking system to the real economy.

As they say, the rest is history as the EU, Japan, UK and US economies struggle for growth.

Criticism of the Bank and its QE policy has therefore increased significantly, with the impact on savers and especially pensioners, as well as defined-benefit pension schemes and their sponsors, at the core of the complaints.

In response to this criticism, the Bank recently published an analysis of QE’s effects on pensioners – entitled “The Distributional Effects of Asset Purchases”. The report claimed that QE pushed equity prices and other risk asset prices higher. However, it was in many ways simplistic, barely touching on the effects of the policy on scheme sponsors.

Whatever the Bank says, the downside of lower yields is the proportional increase in pension fund liabilities, pushing up deficits. This effectively draws money out of sponsoring companies as they are required to increase contributions to close these expanded deficits. Pension Corporation estimates that this requirement will be up to an additional £100bn over the next three years, or about 15pc of current UK corporate cash holdings. This is money that could be better invested to create jobs and support growth.

Regular readers will recognize the highlighted text as the Pension Fund Death Spiral described by your humble blogger.

However, the major beneficiary of this process is HM Government, as it can issue its debt at low yields: a textbook case of financial repression.... 

And the reason that borrowing cheaply is necessary is because the economy isn't growing under the burden of the excess debt.

So what might the Bank do differently? Well, instead of buying gilts, it could start buying assets from the banks in a “bad bank”, or mirror the Troubled Asset Relief Programme (TARP) that worked well in the US. By removing hard-to-shift assets from banks’ balance sheets, the Bank can accelerate the deleveraging process, shortening the time it will take for the banks to feel comfortable lending again....

As shown by Iceland, what it takes to get the banks comfortable lending again is to require the banks to absorb all the losses on the excess debt in the financial system.

While it seems paradoxical to require the banks to recognize losses, it is not.  The reason it is not is that banks are senior secured lenders and they are reluctant to lend when they cannot value the collateral.  The reason they cannot value the collateral is that they know they and every other bank are hiding losses and the value of the collateral would be dramatically lower if the banks recognized these losses.