An economy needs a certain amount of money to operate efficiently. As it grows, an economy needs more money; otherwise, deflation will ensue as more products and services must be bought with the same quantity of money, which causes deflation and its concomitant problems. Central banks usually control the quantity of money to optimize their economy. When people think of the creation of money, they often think of the printing of currency or the stamping of coins. Central banks do this to some extent, but most money in the world today is electronic, in the form of financial information in the databases of financial institutions, such as banks.
How the Federal Reserve of the United States creates money is illustrative of the general process that takes place. The Federal Reserve has 18 primary dealers from which it either buys or sells United States Treasuries. During the credit crisis, the Federal Reserve also bought mortgage-backed securities to support the mortgage market and to support the banks who bought these illiquid securities when many of the underlying mortgages were defaulting. When the Federal Reserve wants to destroy money, it sells Treasuries to its primary dealers, then debits their accounts by the price of the Treasuries. The primary dealers have accounts at the Federal Reserve, and those accounts are credited or debited when transactions take place between the Federal Reserve and the dealers.
Although quantitative easing (QE) is the creation of money, the money is not created because of an expanding economy but rather because of a contracting economy. In other words, quantitative easing is a monetary policy tool designed to stimulate the economy. In quantitative easing, the Federal Reserve buys Treasuries or other securities from its primary dealers and then increments the accounts of the dealers by the amount of the purchase price. Where does this money come from? It does not come from anywhere – the Federal Reserve simply increments the accounts electronically, so that if a primary dealer sells $1 billion in Treasuries to the Federal Reserve, then the Federal Reserve pays the dealer by simply increasing the dealer's account by $1 billion. The primary dealers then invest that money in other assets. The money eventually passes through to the economy, stimulating demand, or so it is thought.
There are several objectives of QE. Credit easing is the creation of money, with the objective of boosting the economy by increasing liquidity and reducing interest rates. Another objective of QE is to rebalance portfolios held by the public, which occurs when the investors who sell their securities to the central bank take the money and buy other assets, thereby increasing their prices, which increases investor confidence in general and stimulates spending. The purchase of bonds also increases their price, thereby lowering their yields, which lowers interest rates for borrowers so that they can increase consumption. If the money is used to buy foreign assets, then that weakens the domestic currency, which stimulates exports.
Another operation performed by the Federal Reserve was what was called Operation Twist, where the Fed sold short-term T-notes and T-bills and bought long-term Treasuries with the proceeds. This frees up money for the holders of the long-term Treasuries to buy other assets, which stimulates the financial markets and increases investor confidence.
Since most bonds are electronic records nowadays, central banks can also retire the bonds that they buy, thereby making the creation of new money permanent. This lowers the government's borrowing costs, thereby lowering the need for tax increases.
Most central banks strive to keep inflation low. Therefore, quantitative easing is generally only used during a financial crisis, such as the recent credit crisis of 2007 to 2009 that has propagated around the world because of easy borrowing. As of 2012, the central banks of the United States and Europe and Great Britain have reduced their interest rates as low as they can go, or that they were able to, right down to 0. Since they cannot lower the nominal interest rate to less than 0, they resort to quantitative easing as a tool to reduce the real interest rate. (However, in 2014, the European Central Bank (ECB) has been charging banks with accounts to hold money there, thereby creating an effective negative interest rate, to motivate the banks to lend more, to stimulate Europe's lagging economy.) Since the real interest rate is equal to the nominal interest rate minus the inflation rate, the real interest rate can be negative if the inflation rate is greater than the nominal interest rate. So, since quantitative easing increases the inflation rate, the real interest rate can be negative.
Another benefit of quantitative easing is that sometimes central banks can provide support for countries indirectly. For instance, the ECB is prohibited by law from providing direct fiscal aid to individual countries of the Eurozone. However, it can buy the debt of these countries, thereby lowering the interest rate that they must pay. Quantitative easing also decreases the cost for borrowers, which helps to stimulate the economy, since borrowers, being generally poorer, tend to spend more than creditors, who tend to be richer. In other words, poorer people have a greater marginal propensity to consume. Indeed, Irving Fisher attributed the primary cause of the Great Depression to the fact that money was being transferred from borrowers to creditors, which decreased the money supply in the market.
Disadvantages of Quantitative Easing
There are several disadvantages to quantitative easing. Because nominal interest rates decline, investors in bonds and other fixed income securities receive less money, which acts as a brake on the economy. Another drawback of quantitative easing is that sovereigns may remain irresponsible in their finances, as is often the case when the government can easily print more money. Greece is a classic example. Because it is part of the Eurozone, Greece had to implement fiscal responsibility so that it can continue to be part of the Eurozone. However, if Greece was still using the drachma, then they can simply print money without the need for enacting politically unpopular, but necessary, reforms. When a country is irresponsible and its finances are in a shambles, then investors will not buy its debt. Therefore, the country will force its central bank to buy its debt, which is, of course, quantitative easing. However, QE on a massive scale will cause hyperinflation. People lose faith in the money and will start using barter for exchanges or a foreign currency, which is often referred to as dollarization.
Wealthy people will ultimately receive most of the QE money, because they are the group that owns the most bonds and Treasuries. Since they usually do not need the money for purchases, they invest the money in equities and other assets, to protect the value of their money from the increases in inflation caused by QE. For instance, the Fed started using QE in 2009, and the price of gold more than doubled by 2011.
Foreign products and services also become more expensive, since the domestic currency loses value compared to other currencies. For instance, because the United States imports a lot of oil, the price of gasoline and other products made from petroleum increase as the value of the dollar decreases, which incurs a significant drag on the economy, in direct opposition to the objective of quantitative easing.
Emerging markets also do not like quantitative easing by the major economies, since people in the QE countries will buy assets in the emerging markets to protect the value of their investments from domestic inflation. But this increases the strength of the emerging market currencies relative to the QE currencies, which will lead to a decline in exports, which many emerging markets depend on. As long as the emerging markets do not also inflate their currency, then investments in those countries will appreciate faster relative to the QE currencies.
Thus, quantitative easing may also incite a currency war, since the domestic currency loses value with respect to foreign currencies, thereby making domestic exports cheaper for foreigners, which may reduce exports by the other countries, and may even reduce the consumption of domestic goods in those countries. The central banks of those countries may retaliate with their own quantitative easing.
Does Quantitative Easing Really Help the Economy?
Although quantitative easing increases inflation, some have argued that central banks should temporarily increase their tolerance for inflation until the economy is stimulated. Then they can reverse course, as the so-called output gap diminishes, bringing the inflation rate back down to the target rate.
Of course, quantitative easing does have its limits. As the inflation rate increases, people start to expect higher inflation and act accordingly, so that it no longer has a stimulatory effect that it had originally. Indeed, this has been observed in the Federal Reserve's QE1 program, which created about $1.25 trillion for the economy, and QE2, which created about $600 billion.
QE1 did significantly increase employment and reduce the output gap; QE2, not so much. However, many people have been disappointed with the results of quantitative easing, because in 2012, the unemployment rate was still very high compared to historical standards. Furthermore, the growth of the economy was taking considerably longer than it had in previous recessions.
I believe that the main reason why QE is not as effective as many people expect, is because the money goes mostly to wealthy bondholders. Since the wealthy tend not to spend money, i.e., their marginal propensity to consume is lower, the stimulatory effect of QE is muted. Indeed, as already argued, wealthy people tend to buy hard assets, such as natural resources, to prevent their wealth from being diminished by inflation. This, in turn, causes the prices of those assets to rise, making other products more expensive, which reduces demand. If the newly created money was used, instead, to reduce the payroll taxes of low income workers, this would stimulate the economy more, since poor people will quickly spend the money simply to survive. The reason why payroll taxes should be reduced is because employment taxes are a regressive tax that places a greater burden on low income workers, the same people hurt most by recessions and depressions.
Another reason why QE is not as effective as it might otherwise be is because many people are in debt, so they must pay back the debt over time. The economy overheated because many people borrowed during the easy credit times, allowing them to spend more. Every Tom, Dick, and Harriette was getting a loan, so eventually the bubbles created had to burst, since lending could not continue indefinitely. The other factor that decreased the effectiveness of quantitative easing is that, since many people lost their jobs, banks were unwilling to lend, since unemployed people are a considerable credit risk. Even those with jobs could not be sure of keeping them, so they, too, were risky. Furthermore, since people didn't know if they were going to be able to keep their job, in many cases, they decreased their spending to save and to pay down their debt. This resulted in a considerable contraction of the economy. It was hard even for many small businesses to get a loan, so they could not expand, even if they wanted to. Hence, low interest rates do not stimulate the economy when so many people and businesses remain a credit risk.
The Best Monetary Policy to Stimulate the Economy is a Fiscal Policy: Lower or Eliminate Taxes on the Poor
To stimulate the economy, money must have velocity: people must spend it repeatedly. If money is just hoarded, then it will have no impact on the economy, regardless of its quantity. The best way to increase the velocity of money is to use it to offset taxes on the poor, who are hurt most by recessions and depressions, and who will quickly spend the money. As it is done now, QE merely makes the rich richer, who are far less apt to spend it. Lowering interest rates, even if it worked, would merely serve to increase the debt load of the public, which would eventually result in less spending, since the debt will have to be repaid. This is why QE is not effective either in the United States or in Europe. On the other hand, lowering taxes on the poor will increase their spending, which will increase business, which will increase money flowing to the middle class, who, in turn, will increase their own spending, and eventually, even the wealthy will benefit. Lowering taxes on the poor will benefit everyone! That is the way the economy works! Additional benefits to lowering or eliminating taxes on the poor include:
- import prices remain steady
- currency wars are avoided
Of course, central banks use quantitative easing because that is a monetary policy tool that they can implement. Because lowering taxes on the poor is a fiscal policy, only Congress can change it, and since Congress is beholden to special interests, especially the rich, that is unlikely to happen soon. Working income, what the tax code refers to as earned income, has always been the most highly taxed form of income — at least in recent decades — and is an effective means of keeping a higher tax burden on working people rather than for the wealthy, who receive much of their income from investments and inheritance. Nonetheless, as already argued, lower taxes on the poor and the middle class will benefit everyone, including the wealthy, and is the best method of stimulating the economy.
Helicopter Money for the Poor
Helicopter money, a term coined by Milton Friedman in his 1969 book, The Optimal Quantity of Money, is a distribution of money by throwing it out of a helicopter, where the people below will grab it and spend it. Friedman envisioned that helicopter money would increase inflation, but would not increase real economic output. Ben Bernanke, a former Federal Reserve Chairman, argued that helicopter money might be a better solution than lowering interest rates to stimulate the economy in a deflationary environment, especially when there is a large economic output gap. The resulting increased spending will simply narrow or close the output gap rather than causing inflation.
In my opinion, helicopter money would be much more effective as an economic stimulus in a deflationary environment if it were distributed only over slums, because as I have argued above, giving more money to the poor would directly stimulate the economy. Indeed, there is no need to print any more money: taxing the rich more and the poor less would stimulate the economy, without causing hyperinflation. The rich would still benefit, because the money would eventually return to them, through their businesses and investments, and the government would collect more tax revenue from the growing economy and the higher velocity of money. Hence, everyone benefits! I should even call this the Utilitarian Tax Policy, since it is the best tax policy that I think will maximize the happiness of everyone, the primary goal of Utilitarianism.