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, causing deflation and its concomitant problems. Central banks control the quantity of money to optimize their economy, creating money to increase the money supply or destroying it to decrease the money supply. 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, 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 primary dealers from which it either buys or sells United States 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. For instance, 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 main monetary policy tool used by the Federal Reserve and other central banks is to increase or decrease the money supply to decrease or increase short-term interest rates, specifically the federal funds rate. The federal funds rate is the rate in which banks borrow in the interbank market. Because banks have minimum reserve requirements, if they fall below these reserve requirements, then they usually satisfy the reserve requirements by borrowing from other banks. Because banks make money from the interest rate spread between the rate at which they charge for lending and the rate that they are charged for borrowing, a higher federal funds rate will cause banks to increase the interest rates on their loans, while a lower federal funds rate will have the opposite effect. So, during a recession, the Fed lowers interest rates to stimulate the economy.
However, during the Great Recession of 2007 to 2009, the Fed tried to stimulate the economy by dropping the federal funds rate to a range of 0% to 0.25%, reaching the effective lower bound (ELB) on nominal interest rates. Even with interest rates this low, the economy grew slowly. At this point, the traditional monetary policy to reduce the interest rate becomes ineffective, since increasing the money supply further has no effect on lowering interest rates, since nominal interest rates cannot be lower than 0. Instead, people and businesses hold the additional money, because low interest rates lower the opportunity cost of holding money, while an uncertain economy makes it riskier to invest, to lend, and to borrow.
Between December 2008 and December 2013, the money supply increased more than 40%, but this increase of $3.5 trillion into the economy did not stimulate it much nor did it increase the inflation rate. The increased demand for money matched the increase in the money supply, because people and businesses were in debt (economists like to say that they were liquidity constrained), so they held onto their money or paid their debt rather than spend or invest it.
This is sometimes called a liquidity trap. Hence, the Fed pursued a different policy: quantitative easing, or what are sometimes called large-scale asset purchase (LSAP) policies. Although quantitative easing (QE) involves 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, when traditional monetary policy tools are inadequate.
In quantitative easing, the Fed creates money to buy securities, but instead of buying short-term securities as it does to lower the federal funds rate, it buys longer-term Treasuries and other federally backed agency securities. For instance, in an operation called Operation Twist, the Fed sold short-term T-notes and T-bills and bought long-term Treasuries with the proceeds. Also during the Great Recession, the Fed started buying mortgage-backed securities in addition to longer-term Treasuries, to directly lower the long-term interest rates. By buying the securities, the Fed increased their demand, raising their prices, and lowering their interest rates, since the price of debt securities is inversely related to their interest rate.
The Fed engaged in 3 rounds of quantitative easing, with each round named sequentially:
- QE1: November 2008–April 2009
- QE2: November 2010–June 2011
- QE3: September 2012–October 2014
The monetary base was increased by $4.5 trillion by the end of 2014. The Bank of England and the European Central Bank also started quantitative easing programs in 2009, and substantially expanded those programs later. As of 2018, the world economy has been growing strongly. Nonetheless, it is difficult to ascertain how much of the growth was due to QE. Japan also had a QE program during the 1990s, but it was unsuccessful in mitigating the continual deflation plaguing their economy. The problem with QE is that by lowering the interest rates on long-term securities, it increases the demand for money, because there are few other places to invest money with little risk. In a stronger economy, increasing the money supply will increase aggregate demand and the inflation rate, but when the economy is in the liquidity trap, the demand for money is stronger, because people and businesses are more anxious about the economy, so increasing the money supply simply causes them to hoard it.
Although the direct effects of QE on the economy cannot be quantified, QE does reduce the yield on long-term debt securities, by increasing demand for these assets specifically, rather than relying on the indirect effect of lowering short-term interest rates, where dealers who have sold their short-term Treasuries to the Fed take the money and buy longer-term securities to earn a return on their increased cash. Since increasing the money supply may eventually increase inflation, QE also reduces the real interest rate by increasing inflation or expected inflation. The real interest rate (r) equals the nominal interest rate (i) minus either actual inflation (π) or expected inflation (πe), as stated succinctly with the Fisher equations:
- Backward-looking Fisher equation: r = i – π
- Forward-looking Fisher equation: r = i – πe
Increasing the money supply also depreciates the currency, stimulating exports, although the stimulation may be blunted by other countries increasing their money supply.
Most central banks strive to keep inflation low. Therefore, quantitative easing is generally only used during a financial crisis, such as during the Great Recession. During and after the Great Recession, the central banks of the United States, Europe, and Great Britain reduced their interest rates as low as they can go, right down to 0. Since they cannot lower the nominal interest rate to less than 0, (although central banks are starting to charge interest rates to hold reserves for other banks, thus creating negative real interest rates) they resort to quantitative easing as a tool to reduce the real interest rate. Since the real interest rate equals the nominal interest rate minus the inflation rate, the real interest rate can be negative if the inflation rate exceeds 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 called 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, causing 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 may increase 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 expect higher inflation and act accordingly, so that it no longer has the stimulatory effect 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.
Employment did significantly increase during QE1 (how much of the increase in employment was caused by QE1 is questionable) and it may have reduced 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, economic growth was taking considerably longer than in previous recessions.
I believe the main reason why QE was not as effective as many people expected 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. Payroll taxes should be reduced because employment taxes are a regressive tax that burdens 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 repay 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 decreasing 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, without knowing if they would be able to keep their job, many people decreased their spending to save and to pay down their debt. This contracted the economy substantially. 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 must 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. Lowering taxes on the poor is a fiscal policy, so 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 on 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. It is trickle-up economics that works, not trickle-down economics.
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. Check out my book Trickle-Up Economics to learn much more detail.