HC 902 Quantitative easing
Written evidence submitted by Roger Farmer, Distinguished Professor of Economics, UCLA
Roger E. A. Farmer is Distinguished Professor of Economics at UCLA and currently Senior Houblon Norman Fellow at the Bank of England. He served as Department Chair from July 2009 through December 2012. He has previously held positions at the University of Pennsylvania, the European University Institute and the University of Toronto. He is a Fellow of the Econometric Society, Research Associate of the National Bureau of Economic Research, Research Associate of the Centre for Economic Policy Research, Fellow Commoner of Cambridge University, and Coeditor of the International Journal of Economic Theory. In 2000, Professor Farmer was awarded the University of Helsinki Medal in recognition of his work on the theory of self-fulfilling crises in macroeconomics.
1) Comments on Previous Evidence Submitted to the Committee
1. Quantitative easing is a set of monetary and fiscal policies, introduced in the wake of the 2008 financial crisis, in an attempt to alleviate the worst effects of the crisis on output growth and unemployment. In my view, those policies have been at least partly successful.
2. The written evidence that has been submitted to the committee reflects a range of opinion and addresses several issues. Among them are
a. Will the treasury incur a loss once QE unwinds?
b. Distributional consequences of the policy (transfers from savers to borrowers)
c. Will the policy be inflationary?
d. Would there a have been a better policy to reduce unemployment?
3. I would be pleased to provide my own views on these and other issues that were raised in previous testimony in response to questions from the Committee. In addition, I would like to point to a set of issues related to the role of financial market volatility as a cause of the crisis. These issues are ones that I have identified in my academic work on asset market volatility and its effects on the real economy. They are based on a coherent view of the cause of the crisis that goes beyond existing Keynesian and classical theories of economics by incorporating new empirical facts that have emerged in the past seventy years.
2) QE has Two Dimensions
1. Quantitative easing refers to increases in the size of central bank balance sheets. Qualitative easing refers to changes in the risk composition of central bank balance sheets.
2. Both policies have been followed by most world central banks in the wake of the 2008 financial crisis. The size of the Bank of England balance sheet has increased fourfold since 2007 and is now equal to 25% of GDP. Whereas the Bank of England used to hold only safe assets of short duration, recently it has begun to hold longer duration assets that put significant risk on the Bank’s balance sheet if interest rates change. This puts taxpayer funds at risk if these assets fall in value.
3. The UK is not unusual. The ECB, the Bank of Japan, the Bank of England and the Fed have all experienced very large increases in the size of their balance sheets.
4. The US has bought riskier assets than the Band of England and is committed to purchase $b84 a month until the economy improves. About half of this is in the form of MBSs (mortgage backed securities). The rest is long-duration treasuries. The UK has bought almost exclusively long-duration gilts (the UK equivalent of treasuries in the US).
3) Financial Markets are Excessively Volatile
1. Financial markets display excess volatility. One measure of excess volatility is variation in the ratio of the average stock price to average earnings, the PE ratio. This ratio has varied historically within very wide bounds. In the US the PE ratio has been as low as 5 and as high as 40. Simple economic theories predict that, if markets are efficient, it should be constant. Financial market volatility is a sign that the financial markets are not efficiently allocating risk.
2. Financial instability remains a threat. When asset prices are high, consumer spending is high and employment is high. When the market crashes, unemployment increases and remains high, often for decades. Unemployment is highly persistent and hence financial crises have very long term effects.
4) Asset Prices and Consumer Prices Should be Separate Goals of Policy
1. Central bankers have discussed financial market price bubbles, and it has been suggested that asset prices should be added as one component of the price index that the Bank targets when it sets monetary policy. That would imply that sometimes, the Bank of England should respond to an asset price bubble by raising the interest rate. A better way to proceed would be to control asset prices separately from consumer prices.
2. If consumer prices and asset prices are separate goals of price stabilization, the Bank would need a separate instrument to control financial volatility. The creation of the Financial Policy Committee goes some way towards this, but the tools currently at its disposal may not be enough.
5) Qualitative Easing as a Separate Policy
1. One potential additional tool of financial stabilization policy would be direct intervention by the Bank in the asset markets, acting as an agent for the Treasury, with the goal of stabilizing fluctuations in the growth rate of a broad index of stocks. The Bank would buy shares and pay for them by issuing debt. It would actively trade its portfolio with the stated aim of stabilizing the growth rate of a market index at a long-run target value consistent with normal output growth and full employment.
3. In periods of depressed economic activity, it may be necessary to maintain the PE ratio above its long-run target until the unemployment rate falls and the economy recovers.
6) Financial Market Stabilization is a Win-Win Policy
1. School leavers whose first job occurs in a recession can expect to earn 15% less over their lifetimes than their peers whose first job occurs in a boom. The inability of our children and grandchildren to participate in today’s financial markets prevents those markets from efficiently allocating risk.
2. Financial stabilization can correct the market failure arising from incomplete participation, by making trades that stabilize financial market volatility on behalf of future generations. It is a fiscal policy that exploits the power of the Treasury to tax and transfer from current and future generations.
7) Financial Market Stabilization will Pay for Itself
1. Historically, equity has paid a return 5% higher on average than long term gilts. That premium exists to compensate market participants for the risk associated with financial market volatility.
2. A sovereign wealth fund, paid for by issuing gilts, would be expected to make money on average since the return it earns on its assets will exceed the interest costs on its liabilities if historical trends continue.
3. However, if the FPC is successful at stabilizing PE ratios, the return on equity would be expected to fall and the return on gilts to rise, until the two assets pay the same return. A properly managed fund would be self-financing and will make neither a profit nor a loss.
4. Financial stabilization policy should be viewed as an alternative to traditional fiscal policy and is fully consistent with the Government’s stated intention to refrain from excessive discretionary expenditure in a time of austerity.
8) The Need for Political Safeguards
1. The implementation of financial stabilization policy would require the design of a set of safe guards to provide political oversight while removing the risk that the policy would be manipulated for short-term political gain. For example, one would not want to give the FPC the ability to buy and sell shares in individual companies. Trading an exchange traded fund would go some way to help solve that problem.
2. One model for the operation of financial stabilization policy would be similar to that of the MPC. The outline and goals of the policy would be set by the Chancellor. The task of implementing the policy would be put into the hands of an appointed committee, with political oversight similar to Senate confirmation hearings in the US. Committee members would have fixed but overlapping terms, similar to the MPC or the members of the Board of Governors of the Federal Reserve System in the United States.
9) Suggested Course of Action
1. Continue to vary the size of the Bank Balance Sheet to control inflation. That policy has been relatively successful since the Bank of England adopted inflation targeting in 1992.
2. Adopt the use of Qualitative Easing to maintain financial stability by trading debt for equity. A policy of this kind would require careful institutional design but could have a big role in preventing the deleterious effects of future financial crises on the real economy.
3. One model would be to give broader powers to the FPC. A second would be to put financial stabilization through asset market trades in the hands of the MPC. In either case, financial stabilization and monetary policy would need to be coordinated.