QE in Australia: be careful what you wish for
While the recent comments made by Australia’s central banker on quantitative easing was a “welcome dose of common sense,” Quay Global Investors’ Chris Bedingfield assesses a number of myths on the effectiveness of such an approach.
The recent comments from Phillip Lowe, governor of the Reserve Bank, about the likelihood of negative interest rates and a potential move into quantitative easing (QE) in Australia were a welcome dose of common sense.
We have long held the view that QE will do very little for the Australian economy, perhaps with the exception of a short-term ‘placebo effect’ – a view that is backed by almost 20 years of international QE evidence.
As Dr Lowe noted, there are limitations to the ability of “easy money” from the central bank to stimulate the economy – and, we would add, serious doubts about its efficacy. Instead, the government should be looking at other, fiscal, measures to achieve its aims.
There are a number of myths about QE.
Myth 1 - QE is “money printing”, characterised as injecting cash into the economy.
The truth is that QE is nothing more than an asset swap between the central bank and the private sector. The swap is of one form of monetary instrument (bonds) for another (cash).
Myth 2 - QE will inject new spending power into the economy.
Owners of bonds are natural savers – there is scant evidence to show swapping bonds for cash increases spending outcomes in the real economy.
Myth 3 - QE will force down long-term interest rates.
US history – and 10 year bond yields – actually show that when QE commenced long-term interest rates rose, and when QE ended long-term interest rates fell.
Myth 4 - QE provides cash for banks to lend.
Banks do not need deposits or reserves to lend. They simply need enough regulatory capital (from shareholders) and a sufficient supply of credit-worthy borrowers to create a loan. And the loan creates the deposit. Therefore, the mechanics of QE, which adds deposits and reserves in exchange for bonds, do not impact banks’ ability or willingness to extend loans.
Myth 5 - QE drives long-term share market performance.
The easy response to this myth is Japan. There, QE has been implemented for 20 years and the equity market remains around 40 per cent below its 1989 peak. Supporters of QE (i.e. Bank of Japan) argue QE has not worked ‘yet’ – we need more time.
QE has largely failed to deliver because functionally it operates as a private sector tax aimed at the banking system, the wealthy and anyone that holds a superannuation account
More time. Really? After 20 years?
QE has largely failed to deliver because functionally it operates as a private sector tax aimed at the banking system, the wealthy and anyone that holds a superannuation account.
This is because QE encourages the sale of low risk low yielding assets for even lower yielding cash, resulting in lower net interest income to the private sector. Where does this income go? To the central bank on the other side of the trade, acquiring higher yielding bonds for the lower cost cash. In effect, the central bank is making an investment spread at the expense of the natural holders of bonds (including banks and superannuation accounts).
In Australia (and the US), excess capital (profits) are remitted to the treasury – in the same way that cash receipts from the tax office are remitted to the treasury.
For investors seeking Aussie QE, be careful what you wish for. You are asking for the wider economy to be taxed.
If QE does not work, why do it?
This is difficult to answer, as we do not have access to the inner thinking of central banks (or bankers). We know that Japan has used QE since 2001 for little or no inflationary or stimulatory effect. Further, there appears to be little evidence it worked in the US, Europe or the UK.
Having said that, we acknowledge that during extreme credit events, central bank (and treasury) intervention to buy assets can help. In 2008, as the US banking system was on the verge of collapse, the Treasury and Fed acquired risky assets (TARP), which stabilised member bank balance sheets. Until this time, banks were unwilling to lend to each other, causing a collapse in the payment system. Under this scenario (bad assets swapped for good cash), asset purchases helped stabilise the banking system.
However, outside of a banking crisis, QE is largely ineffective. It is not inflationary (because it is not money printing), and it is not stimulatory (it is functionally a tax). Investors expecting Aussie QE to provide economic salvation will be disappointed.
For the economy to turn the corner, what is needed is a significant federal government fiscal deficit, which is true money printing. Unfortunately, based on the current political need to achieve a surplus, we hold out little hope.
Chris Bedingfield is the principal of Quay Global Investors