The dangers and drawbacks of Quantitative Easing
Generally, quantitative easing (central banks buying up bonds with newly created money) is expected to boost economic growth as it has the following effects:
- Buying up large quantities of bonds suppresses long-term interest rates. This is extremely important, as long-term interest rates are far more important for economic growth than short-term interest rates.
- Substantially forcing down interest rates – particularly yields on government bonds – encourages investors to seek refuge in riskier investments, because the return is higher (but the risks are also higher). In other words: Quantitative easing generates an increase in investment in stocks, company bonds, and suchlike.
- The best thing, naturally, would be if lower interest rates were to immediately prompt more borrowing and less saving, but it can also be encouraged indirectly. Higher stock and bond prices improve the balance sheet position for many parties. If too many old debts were the reason for not borrowing any more, that situation changes if asset values rise and particularly if housing prices rise as well.
- Generally, the currency of the country implementing quantitative easing depreciates, as it becomes more appealing for domestic investors to invest in the country in question, due to lower interest rates. There is also more money in circulation, part of which will probably be invested elsewhere. A cheaper currency then aids foreign trade.
However, QE cannot simply generate wealth, and the drawbacks and potential risks of even more QE will become greater the more money has been created already. Thereby, QE has several drawbacks worth to consider (both for policy makers and investors):
- It will only buy more time. It does not solve the underlying economic problems.
- The pressure on politicians to take the necessary structural measures to create higher economic growth is largely alleviated is interest rates are being depressed, even though such measures is where the solution to the economic woes has to come from.
- (Speculation of) quantitative easing has an upward effect on commodity prices. As Western countries and Japan have to import a lot of commodities, that inhibits growth.
- Quantitative easing forces investors to step into ever-riskier investments. That could cause an enormous blow in a subsequent recession.
- Should QE achieve to (temporarily) lift economic growth through higher credit extension, inflation (expectations) will rise immediately as the enormous amount of money created flows into the real economy. Investors in bonds will anticipate this, and will begin selling bonds – they lose more value the higher inflation expectations – so there is a high risks that interest rates rise even more than inflation. The result is that it becomes increasingly expensive for the both the government and the private sector to (re)finance debts, and risks of bankruptcy loom.
- If the central bank does try to avert higher inflation and interest rates when the economy starts growing again, it has to drain the money it has pumped into the banks before. The more money was printed, the more money has to be withdrawn. To the extent that high money creation has boosted asset prices, the opposite occurs if liquidity is withdrawn from the system. The more money has been printed, the more downward pressure there will be on asset prices if the central bank reverses this process.
- Japanis still struggling with the additional problem of the financial markets easily interpreting quantitative easing as monetarily financing budget deficits. As soon as that happens, interest rates will rise and the Japanese government will be bankrupt.