History of Q.E. and previous uses:
Much of the negative connotation of the term inflation and apprehension surrounding the concept comes from the hyperinflation experienced by Germany, which began after WWI in 1921 and lasted until 1924. The origins of this inflationary problem began for the Germans when the country’s leaders, convinced that the First World War would be short-lived, chose to finance their military operations through monetary expansion rather than increased savings and taxation.[1] To do this, German leaders suspended citizen’s ability to convert their German marks into gold and this, combined with the increased monetary production to finance the war, led to a 50% drop in the mark’s value against the dollar by the end of 1918.[2]
In 1919, the Treaty of Versailles destroyed Germany’s high aspirations in two ways: first by marking the official surrender and disarmament of the German army, and second, by demanding reparations of $12.5 billion, an especially excessive amount for the time.[3] In his book The Economics Consequences of the Peace, John Maynard Keynes prophesized the economic and political disarray which would plague the German Republic following the treaty, and in regards to the relationship between monetary creation and inflation found that “the inflationism of the currency systems of Europe has proceeded to extraordinary lengths”.[4] Keynes’ prediction soon proved correct, as by 1924, German marks in circulation reached 497 quintillion, exponentially larger than their level of 29.2 billion just five years before. To make matters worse, when the Germans defaulted on reparations payments, the French and Belgians occupied the German region of Ruhr, their “industrial heartland,” which produced 85 percent of the country’s coal.[5] In the same year, the exchange rate was 1 trillion marks per dollar and a wheelbarrow of marks was insufficient to buy a newspaper. Workers began to be paid twice daily, at which point they would rush to local businesses to buy supplies before the price hiked any further.[6] As the Economist notes, by the time hyperinflation had stabilized in 1924, the effect had been so severe that many in Germany were ready to believe that “Germany had been stabbed in the back by a conspiracy of Jews, international financiers and local appeasers”.[7] Though not the sole factor, the oppressive terms of the Treaty of Versailles and the subsequent German hyperinflation, was a major contributing factor in the rise of Adolf Hitler’s National Socialist Party and the tension which caused WWII.
Hyperinflation within global economies is a problem which is still of relevant concern today, a fact illustrated by the hyperinflation experienced by Zimbabwe. The primary causes of Zimbabwe’s hyperinflation was a drop in their overall economic output, as domestic productive capabilities were greatly debilitated by turmoil following the country’s civil war and confiscation of white-owned land.[8] The problem was exacerbated by President Robert Mugabe’s decision to abandon the keeping of financial statistics on inflation within the country. As production continued to fall, and the government printed more money to attempt and solve the problem, inflation rates soared, reaching 231 million percent by October 9th, 2008. To combat the problem, the Zimbabwean government abandoned its currency in 2009, and because the country has yet to release a new currency, prices in the country are currently set in U.S. dollars.[9]
Despite historical evidence, noted by the Wall Street Journal’s Jason Zweig, that the United States adopted an approach similar to the modern asset-buying program to deal with the recession of 1866 by buying bonds and flooding the markets with cash, overall consensus on the origins of the modern conception of “quantitative easing” and Fed action points to the policy decisions of the Bank of Japan from 2001-06.[10] In 1999, the Japanese economy was hampered by deflation, and after lowering short-term interest rates to close to zero in 1999 in a policy dubbed ZIRP (Zero Interest Rate Policy), the Bank of Japan was still unable to reinvigorate their struggling economy and a liquidity trap ensued.[11] To further stimulate the economy, on March 19th, 2001, the Bank of Japan adopted a QEP (quantitative easing policy) in an attempt to maintain their ZIRP “until the core CPI registers stably a zero percent or an increases year on year”.[12] To accomplish this goal, the Bank shifted its primary focus from the overnight call rate to the current account balances within their banks, and the Bank of Japan “increased its target for ‘current account balances’ at commercial banks far in excess of required reserve levels, over-capitalizing the banks thus forcing them to lend more at minimal risk”.[13] Additionally, Japan’s central bank instituted a program of Japanese Government Bond, or JGB, purchases to stimulate long term investment, raising the ceiling on long-term JGB purchases “from 400 billion yen to 1.2 trillion”.[14] The reasoning was that by purchasing these longer-termed bonds, the yield curve on JGBs would flatten, making short and long term debt closer to perfect substitutes, thus incentivizing firms to invest in longer term investment and more readily inspire the Japanese economy to not only shake the malaise that was pervasive in the current economic conditions through immediate consumption but also to be sufficiently capitalized and equipped to grow at a healthy rate in the future.
Some have argued that the quantitative easing program of the Bank of Japan also “specifically targeted weaker areas of the Japanese financial system to maintain the pace of credit creation”.[15] Policy Board minutes from the period seem to give legitimacy to these assertions, showing that “some members were particularly moved to embark on the quantitative easing policy as a vehicle to maintain the rate of credit creation by Japanese commercial banks”.[16] This action seemed imperative at the time due to the credit downgrades experience by “19 Japanese banks,” as the Bank of Japan realized that without sufficient credit in the economy, their actions to both improve overall liquidity and incentivize long term investment would prove moot. Overall, the quantitative easing program adopted by the Bank of Japan was one designed at battling deflation within the economy, a goal which they worked to accomplish by not only directly injecting liquidity within the market, but also by targeting long term interest rates and the credit of commercial Japanese banks. Important to understanding the modern connotation of the term “quantitative easing,” and Ben Bernanke’s subsequent desire to distance the actions of the Federal Reserve from the classification of being directly modeled after Japan’s policies, was the success of the Japanese program itself.
In 2006, the Federal Reserve Bank of San Francisco released an economic letter by Vice President Mark Spiegel assessing the overall success of Japan’s quantitative easing program as it winded down. As is typical of any economic policy decision, the FRBSF letter addresses the conflicting empirical results of the program in their current account balance and longer term interest rate targeting. Spiegel ultimately concluded that, given the mixed assessments of the program’s impact on current account balances, as well as its effects on long-term bond yields, the Bank of Japan’s quantitative easing experiment failed in a number of key benchmarks. While there appeared “to be measurable declines in longer-term interest rates,” as well as a “greater risk-tolerance in the Japanese financial system,” the program failed in two regards: first, it failed to completely quell the deflation which plagued the economy at the time and second, that by “strengthening the performance of the weakest Japanese banks” the program may have inadvertently had “the undesired impact of delaying structural reform”.[17]
Though Spiegel’s assessment of Japan’s quantitative easing as damaging to financial reform within the country may qualify as a subjective opinion, the claim regarding Japanese deflation during the time is supported by tangible evidence. From the years 2005-10, Japanese inflation rate fluctuated in a range of between -2.5 percent and 2.3 percent with a mean of -0.09 percent.[18] In his critique of the system, Bank of Japan Governor Masaaki Shirakawa quantifies this statistic as evidence that the program did not effectively “change the perception in financial markets that deflation would persist”.[19] An IMF report on quantitative easing finds that “most believe that the failure to deal resolutely with the undercapitalized banking system had doomed the monetary and fiscal efforts to reignite the economy”.[20] Based on the fact that deflation within the Japanese marketplace was the primary cause of the country’s economic problems, the pervading consensus that the actions of the Bank of Japan were not able to address this fundamental problem does not lend itself to viewing the policies as successful as a whole. Given the, what Shirakawa calls “striking similarities” found by many between the Bank of Japan’s policy actions and those adopted by the Federal Reserve in the years since the 2007 downturn, it is not difficult to see why Chairman Bernanke would hope to distance the classification of the Federal Reserve’s policies from those of the Bank of Japan.
The Federal Reserve is not alone in their implementation of QE programs in response to the 2007 financial collapse, however, as other leading economies have implemented similar quantitative easing policies, the Bank of England being one of these countries, beginning their own QE policy in March of 2009. Explaining their policy decisions, the Bank of England states that when interest rates “are almost at zero, and there is still a significant risk of very low inflation, the Bank can increase the quantity of money,” through a process that “is sometimes known as ‘quantitative easing’”.[21] Their approach to this monetary creation is different in composition than the Fed’s actions; as despite the Bank’s claims that it “creates money and uses it to buy assets such as government bonds and high-quality debt from private companies,” the majority of their balance sheet expansion is from the purchase of government bonds.[22]
While the Bank of England’s “Credit Easing Program” has authorized the purchase of up to 50 billion pounds of a “a broad range of high-quality private assets, including commercial paper and corporate bonds, as of November 2009, such purchases amounted to only 1 billion pounds, versus 75 billion pounds spent on a three month “Asset Purchase Program” focused mainly on the purchase of medium to long-term government notes and bonds.[23] The Bank of England has placed an explicit goal of achieving a target rate of 2 percent for inflation, a goal it hopes to achieve by both increasing the available cash for private companies through corporate asset purchases, as well as by injecting more money into bank reserves to increase economy wide lending.
Despite their explicit inflationary goal, however, empirical evidence shows that bank lending within the private, non-financial sector has turned negative in the U.K., and though corporate bond spreads have narrowed, the small amount of their balance sheet which is occupied by the corporate bond purchases seems to be the primary issue. Both the balance sheets of the United States and the United Kingdom have grown substantially since they have adopted their respective programs, yet the composition of the U.K.’s balance sheet is much more heavily focused on the purchases of government bonds in contrast to the more diverse holdings of the Fed balance sheet.[24]
[1] Goodman, George. “Commanding Heights : The German Hyperinflation, 1923.” PBS. Public Broadcasting Service, 1981. Web. 8 Nov. 2011.
[2] Edition, Print. “Millennium Issue: German Hyperinflation: Loads of Money | The Economist.” The Economist. 23 Dec. 1999. Web. 4 Nov. 2011.
[3] See . “Millennium Issue: German Hyperinflation: Loads of Money | The Economist”.
[4] Keynes, John Maynard. “Commanding Heights : Keynes on Inflation.” Economic Consequences of the Peace. PBS, Aug. 1919. Web. 13 Nov. 2011.
[5] See . “Millennium Issue: German Hyperinflation: Loads of Money | The Economist”.
[6] See Goodman.
[7] See . “Millennium Issue: German Hyperinflation: Loads of Money | The Economist”.
[8] Coltart, David. “A Decade of Suffering In Zimbabwe.” The Cato Institute. The Cato Institute, 24 Mar. 2008. Web. 6 Nov. 2011.
[9] “Zimbabwe Abandons Its Currency.” BBC News. British Broadcasting Company, 29 Jan. 2009. Web. 7 Nov. 2011.
[10] Zweig, Jason. “Quantitative Easing New? Don’t Believe It – Total Return – WSJ.” WSJ Blogs – WSJ. The Wall Street Journal, 31 Oct. 2011. Web. 9 Nov. 2011.
[11] See Klyuev et al.
[12] See Klyuev et al.
[13] Allen, Glen. “Quantitative Easing – A Lesson Learned from Japan | Oye! Times.” Oye! Times. 3 Nov. 2010. Web. 4 Nov. 2011.
[14] Spiegel, Mark M. “Did Quantitative Easing by the Bank of Japan “Work”?” The Federal Reserve Bank of San Francisco: Economic Research, Educational Resources, Community Development, Consumerand Banking Information. 20 Oct. 2006. Web. 1 Nov. 2011.
[15] See Spiegel.
[16] See Spiegel.
[17] See Spiegel.
[18] See Allen.
[19] See Shirakawa.
[20] See Klyuev et al.
[21] Bank of England. Quantitative Easing Explained. London: Bank of England, 2009. Public Information and Enquiries Group. Bank of England, Oct. 2009. Web. 4 Nov. 2011.
[22] See Klyuev et al.
[23] See Klyuev et al.
[24] See Klyuev et al.
