Due to the economic crisis triggered by the Covid-19 pandemic, central banks around the world adopted unprecedented easy-money policies, lowering interest rates often to 0% and implementing quantitative easing on a broad scale.
The intention of such policies is to stimulate economic activity, which it does accomplish to a certain extent. Lower interest rates make it easier for everyone to borrow money, so even those on the verge of bankruptcy can simply borrow money at a lower interest rate to pay off previous debt that has a higher interest rate.
This is just a temporary stopgap for many companies, though. Inefficient businesses are almost certain to continue burning money even if they get a slight break on their debt repayments, and businesses that maintain a strong balance sheet would likely have been fine even without lower interest rates.
Those who expected quantitative easing to substantially benefit the economy may now find themselves wondering why central banks, including the Federal Reserve, still find such measures necessary. After all, the economy has made substantial progress in recovering from the pandemic. If the goal of quantitative easing is truly to avert an economic crisis by lowering interest rates, why are central banks still hesitant to roll back quantitative easing measures?
In reality, the effectiveness of quantitative easing in terms of supporting the economy and reducing unemployment may not be as high as some people think. Quantitative easing is a macro policy, so any real effect it has on businesses and consumers is going to be a secondary trickle-down effect from the real beneficiary of quantitative easing – financial assets.
What quantitative easing does
Quantitative easing is a monetary policy whereby a central bank purchases financial assets in order to reduce interest rates, increase the supply of money and make it easier for business and consumers to borrow money. By buying securities with a longer-term maturity, quantitative easing can lower longer-term market interest rates versus standard rate policy, which lowers shorter-term market interest rates by adjusting the target for the federal funds rate.
This has a variety of effects which occur in stages over time. At first, as central banks buy financial assets, more liquidity enters the pockets of the previous owners of said assets (typically banks or other financial institutions). The financial assets being bought have traditionally been government treasuries and mortgage-backed securities, though the U.S. Fed has also bought corporate bonds via exchange-traded funds.
With the extra cash, financial institutions now have more funds to lend out or purchase other assets even as interest rates decline. Sovereign debt also becomes substantially cheaper to issue, making it easier for governments to issue new debt. Given the low yields on fixed-income assets, investors are also driven away from these assets toward equity markets in search of yields, driving up stock prices and increasing venture capital.
An expansionary policy
Quantitative easing may cause interest rates to decrease in the short term, but in the long term, it will naturally cause interest rates to rise again. This is because quantitative easing is an expansionary monetary policy, as evidenced by the fact that the end result of quantitative easing is driving up the prices of financial assets to the point where many investors see new startups as the main sources of high yield potential. By injecting so much cash into markets, it signals that the economy is in an expansionary phase.
What happens during a period of economic expansion? When an economy is expanding naturally, both industrial markets and financial markets will grow. However, during the artificial expansion phase triggered by quantitative easing, the majority of the funds generated will be funneled towards the financial markets, and relatively little of this money will go to the real economy.
With so much monetary stimulus for financial markets, assets can very quickly reach premium valuations that put investors on edge in regards to future gains. Can stocks really continue climbing if they are already priced so high? Where should investors go next in search of yields? Treasury bonds are also not worth buying for investors at this stage – only the central bank wants to buy these when yields are so low.
Bubble machine
It’s at this point that quantitative easing transitions from price support to a veritable bubble machine. Very little of the liquidity from quantitative easing measures is going to means of production, as investors do not see high yield potential in industry. Increasingly, money is directed toward already-overvalued stocks or startups that oftentimes have yet to produce a profit.
This increase in “speculative demand for money” is something that John Maynard Keynes discussed nearly a century ago in his book “A Treatise on Money.” Keynes argued that during a sharp economic downturn, money is not hoarded. Instead, it is shifted from industrial to financial circulation. In industrial circulation, money goes toward the production of goods, but in financial circulation, it is exchanged for “the business of holding and exchanging existing titles to wealth.”
The main effect of quantitative easing has been to increase the speculative demand for money. Much has changed about financial markets since Keynes’ time, but the same general principle applies. In 2021, there have been a record 703 traditional initial public offerings and 441 SPAC IPOs in the U.S. alone, which is a mind-blowing number considering that the year with the second most public offerings in history was 2020 with 450 IPOs and 248 SPAC IPOs.
In other words, the Fed doesn’t want to reduce quantitative easing just yet because the speculative demand for money appears to be relying on it. The fear is that without this support for the prices of financial assets, the bubble will immediately burst.
That might not necessarily happen, and even if it does, it might not be a bad thing. If quantitative easing is scaled back on its own, without any substantial investments being transferred to industry rather than speculation, it could result in a stock market crash that is crippling both for financial markets and for the real economy. However, if the government and investors take the cash generated from quantitative easing and actually begin spending it, it will help grow the real economy and contribute to companies’ profits.
Conclusion
The Fed has stated several times that the reason it is hesitant to roll back quantitative easing is because it has not yet done enough to improve the real economy. However, quantitative easing has done relatively little to help the real economy compared to the benefits that it has provided for the owners of financial assets.
This has resulted in bubbles being formed all over equity markets as investors pay top dollar for equities in the desperate search for higher yields. This may seem like a disastrous situation at first, and it can easily turn out to be so if handled incorrectly.
However, the solution is baked into the problem; if money flows from industrial to financial in times of economic crisis, it should flow from financial to industrial in times of economic expansion. The governments that have been printing money and the financial institutions and individuals that have been snapping up overpriced and speculative assets need to begin spending that money to grow the real economy and keep some of the bubbles – the ones that are worth investing in – from bursting.
