A recent Goldman Sachs piece on the UK holds the view that the BoE’s recent resumption of asset purchases will permit and prompt UK fiscal policy to be looser, postponing consolidation of the deficit. The mechanism at work is that, comforted by the knowledge that there is a large buyer with a deep pocket for the debt, yields are lower, and this in turn makes the government more comfortable about borrowing, the yield reduction providing more fiscal space.
I don’t hold this view. But it is interesting to think it through, because it gets at what QE is, and what outsiders seem to think it is.
The way I see it – and the way I think both the government and the BoE see it – is the following. The reduction in yields acts as a substitute for lowering the short-term interest rate, and, supposing this to be adequate to bring about a desirable path for inflation and the output gap, would allow tighter fiscal policy than otherwise. One of the arguments made by the government’s critics uses the same logic in reverse. That line of thought – repeated recently in Paul Krugman’s blog – wishes for rates to be higher as a precaution to provide more room for a future cut to respond to future recessionary shock.
The ‘fiscal space’ argument used to suggest that QE permitted looser fiscal policy isn’t relevant, in my opinion, now, because the UK, at a debt to GDP ratio of about 85%, is a long way from the point at which markets might worry about default, and require corresponding premia to compensate [a point which is not, as Robert Peston recently mentioned in his blog ‘conventionally taken to be 90%’].
I can think of two arguments that might lead you to think that QE made no difference to fiscal policy. One is that hypothetically, a recession is so deep that fiscal policy is led to loosen on a trajectory that is as generous as could be risked, given available fiscal space, the duration of the shock, and the likelihood of another. Whatever QE is tried is on too small a scale to change the need for maximally stimulative fiscal policy. You could just about run this argument as a description of UK fiscal policy 2010-12. But some would disagree.
A second ‘irrelevance’ argument is that QE is ineffective. Bernanke joked that QE didn’t work in theory, something taught us many times over, by Wallace, Krugman, Aurbach and Obstfeld, Eggertson and Woodford and others. Empirical studies of QE find variable, but reliably positive effects on impact. But this is not proof that its effect endures. A monetary stimulus that is not a stimulus and is recognised as such would not have any effect on the fiscal authority’s behaviour.
Two ‘QE is financing’ arguments that have more legs, but which the authorities will deny until they are blue in the face, are these.
First, QE is helicopter money in stages, and by disguise. Both government and central bank recognise that conventional fiscal space might be running out, and so the central bank buys debt that otherwise the market might not bear. There is lip service paid to selling it back, but that never happens. We will have to wait quite a while to get a chance for the authorities to rebut this conspiracy theory conclusively.
A second financing argument is that QE tilts the yield curve in such a way that the Treasury, for its own purposes, takes advantage, and skews issuance. The intention at the outset was that the UK’s Debt Management Office would not do this. But as I blogged some time ago, you can see evidence that its customary practice of consulting with market clients over what they want issued would have given them cover to do just that. Summers also worried that the US Treasury was ‘undoing’ the Fed’s QE by tilting issuance towards long end debt.
[Sorry for not providing links: voice recognition software can’t do this!]