QE Revisited – Where Has All the Money Gone?

Many thanks to those who attended my presentation at the City Book Fair in London yesterday, and particularly to the questionner who subjected my critique of Quantitative Easing to vigorous challenge.

I welcome this, as it is vitally important that policy is based on a sound factual foundation.

To summarise the exchange:

My case against Quantitative Easing, set out in detail in Chapter 10 of The Golden Guinea and in a series of comments on this website, is as follows:

1. It has completely failed to achieve the objectives originally set for it, of boosting bank lending, output and employment.

2. The reason that it has failed is that the money pumped into the economy by the Bank of England has fed through to higher prices and caused a significant decline in the rate at which money circulates around the economy.  This has occurred because QE has had the perverse and presumably unintended impact of impoverishing small savers, pensioners, those saving for their pensions, and companies whose unfunded pension scheme liabilities have soared, forcing them to cut back on new investment.

In terms of the simple quantity theory of money, MV = PQ, an increase in M has failed to increase Q because it has been offset by a fall in V and a rise in P.

My interlocutor at yesterday’s session questioned the factual basis of my case. Not even he could challenge the statement that prices have increased.  In March 2009, when QE began, the Retail Price Index stood at 211.  By August 2012, it had risen to 243 – an increase of 15%.

What he did challenge was my statement that V, the rate at which money is circulating around the UK economy, has fallen very sharply since QE was introduced.  If V has fallen sharply, it undermines the central premise of monetarist theory, namely that the demand for money is (reasonably) constant.

So here are the facts:

The velocity of circulation may be defined as equal to the UK’s GDP during any year, divided by the quantity of money at the beginning of the year.

Sterling M4.  The outstanding stock of M4 at December 31st 2007 was £1.67 trillion according to the Bank of England’s statistics. The UK’s GDP in 2008 was £1.44 trillion. Therefore, the velocity of circulation of M4 in 2008 – the year immediately preceding the introduction of QE – was 1.44 / 1.67, or 0.86.

By the end of December 2010, M4 had risen to £2.15 trillion, largely as a result of QE.  UK GDP in 2011 was £1.55 trillion. Thus, the velocity of circulation of M4 had fallen to 0.71 (= 1.55 / 2.15).  So the velocity of circulation of M4 in 2011 was around 18% lower than it had been in 2008.

Sterling M3.  The same result is evident for M3 (series LPMVWXL in the BoE’s statistics). M3 stood at £1.82 trillion at the end of December 2007, rising to £2.32 trillion by end-December 2010. The velocity of circulation of M3 therefore fell from 0.79 in 2008 (before QE) to 0.66 in 2011, or by around 17%.

I have also measured V for M2, M1 and M0 and the results are all similar.  The velocity of circulation of M2 fell by 12% and M1 by 10% in 2011 compared to 2008.  My point is this:

It doesn’t matter which measure of money is used – the velocity of circulation fell very significantly in the three years following introduction of Quantitative Easing.

A second objection raised to my critique was as follows: the questionner claimed that QE had indirectly stimulated economic recovery by driving down the external value of Sterling.  Again, this statement is simply factually incorrect.  Here are the facts:

In July 2007, at the onset of the credit crunch, the trade weighted exchange rate of Sterling stood at 105, according to Bank of England statistics. By March 2009 when QE was introduced, it had fallen to 77, or by around 27%.  This, in my view, reflected a progressive erosion of confidence in the UK among international investors over that period as first Northern Rock, and then RBS and Lloyds-HBOS, collapsed.  However, it has not fallen at all since March 2009. On the contrary, Sterling’s trade-weighted exchange rate has since  recovered to a current level of around 84 – an appreciation of approximately 9%. So the argument that QE has helped to stimulate UK recovery by making our exports more competitive is wholly inconsistent with the evidence.

Just for the record. No one would wish more than me that quantitative easing had achieved the objectives set for it when it was introduced in March 2009.

But as an economist, I am professionally obliged to live in the world of facts, however unpleasant or inconvenient they may be, not in a world of fantasy where figures are fabricated to suit particular dogmas.

The hard statistics tell me that QE has failed.

This is the story told by statistics produced by the Bank of England itself – not by me.

The Bank of England has pumped £375 billion of new money into the economy through QE, or approximately 25% of British GDP.  Where has this money gone?  The statistical answer is – it has been swallowed up by higher prices, and a declining velocity of circulation.  QE has had no beneficial impact whatsoever on output, real incomes or employment.  Quite the reverse.  Through its perverse impact on savings, pensions and investment, it has hampered the recovery of output and jobs.  Through its impact on inflation, it has driven down real incomes.

It is on these grounds that I ask the Bank of England’s Monetary Policy Committee to call a final halt to QE, before any more damage is done.

If it does so, I forecast a gradual, weak but sustained recovery in the economy as the process of cyclical adjustment proceeds.  But if QE is resumed, I fear that it will drive the UK economy back into a stagflationary recession.

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