Wednesday, 3 November 2010

Why QEII Is Sunk

“It is clear that there is a shortage of means of payment during a period of crisis. The convertibility of bills of exchange replaces the metamorphosis of commodities themselves, and so much more so exactly at such times the more a portion of the firms operates on pure credit.
Ignorant and mistaken bank legislation, such as that of 1844-45, can intensify this money crisis. But no kind of bank legislation can eliminate a crisis.”

Marx Capital III Ch30

The US Federal Reserve has launched its much expected second round of Quantitative Easing (QEII) . According to CNBC its proposing to spend up to $600 billion, or $75 billion a month, buying Government Bonds. That is actually less than the $1 trillion that had been talked about. In his blog Paul Mason, has set out some of the background. But, for the reasons set out by Marx above, it is doomed to failure.

Marx sets out in Capital III the role of Credit. It has several functions. Firstly, Credit takes on the function of money. At first credit arises between businesses. Company A supplies goods to company B, but does not require payment until some later date. As Company B supplies to C,D,E, etc., and as these companies also supply to other companies, the possibility arises for all of these IOU's to be netted off against each other, so that only the outstanding amounts have to be paid. As Marx says, one of the first functions of Credit is then to reduce the amount of actual currency required in circulation. It increases the velocity of circulation. But, special institutions can then arise who specialise in dealing with the Bills of Exchange. Any company not wanting to wait for payment can pass such a Bill to a Discount House who will pay cash immediately in return for a small payment a discount. In addition Banks, where all of these organisations hold accounts can remove the need for actual currency transactions by simply making accounting adjustments, debiting the account of one organisation and crediting that of another.

But, this credit can then also fulfil one of the other functions of money; that of store of value. The debt owed to one participant represents a certain quantity of value equal to the value of the commodities it has sold, and which the counterpart of the debt. On the basis of this store of value, the owner of the debt can raise additional finance, by using it as security – it acts as leverage. Finally, in the same way that Money once established becomes the basis of the creation of Capital, so Credit can be used to create Capital. But, as Marx demonstrates, Credit takes on a life of its own. The deposits made by one group form the basis of lending by Banks to others, which in turn as they are spent, become the source of yet further deposits, what today is known as the Credit multiplier, by which the private banking sector can effectively create an almost limitless supply of credit money, in the form of bank deposits. To the extent that this expansion of credit goes beyond the actual production of value within the real economy, the Capital created with it is in reality what Marx calls fictitious Capital. It is not the cause of the tendency of capitalism to create crises of overproduction, but it exacerbates that tendency, and can be a spark to such crises.

But, the opposite can be true. In the Chapter of Capital cited above, Marx describes the crises of 1847 and 1857. In 1844, the Bank Act was passed, which was based on an incorrect theory of money propounded by Ricardo. The Bank Act essentially limited the issue of currency based on the holdings of Gold by the Bank of England. In 1847, as a result of crop failure, England and Ireland needed to import food from the Continent. In the 1840's a massive expansion of textile production had led to the flooding of Britain's export markets. Partly, as a consequence of this, Britain could not pay for these food imports by corresponding exports of goods. It had to pay by a transfer of Gold Bullion. But, under the terms of the Bank Act, this meant that it had to curtail the currency issue. This was stupid. Britain had massive Gold Reserves. The consequence of curtailing the money supply under these conditions was that a shortage of currency arose in circulation. Even allowing for firms using credit, and bank transfers to reduce the need for currency, they still needed currency to pay their workers, and for small transactions. The shortage of currency soon began to gum up the works. Worse, once it became apparent that there was a shortage, people did what they always do when they notice a shortage – they panicked. Those with currency hung on to it, worsening the shortage. And, where firms had been prepared to accept credit, they now demanded cash payment to ensure they got paid, and to increase their own cash balances. That again increased the demand for currency, and made the shortage worse. If any of this sounds familiar it is precisely the process that occurred with the Credit Crunch. The result was also the same, an increasing demand for money at a time when the supply was curtailed resulted in a sharp increase in interest rates. The notable thing is that when eventually the Bank Act had to be suspended, and more money was put into circulation, the crisis was quickly overcome.

It might be thought then that the same would be true now, that QEII should work just as well. But, the situation is not the same. QEI worked to overcome the immediate problem of the Credit Crunch in 2008, for the same reason that the suspension of the Bank Act in 1847 worked. In 2008, the Credit Crunch was not actually a shortage of Money circulating in the economy. It was a seizing up of lending between banks. That was because the sub-prime debacle meant that every bank doubted the safety of every other Bank. None wanted to lend to any other because, one they wanted to hold on to their cash in case they had an immediate call on it, and two they didn't know if the bank they lent to might not pay it back. As I pointed out at the time, one solution to that was that states could step in to guarantee their national banks, but with the obvious downside that this could result in that situation simply being raised to the level of the relation between states. That is what we have seen as the creditworthiness of some states like Greece has then be called into question – a situation which should not, and would not exist if the EU itself had all the aspects of a Federal State.

In other words in 2008 the situation was one in which there was a demand for money that was not being satisfied, and which could only be satisfied if central Banks stepped in to fulfil their function as lenders of last resort. But, the problem today is not one of an unsatisfied demand for money. On the contrary, as I wrote recently the globe is awash with money. Microsoft has just borrowed several billion dollars even though it has nearly $50 billion of cash, simply because it can do so at ridiculously low interest rates. The problem today is not an unsatisfied demand for money requiring more Supply, it is, on the contrary, a problem of lack of demand for all of the money available. This is what is so economically illiterate about the policy of the Liberal-Tories, and their right-wing populist equivalents in Europe, and in the Tea Party in the US. The Federal Reserve is hoping that by pumping even more money into bank coffers, this money will feed into the economy, countering the deflationary tendencies in the US economy, and thereby stimulating consumers and businesses to spend. But, it is precisely the scenario described by Keynes of pushing on a piece of string. They are pushing from behind, but without the demand for that money to pull it from the other end, it just keeps folding up on itself and going nowhere.

The consequences of that vary depending upon the other conditions within each economy. In the US, as I've pointed out before, its massive size, its potential to meet a large part of its requirements internally, especially for food and raw materials, means that the potential for this money leaching out into higher prices is limited. To the extent that huge companies like Wal-Mart, who buy most of their products from China, borrow some of this cheap money to pay for its imports, it will find its way into the economy, and out of the banks vaults. To the extent that this increased supply of dollars to pay for these imports reduces the value of the dollar, it will lead to a certain amount of inflation, as will the extent to which it goes to monetise the already rising prices of Chinese goods. But, its not clear that huge companies like Wal-Mart, with large cash balances of their own, need to borrow to buy. It may, and there is some evidence it is, find its way into yet another asset price bubble, pushing up stock market values. But' ultimately, those values themselves depend upon the view of profitability of companies. At the moment they are going up, but that could quickly reverse. In short, the mechanism by which this extra money could promote economic activity is not clear. Nor is it clear that on balance it can prevent a slide into deflation.

In Britain, that is not the case. Highly dependent upon imports, the transmission belt of increased money supply into prices is clear. In different circumstances that could indeed be a stimulus to increased economic activity, as higher prices run through, at least in the short run, into higher profits. But, having spent months talking down the economy, and warning everyone that the economy was in a ditch as bad as Greece, that is not likely to happen, because everyone has taken the Government at its word, and headed for the trenches to hunker down. Confidence is down, consumers are hoarding cash to be ready for the worst that the Liberal-Tories have told them is coming, and businesses, other than those that have some clarity in export markets – not many – are doing the same. The latest employment statistics demonstrate that, and the report out from the Institute of Personnel, warning of 1.5 million job losses in the private sector over the next 5 years, indicates where things are going. That is before the effects of the Cuts, and the VAT and other Tax rises take effect. In other words, under current conditions the only people wanting to borrow any new money put into British banks through QE, will be those who need it to stay afloat. Its no wonder that the Banks have no interest in lending to those firms and individuals, especially as those same banks still have an unknown number of outstanding loans to such borrowers of dubious quality. The evidence of Anglo-Irish bank and other European Banks in recent weeks is a testimony to that, and once the housing collapse in the UK begins to escalate that reality will become all too apparent. The only likely consequence of the QE already undertaken in the UK, let alone any additional QE, will be to monetise the increasing costs of UK imports, and thereby to sustain, and to enhance the existing inflationary trends. Yet, it will be impossible for it to prevent the collapse of the bubble in property prices. The only way that might be possible would be if the suggestion of one financial think tank out today were adopted, which is for the State to step in and create a new Bad Bank, which effectively bailed the Banks out, by taking all of their defaulting mortgages off their hands. But, how could a Liberal-Tory Government, which has built its house on the sand of an imminent need to reduce the deficit, justify literally handing over several billions of pounds yet again to the Banks, whilst cutting tens of billions from Public Services?

The reality is in the US, and in the UK and Europe, QE is a pointless exercise, if its intention is to stimulate economic activity rather than to deal with a Credit crunch. Pointless that is, unless it is combined with fiscal measures that, at the same time, create a demand for that money, and transmit it directly into the economy. In other words, rather than cutting spending, only a large fiscal stimulus can be effective. It needs that to pull on the string, whilst the monetary authorities feed it out from the other end. But, the populists have cut off that line of salvation for themselves.

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