Disadvantages of Quantitative Easing

The goal of the monetary policy of any economy is to provide stability. That is the purpose for which the central banks were created in the first place. The charter of each of the central banks like Fed, Bank of England and Bank of Japan mention fiscal stability as their number one objective.

However, critics believe that policies such as quantitative easing work in the opposite direction. In the short term, they provide monetary stimulus. However, in the long run, they create monetary instability which defeats the entire purpose of having a central bank. In this article, we will have a closer look at some more criticisms of the quantitative easing policy.

Inflation

The goal of the central banks is to keep inflation at a bare minimum. However, the policy of quantitative easing does the exact opposite. Since this policy creates money and uses this money to further amplify lending by using this money as reserves, it is inherently inflationary. There is not much empirical evidence about the quantum of inflation that is caused by quantitative easing. This is because quantitative easing is a relatively recent phenomenon.

However, economic policy suggests that quantitative easing will be used in a depressed economy and therefore the first effects of inflation will be good as they will stimulate the economy. The later effects of such stimulation will be difficult to manage when the economy recovers. Therefore it is highly likely that quantitative easing solves one problem but creates another in the next few years. It is therefore only a temporary quick fix and not a long term solution.

Interest Rates

Like inflation, the goal of the central banks is to keep the interest rates at somewhat stable levels. The more fluctuation there is in the interest rates in the economy, the worse is the performance of the central bank. It is stability that brings about a strong consumer confidence which in turn brings about a strong economy. On the other hand, if prices fluctuate wildly, consumers do not feel the same level of confidence and economy gets depressed in the long run as consumers tend to delay spending and avoid purchases.

The policy of quantitative easing brings about a fall in the interest rates in the short run. However, in the long run it leads to inflation which causes the interest rates to rise causing the exact opposite of financial stability. Therefore, critics of quantitative easing believe that it is a disruptive policy that creates negative effects in the economy.

Business Cycles

Many critics believe that quantitative easing is the culprit behind creation of the business cycles. They believe that quantitative easing creates easy money in the economy. This money then reaches lenders who want to lend it out at any cost. They compete amongst themselves to find borrowers. In the process of this competition, they end up lending money to people who shouldn’t have received the loans in the first place. Therefore, the policy of quantitative easing first creates a boom i.e. an expansionary phase wherein the banks are lending money to everyone and when all businesses are growing.

However, later the same monetary policy leads to deleveraging by the banks. This is because when quantitative easing stops, money becomes tight. This causes banks to call in their loans and as a result businesses start contracting i.e. a recession ensues. Therefore the same policy of quantitative easing caused both the boom as well the recession phase in the economy!

Employment

Employment is closely linked with the business cycles. The boom phase witnesses massive creation of employment. Banks lend easy money to businesses and they then use this money to expand, creating jobs in the process. Thus, the use of quantitative easing does create jobs in the short run. However, in the process the economy gets used to growing only after receiving monetary injections from the central bank. Therefore, as and when the bond buying stops so does the bank lending and businesses start to contract. It is a well known fact that as and when businesses contract, they reduce the number of employees that they can hire. As a result, people get fired and therefore employment levels plummet. Once again, quantitative easing was supposed to stabilize the employment rate. Instead it destabilized it by first raising it and then making it fall.

Asset Bubbles

Abundance of money always creates bubbles in the asset markets. Higher salaries and higher profits always find their way into these markets raising the prices of assets that are traded in them. Therefore the policy of quantitative easing leads to an asset bubble forming in the market. Once again, the market, like the economy in general becomes hooked to the increasing amounts of monetary stimulus that are received on a day to day basis and once this stimulus stops people start pulling their money out of the markets causing the prices to crash. Thus, the policy of quantitative easing could lead to an increase as well a sudden crash in the market prices bringing about huge transfers of wealth.

The theory of quantitative easing is therefore relatively untested. There are big arguments on both sides of this theory. Some people believe that it is extremely useful whereas others believe that it is dangerous and can bring down entire economies.