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Why Quantitative Easing Didn't Work

Updated on October 16, 2013

What is Quantitative Easing?

Quantitative easing is when a government buys financial assets from banks and/or other private institutions with newly created money. The idea is to push more dollars into the economy.

In QE Round 1 (QE1), the U.S. government bought up a mix of mortgage-backed securities and government bonds from banks. In QE2, the government bought more government bonds from banks.

How Much Did This Cost Us?

Nothing, really.

Government bonds are basically dollar equivalents. You exchange your dollars for t-bills, and when they mature, you exchange your t-bills for dollars (plus a tiny bit of interest). So when you (or a bank) buys or sells t-bills, you aren't changing your financial position at all. The same is true on the government's side of the ledger. Cost to the government: zero.

Mortgage-Backed Securities are a bit different, as they are bank-created credit. The government bought those suspect assets from banks with dollars, basically putting banks in the same position they would have been in had the MBS's held their value. But as the holder of those MBS's, the government received dollars as those MBS's matured - probably not the full value, but it wasn't just a money giveaway, either. The government got most of that money back. Cost to the government: whatever losses they took on MBS values, if any.

So, Why Didn't QE Work?

Taking toxic assets off of the banks' hands, plus exchanging dollars for their t-bill holdings was supposed to make the banks cash-rich, which in turn would spur the banks to make more loans, which would in turn spur the economy. This thinking is flawed on a few levels, though. The decision to loan money is not dependent on how much cash a bank has on hand (for an explanation, see my article, Why Interest Rates Aren't Going Up). Banks are not reserve-constrained, so the decision to loan out money is always based on the creditworthiness of the borrower and the risk-reward calculations of the bank. And since the housing crash affected just about everybody, people weren't spending money and the economy was tanking because of it. So there were simply not very many creditworthy borrowers out there. Who's going to start or expand a business in down times? So few loans were made, and the banks instead held onto that excess cash, even converting much of it right back into government securities.

When it was all said and done, considering that the government recovered most of the value of their MBS's, very few net dollars were added into the economy - and all of those went to the banks.

Plus, most aggravating of all, the banks were taken off the hook for their stupid and risky investments in MBS's. I'm sure that bank executives rewarded themselves richly for that.

What Should Have Been Done Instead

Adding dollars into a down economy is generally a good idea, but a lot depends on where they are added. Spurring consumer spending is the key, and the way to do that is to put money into the hands of people that will spend it - poor people, basically. Instead, QE put cash into the hands of the banks. Normal people never saw a penny of it.

The best idea I heard of came from Warren Mosler. His suggestion in response to the mortgage crisis would be to immediately eliminate FICA taxes. People paying mortgages generally have jobs, and eliminating FICA taxes would immediately give wage earners a large boost in their take-home pay, hopefully enough to continue to make mortgage payments even after their adjustable-rate mortgage rates went up. MBS's were only toxic because of the high rate of default - lower that default rate, and the problem is solved.


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    • JohnfrmCleveland profile image

      John 5 years ago from Cleveland, OH

      Chris57, thank you for your comment.

      I agree that monetary policy isn't terribly effective at addressing economic problems. Fiscal policy is where some real good can be done. Unfortunately, far too many people (especially politicians) are still laboring under the misconception that countries sovereign in their own currency have to borrow money to spend money. Few even understand the difference between pure fiat currencies and the Eurozone countries. I think there will be an upcoming hub on that subject...

    • CHRIS57 profile image

      CHRIS57 5 years ago from Northern Germany

      Quantitive Easing is nothing else but a monetary effort to shift corporate and household debt to public debt. Doesn´t change a thing in the overall economic situation. No structural reforms, no nothing. How is anyone to expect improvements from QE?

      Sometimes i think monetary action is like putting a newspaper sheet over a pile of stinking manure. The effect is that you don´t see the mess and it doesn´t smell (in the beginning). But then the newspaper gets wet and dirty and the manure gets bigger and bigger. So you need more and more sheets of paper to cover the dirt.

      The manure is the economic mess, the newspaper sheet is money. In both, the monetary playing fields and in the smelly example, all you achieve is buying time. But - as long as you don´t clean up the mess ...