I met an expert on drug addiction this week. We talked about the extent to which addicts can be functioning members of society, and what it is that can push them over the edge from functioning to non-functioning. I’ll write some more about this and on the economic consequences of our drugs policies on the blog at some point in the coming weeks (those who want a head start on the subject can read Dr Max Rendall’s Legalize).
But, rather like many other things, the conversation made me think of quantitative easing (QE) in Britain, and in particular in America. For a long time now we have been almost drowning in newly created electronic money. It has had some pretty trying side effects – not least the astonishing transfer of wealth from poor to rich, thanks to regular inflation and soaring asset prices. But so far, our economies are putting up a good show of producing a degree of normality.
Sure, London house prices are behaving rather oddly, the American stock market is hitting uncomfortable highs, and emerging markets are more nervy than usual. But overall, a Martian landing here at any point over the last couple of years, who didn’t know and wasn’t told that the only thing keeping the show on the road was massive QE, might have come away thinking that things were mostly just fine. A functioning economy.
But this period of unstable equilibrium is beginning to look like it can’t last much longer. James Ferguson has written a brilliant cover story for us this week on why he thinks that QE in Europe is inevitable (unusually, we all agree on this), and what you should do about it (buy more European stocks). Read it carefully and you’ll see that along the way he refers to the American banks as more or less fixed. This really matters.
Why? Because during their struggle to survive, they cut back on lending hugely. That was very deflationary (falling bank lending cuts the money supply). QE was introduced to counter-balance the fall in lending: the Fed printed enough money to compensate for the fall in lending, and there was no deflation. As fast as the banks reduced the supply of money, the Fed raised it again.
However, now that the banks are lending again there is no need for QE. Keeping it (as the Fed has clearly decided to do) simply means that new money is being created by not one, but two sources – the Fed and the commercial banks. Instead of a negative meeting a positive and coming out neutral, we have two positives. The natural result of this? Fast inflation. And that, as James points out, is very probably the real reason why inflation expectations and Treasury yields in America have been rising. Not because the market expects QE to end – but because it suspects it never will.