Central banks in the U.S., Britain, the euro zone and now Japan are engaged in a grand experiment of massive creation of money, one never before seen, in order to underpin the fragile global economic recovery. Some commentators are now warning us of the dangers of this exceptional "quantitative easing" – but they often forget to examine the consequences of not engaging in massive credit creation. Although printing money is risky, we firmly believe that not acting through exceptional monetary stimulus would have been far worse.
More than four years after the financial crisis, the popular media in Canada and elsewhere have discovered the powerful role played in recent times by central banks around the world. We have been treated to breathless stories about how central banks have created money out of nothing – called quantitative easing (QE) – to keep their respective economies afloat. Similarly, we have been warned that central banks are independent actors, accountable to no one, that are in apparent danger of running amok and destroying the economic recovery in a great monetary rupture.
Let's examine those two claims in order.
It is entirely true that these central banks are engaged in massive creation of money on their balance sheets. While the specific circumstances differ a bit among the countries, in general the normal mechanics for converting the available money supply into new credit for governments, businesses and consumers via the banking system has been impaired. Central banks are therefore creating exceptional liquidity on their balance sheets as a way to restore more normal credit conditions, by kick-starting and then supporting the ongoing creation of credit across the economy, directly and through the banking system.
In some cases, such as in the United States, the exceptional new money is being used to buy bonds to finance government deficits and private investment. In other cases, it is being used to shore up commercial banks. In Japan, the recent introduction of QE is an attempt to break a two-decade-long psychology of deflation and recurring recession, and to help create some mild inflation and restore more positive business and consumer confidence and sustained economic growth. (There has been no QE in Canada.)
This burst of quantitative easing is bloating central bank balance sheets and, for some, is raising the spectre of inflation. However, the economies that are engaged in QE are so far below their potential growth path that there is ample economic slack and spare capacity, high unemployment, and little power to raise prices. Hence, inflation remains muted in all cases but Britain; and as noted, Japan has been grappling with deflation for two decades.
On the second point, it is entirely true that most central banks operate with a high degree of the independence from political authorities. This arms-length independence has been hard-won over many decades. It inoculates central banks from partisan political forces, allowing them to focus on their (normal) core objective, which is preserving the value of money and keeping inflation in check.
But these are not normal times, which is why central banks are engaged in such extraordinary action. Financial markets, international organizations such as the IMF and OECD, other governments and many observers are constantly watching their actions, providing a countervailing influence (if not direct political control). If anything, central bankers in Europe and Japan can be justifiably accused of excessive caution and timidity in not engaging in QE sooner – not excessive action.
The real challenge lies ahead: How to pull back on the exceptional monetary expansion once the economic recovery firms up unambiguously and becomes more self-sustaining. There is no clear road map back to "normal." We are in the midst of a grand experiment in activist monetary policy, which is risky business. The gradual withdrawal of QE and the restoration of more normal monetary conditions, with higher nominal and real interest rates, will have to be guided by common sense, professional judgment and internal debate, not by a hard set of mechanical rules.
Nevertheless, the current extraordinary exercise is far more worthy than sitting on the sidelines and doing nothing, as some seem to suggest. It would have been irresponsible of the central bankers to allow the economy to limp along with high structural unemployment and depressed confidence, or even dip back into sustained recession. So this is risky business – but it beats the alternative.
Glen Hodgson is senior vice-president and chief economist at the Conference Board of Canada