Afternoon:
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When the Governor of the Bank of England Mervyn King announced his embrace of quantitative easing in the spring he said it would take six months before one could judge whether or not the policy was a success. That was six months ago. So now people are beginning to ask the question.
Unfortunately the answer is not easy, not least because most people have only the vaguest idea what the policy actually is, though naturally they are loath to admit this, and therefore find it rather difficult to assess.
The Bank, therefore, has come under increasing fire from a number of quarters for reasons it does not think are entirely fair, so yesterday it hit back.
A speech delivered in Northern Ireland by monetary policy committee member David Miles sought to explain what quantitative easing was and by extension what were the appropriate benchmarks to judge whether or not it was working. The coded message was that if the policy was going to be judged, the Bank would prefer it to be judged against the correct parameters.
The issue for Miles is not whether bank lending has increased, still less whether the money supply has gone up — the two things which are most often latched on to.
Rather, in his view, the key thing is that QE has lowered the yields on government securities. This in turn has brought down the yield on corporate bonds. As a result companies have been more willing to raise new capital by issuing more of these bonds, and investors have been willing to buy them. This enthusiasm has to some extent overflowed into the equity markets with the result, as has been widely observed, that companies have been able to raise a vast amount of new capital via rights issues.
Put these two things together and you find that companies have been able to reduce their dependence on the still-crippled banking system, The alternative in the absence of QE might well have been that companies would have had to cut their reliance on bank lending in the traditional way, by going bust, or at the very least by cutting back drastically. The fact that this has not happened on anything like the anticipated scale is arguably the most tangible proof that the policy is working. We would have missed it if it had not been there.
But if that is a passable case for the defence it is perhaps just as well that the public at large do not really understand the actual mechanics of what is happening so they do not realise how quantitative easing has fuelled one of the biggest profit bonanzas ever for the investment banks, or those who have survived.
The very people who were at the heart of the activities which brought the system to its knees just 12 months ago are back doing what they have always done, and making even more money now than they did before. Forget the fuss about bonuses, just look at the profits.
In the US, where the figures are more easily accessed, the story runs like this. First the banks buy US Treasury bonds with the virtually free money provided for them by the US Federal Reserve under its quantitative easing programme.
The investment banks did not get where they are today by sitting on holdings of government bonds, so they have used these holdings of Treasuries as collateral to raise further loans. This borrowing gears up their balance sheets and they then get further gearing by using these funds to trade in the derivatives markets, where the lack of competition owing to the bankruptcy of the likes of Lehman means that the profit margins are vast.
The results are there for all to see. The volumes of bank trading in the derivatives markets in the first half of this year were higher than they have ever been, although there are fewer players. So much money is being made that the huge shrinkage in investment bank assets which we saw last year has been comprehensively reversed. This year bank balance sheets have grown by at least $500 billion, which is a turnaround of well over a trillion dollars in not much more than six months. Investment banks may have been forced by the crisis to change their status in order to shelter under the Federal Reserve umbrella, but they have not changed their spots. They have rarely if ever been so profitable.
In summary quantitative easing has revitalised the financial system with the money sloshing through the derivatives markets and then overflowing into the cash markets, where it has caused the revival of interest in shares and bonds. The financial markets are flourishing on the back of this credit boom. The trouble of course is that the credit is all getting stuck there; none of it is being lent to real people in the real economy.
You have to ask how long this can continue. The Federal Reserve has the power to do almost anything as long as it believes the US economy is in dire straits. The question though is how long before someone in Congress realises that Goldman Sachs is making record profits and thinks maybe things are not so dire after all. The penny must drop soon. QE may not be allowed to continue as long as Ben Bernanke might like, or long enough for it to benefit the real economy.
