Friday, October 12, 2012

Everything You Wanted To Know About Qualitative Easing

It took me a minute to realise that this new paper I was reading wasn’t a tract about Quantitative Easing, but about Qualitative Easing.

What’s the difference? Quantitative easing refers to the creation of new money that is then used to purchase risky bonds and other securities, thus expanding a central bank’s balance sheet and injecting liquidity into the financial system. Qualitative easing on the other hand refers to the purchase of risky bonds and other securities with higher quality securities such as government bonds or central bank papers. In this case, there’s no increase in a central bank’s balance sheet, and no additional injection of liquidity into the system.

But let the man (he’s head of economics at UCLA) explain it in his own words (abstract):

Qualitative Easing: How it Works and Why it Matters
Roger E.A. Farmer

This paper is about the effectiveness of qualitative easing; a government policy that is designed to mitigate risk through central bank purchases of privately held risky assets and their replacement by government debt, with a return that is guaranteed by the taxpayer. Policies of this kind have recently been carried out by national central banks, backed by implicit guarantees from national treasuries. I construct a general equilibrium model where agents have rational expectations and there is a complete set of financial securities, but where agents are unable to participate in financial markets that open before they are born. I show that a change in the asset composition of the central bank’s balance sheet will change equilibrium asset prices. Further, I prove that a policy in which the central bank stabilizes fluctuations in the stock market is Pareto improving and is costless to implement.

Don’t read the paper if you’re allergic to math or economic theorising. Suffice to say it’s not aimed at the general reader. The theoretical framework used is one I have trouble with (general equilibrium, ratex, almost complete markets), but it is internal consistent. I also have some sympathy for the conclusion, though I have to hasten to add that its not something you want to try in a country with less than mature financial markets.

Having said that, targeting the markets for “risky” assets has been tried before (Hong Kong, Singapore) and is an unspoken feature of Malaysia’s markets, too, when you consider the role of EPF, PNB, Valuecap, Ekuinas and so on. The difference is that the paper looks at central bank action rather than pseudo-fiscal action via government linked entities. The principle is the same however, so the conclusions may still hold.

So is this a good idea? I’d say the evidence is lacking, even if the theory is sound – it’s hard to separate the historical impact of such moves when other policy instruments are at play at the same time i.e. there is no ceteris paribus in the real world. I’d be a little leery given that market microstructures play an important role as well – the level of liquidity, breadth and depth of markets matter.

Technical Notes

Farmer, Roger E.A., "Qualitative Easing: How it Works and Why it Matters", NBER Working Paper No. 18421, September 2012

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