STRUGGLING TO MAKE SENSE OF QUANTITATIVE EASING / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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NOVEMBER 18, 2010, 9:47 A.M. ET.

Struggling to Make Sense of Quantitative Easing .

By SIMON NIXON

What exactly is the point of quantitative easing? Two weeks after the U.S. Federal Reserve decided to buy $600 billion of government bonds, the debate still rages. Yet even to ask the question is "ill-judged", according to the governor of the Bank of England. QE is a respectable monetary tool that has been written about in textbooks for a very long time, Mervyn King said last week. To attack the instrument—rather than the decision to use it—is "bizarre," he said.


But the lack of clarity from central bankers over their motives may actually mean QE ends up doing more harm than good.


Mr. King is certainly right there's nothing new about QE. It was used in Japan in the 1990s, where it proved ineffectual. And it was used in Germany in the 1920s, where it worked rather too well, triggering hyperinflation.


Presumably the textbook version of QE advocates government bond-buying on a scale somewhere between Japan and the Weimar Republic, but no central banker has yet said what the optimal scale might be. The U.K. has already purchased 30% of the existing stock of national debt, and the Monetary Policy Committee is clearly willing to countenance buying much more.


The question is what all this government bond-buying is supposed to achieve. Mr. King last week was unequivocal, pointing to lower bond yields as evidence the policy in the U.K. had worked. That would be impressive if it were true. But unfortunately for Mr. King, U.K. government-bond yields actually rose during the period the BOE was buying bonds and have only fallen to record lows since it stopped. That experience corresponds with that of the U.S., where bond yields have risen since the Fed's bond-buying announcement.


Of course, not so long ago Mr. King and his BOE colleagues dismissed any suggestion that QE was targeting bond yields, acutely sensitive to any suggestion they were trying to artificially lower government borrowing costs. Instead, the BOE used to talk about how QE was designed to boost broad money growth. But embarrassingly, broad money growth—based on the BOE's favored measure which excludes financial intermediaries—has remained stubbornly below 2% for the last year.


Meanwhile, other explanations for QE abound. The Chinese believe the U.S. is using QE to attempt an underhand devaluation of the dollar, a view apparently shared by former Fed chairman Alan Greenspan. Others believe the purpose of QE could and should be to provide liquidity to the banking system, both via the accumulation of cash deposits and the increased supply of funds to buy bank bonds. On this analysis, QE is akin to the European Central Bank's unlimited liquidity operations and may in fact be one of the few channels via which QE could be said to have been a genuine success.


Given so many competing views, it's no wonder people are confused. Some economists have concluded the attitude of central banks to QE is to shoot first and declare whatever they hit is the target.


But that is hardly a recipe to instill confidence, perhaps the most important channel through which QE is likely to work. In fact, confusion over motives could even act to damage confidence if the markets start to question a central bank's commitment to fighting inflation and willingness to unwind QE. It is hard to feel confident about how QE will end if you don't know why it was begun.


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