Monetarists’ blind spot on quantitative easing

In this month's Standpoint magazine Tim Congdon has written a rich and insightful contribution to the debate about quantitative easing. He challenges Gordon Brown's portrayal of his own role in the financial crisis, arguing that instead of the response being his ‘brainchild’ the then Prime Minister required a layman's briefing and did not grasp the orthodoxy of the policy for situations when nominal income is falling. Congdon argues that Brown's strategy rested on two pillars – bank recapitalisation (which reduced liquidity) and quantitative easing (which increased it). He portrays Brown as a lucky leader that reluctantly had the right answer thrust upon him (QE) whilst doing his best to make matters worse (recapitalisation).

This article is useful because it clearly distinguishes the orthodox monetarist view of the crisis with that of the Austrian school. In a previous blog post I offered a ‘test’ to distinguish the two schools of thought, and Congdon provides us with the ideal-type monetarist answer. He gives the impression that in 2008 the economy was fundamentally sound, and that the Great Recession of 2009 was entirely avoidable – if it were not for an error by the central bank at the height of the crisis then we would not have entered a recession.

The Austrian school agrees that monetary policy errors were the cause of the recession, but believes that these errors were made long before 2008. Indeed years of artificially low interest rates led to an unsustainable boom and widespread misallocations of capital (manifesting themselves largely in the housing industry). Due to this disruption in economic coordination a recession was inevitable, and the best hope for monetary policy was that it prevented the ‘primary recession’ caused by the bubble unwinding turning into a "secondary recession" that sucked in the whole economy.

This explains why Congdon views events in 2008 as a liquidity crisis and not a solvency one. Indeed he uses the example of National Westminster in 1974 to suggest that if taxpayers earn a positive return on RBS and Lloyds it will conclusively prove they were always solvent. In Congdon's world if only the right people were in charge and had injected liquidity when it was needed, we could all carry on as before.

Some people within the Austrian school take an alternative view and argue that when the interbank market froze in August 2007 this reflected the fundemental insolvency of the entire banking industry. These tend to be the same economists – inspired chiefly by Murray Rothbard – who view fractional reserve banking to be inherently unstable and argue that deflation is a necessary means to purge the system. But just as the monetarist view is too rosy, the Rothbardian view is too pessimistic.

Call me naive, but as an Austrian school economist (that does not follow the Rothbardian approach to banking) I think there is a sensible middle ground. It shouldn't be a debate about whether all banks were solvent or whether all banks were insolvent, but an acceptance that some banks were suffering a liquidity crisis, some were insolvent, and the main problem was that we didn't know which were which!

Austrian economists are happy to acknowledge that under certain theoretical conditions QE can work as Congdon suggests – when the demand for money rises a corresponding increase in the supply can restore monetary equilibrium without forcing an adjustment to take place through prices and output. Expansionary monetary policy can prevent the ‘secondary recession’ and avoid the economic pain caused by a contraction of the money supply.

However, there is an alternative – why can't the Bank of England simply fulfil its traditional role as being lender of last resort? To quote George Selgin:

‘Bagehot's preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at "penalty" rates.’

In a world where central banks exist, this is the mechanism by which we distinguish between the temporary illiquid to the fundamentally insolvent. And unlike QE it avoids a slew of unfavourable side effects, such as expanding the scope of the Bank of England (by redefining the types of assets and types of institutions they deal with); expanding their discretionary powers; generating regime uncertainty; increasing the upside risk of inflation; and placing epistemic burdens on policymakers that there is no hope they can shoulder.

A recent article in The Economist claimed,

‘this support was supposed to be short-term, not continuous: a central bank should be an emergency room, not a hospice.’

Well hang on a minute – the original role of central banks was to (i) offer lines of credit to sound banks that cannot find credit by other means; and (ii) close down unsound banks in an orderly manner. They are supposed to be an emergency room and a hospice. And rather than drench the entire market in liquidity whenever a crisis hits, sometimes we need to allow the tide to go out to see who's swimming naked. Perhaps if we found institutions (as opposed to people) that were better able to distinguish between liquidity and solvency problems, such crises would be less likely to occur in the first place.

This hits the nail nicely on the head but why is King still governor of the Bank of England? A man who has been responsible for so many errors can neither be expected to see the next crisis in advance nor can he be expected to have any sensible answers. There was a time when I would have preferred to see a number of people appointed to the post in preference to King; now I would prefer anyone.
waramess has entirely missed the point - it's about institutions, not individuals. Frankly, King shouldn't have been in a position to have made those mistakes. However, I'd also suggest that the best means to find good institutions is to allow them to develop organically via the action of the market and free choice rather than by central diktat (which is what the original Bank of England was, to a degree). I'm more in agreement with Anthony Evans rather than Tim Congdon but I seem to remember Congdon's own article for the IEA's 'verdict on the crash' came to pretty much the same conclusions regarding the BofE's role as lender of last resort.
Thanks for this interesting post! One comment though: it seems to me that you are slightly misrepresenting the "Rothbardian" view of banking (one that thinks fractional reserve banking is inherently unstable), even though admittedly some of his followers have taken the positions you identify here. In my understanding - and I'm writing as a FRB-skeptic - your middle-ground interpretation of the recent crisis is compatible with a principled preference for a 100% reserve requirement on bank deposits properly so-called. Rothbard would have agreed that in a FRB world even unbacked deposits are money, and he argued that a return to sound money (for example gold + prohibition of FRB) requires that the transitional calculations of quantify of money take those deposits into account. Otherwise the transition would create a huge monetary contraction and punish ordinary citizens who have been fooled into trusting in bank accounts. There is scope for different interpretations even within the "100 % school". But all would agree that it's the conflation of deposit-taking and lending (i.e. fractional reserve banking) that gets us into trouble and, sooner or later, leads to the establishment of a central bank, and the rest of the story is right before us.
If I recall his pamphlet "Central Banking in a Free Society" correctly, Congdon shares your views on the BoE acting as lender of last resort. However, he also wants to privatise the BoE. Obviously, liquidity support is preferrable to QE before a crisis gets going. However, once the central bank has allowed a monetary disequilibrium to take hold, the big guns have to be brought in or the market economy faces an avoidable constriction of supply by the monopoly providers of money.

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