Qualitative Easing: How it Works and Why it Matters

From the Fed conference in St. Louis, Roger Farmer makes what I think is a useful distinction between quantitative
easing and qualitative easing (the distinction, first made by Buiter in 2008, is useful inependent of his paper; in the paper he argues that it’s the composition of the
balance sheet, not the size, that matters — in the model people cannot participate in financial markets that open before they are born leading to incomplete participation — qualitative easing works by completing markets and having the Fed engage in Pareto improving trades):

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

1 Introduction Central banks throughout the world have
recently engaged in two kinds of unconventional monetary policies:
quantitative easing (QE), which is “an increase in the size of the balance
sheet of the central bank through an increase it is monetary liabilities”,
and qualitative easing (QuaE) which is “a shift in the composition of the
assets of the central bank towards less liquid and riskier assets, holding
constant the size of the balance sheet.”[1]

I have made the case, in a recent series of books and articles, (Farmer,
2006, 2010a,b,c,d, 2012, 2013), that qualitative easing can stabilize
economic activity and that a policy of this kind will increase economic
welfare. In this paper I provide an economic model that shows how
qualitative easing works and why it matters.

Because qualitative easing is conducted by the central bank, it is often
classified as a monetary policy. But because it adds risk to the public
balance sheet that is ultimately borne by the taxpayer, QuaE is better
thought of as a fiscal or quasi-fiscal policy (Buiter, 2010). This
distinction is important because, in order to be effective, QuaE necessarily
redistributes resources from one group of agents to another.

The misclassification of QuaE as monetary policy has led to considerable
confusion over its effectiveness and a misunderstanding of the channel by
which it operates. For example, in an influential piece that was presented
at the 2012 Jackson Hole Conference, Woodford (2012) made the claim that
QuaE is unlikely to be effective and, to the extent that it does stimulate
economic activity, that stimulus must come through the impact of QuaE on the
expectations of financial market participants of future Fed policy actions.

The claim that QuaE is ineffective, is based on the assumption that it has
no effect on the distribution of resources, either between borrowers and
lenders in the current financial markets, or between current market
participants and those yet to be born. I will argue here, that that
assumption is not a good characterization of the way that QuaE operates, and
that QuaE is effective precisely because it alters the distribution of
resources by effecting Pareto improving trades that agents are unable to
carry out for themselves.

I make the case for qualitative easing by constructing a simple general
equilibrium model where agents are rational, expectations are rational and
the financial markets are complete. My work differs from most conventional
models of financial markets because I make the not unreasonable assumption,
that agents cannot participate in financial markets that open before they
are born. In this environment, I show that qualitative easing changes asset
prices and that a policy where the central bank uses QuaE to stabilize the
value of the stock market is Pareto improving and is costless to implement.

My argument builds upon an important theoretical insight due to Cass and
Shell (1983), who distinguish between intrinsic uncertainty and extrinsic
uncertainty. Intrinsic uncertainty is a random variable that influences the
fundamentals of the economy; preferences, technologies and endowments.
Extrinsic uncertainty is anything that does not. Cass and Shell refer to
extrinsic uncertainty as sunspots.[2]

In this paper, I prove four propositions. First, I show that employment,
consumption and the real wage are a function of the amount of outstanding
private debt. Second, I prove that the existence of complete insurance
markets is insufficient to prevent the existence of equilibria where
employment, consumption and the real wage differ in different states, even
when all uncertainty is extrinsic. Third, I introduce a central bank and I
show that a central bank swap of safe for risky assets will change the
relative price of debt and equity. Finally, I prove that a policy of
stabilizing the value of the stock market is welfare improving and that it
does not involve a cost to the taxpayer in any state of the world.

…

10 Conclusion An asset price stabilization policy is now
under discussion as a result of the failure of traditional monetary policy
to move the economy out of the current recession. Most of the academic
literature sees the purchase of risky assets by the central bank as an
alternative form of monetary policy. In this view, if a central bank asset
policy works at all, it works by signaling the intent of future policy
makers to keep interest rates low for a longer period than would normally be
warranted, once the economy begins to recover. In my view, that argument is
incorrect.

Central bank asset purchases have little if anything to do with
traditional monetary policy. In some models, asset swaps by the central
banks are effective because the central bank has the monopoly power to print
money. Although that channel may play a secondary role when the interest
rate is at the zero lower bound (Farmer, 2013), it is not the primary
channel through which qualitative easing affects asset prices. Central bank
open market operations in risky assets are effective because government has
the ability to complete the financial markets by standing in for agents who
are unable to transact before they are born and it is a policy that would be
effective, even in a world where money was not needed as a medium of
exchange.

I have made the case, in a recent series of books and articles (Farmer,
2006, 2010a,b,c,d, 2012, 2013), that qualitative easing matters. In this
paper I have provided an economic model that shows why it matters.

[1] The quote is from Willem Buiter (2008) who proposed this very useful
taxonomy in a piece on his ‘Maverecon’ Financial Times blog.

[2] This is quite different from the original usage of the term by Jevons
(1878) who developed a theory of the business cycle, driven by fluctuations
in agricultural conditions that were ultimately caused by physical sunspot
activity.