In hindsight, was quantitative easing over such a long period the right policy decision? originally appeared on Quora - the place to gain and share knowledge, empowering people to learn from others and better understand the world.

Answer by Victor Xing, investment analyst with 5 years of experience on a trading desk, on Quora:

Central bank decisions to maintain large balance sheets for a prolonged period of time have been consistent with their policy objectives.

Yet, this perspective carries a significant ramification. If central bank decisions are consistent with objectives, then the debate over "right" versus "wrong" should rest on the soundness of central bank objectives as prescribed by public officials:

  • The Public generally expects central bank policymakers to implement policies to achieve the best economic outcome
  • Instead, central banks are tasked to implement policies to achieve a narrower set of objectives, with the explicit assumption that meeting these objectives would result in the best economic outcome

Despite the challenge of reaching consensus over the definition of "best economic outcome," one can evaluate central bank policies' impact on the real economy and assess their merits under the context of policy mandate.

Low productivity as a side effect of QE and low rates

From the perspective of many policymakers, low rates and subsequent QE programs created conditions to reverse the crisis-induced deleveraging and help averted the scenario of deflation. This is very specific to meeting the "price stability" objective shared by a number of central banks.

However, not all effects are positive. Dallas Fed President Kaplan recently highlighted two essential drivers of growth:

  • Growth in labor force (this is subject to demographic factors, as well as immigration policy)
  • Growth in productivity - this is an area of concern, as productivity growth have been sluggish since the Great Recession (please see below)

Unfortunately, prolonged low rates and persistently large balance sheets was identified as a factor behind low productivity.

Bank of England Chief Economist Haldane highlighted that QE and low rates' stimulative effects in preventing low-productivity "zombie" companies from bankruptcy (a less severe version of Japan's Lost Decade), as low interest rates drove yield-seeking investors to buy riskier corporate debt, thus lowering funding costs for all corporations including those with unsustainable business models.

As a result, these less productive "zombie" firms linger on to drag down aggregate productivity and act as a headwind for growth.

For the purposes of the experiment, we assume a default threshold for the interest cover ratio of one. That is to say, we assume a company that cannot cover its interest payments with profits fails. Different assumptions are clearly possible. The effect of higher interest rates is to shift the distribution of companies' interest cover ratios to the left, so that a number of them now lie below the solvency threshold. In the simulation, an extra 10% of companies go bankrupt. This would translate into an immediate loss of around 1½ million jobs - a very significant macro-economic cost.

Nonetheless, there are also prospectively productivity benefits. The scale of these benefits depends on the productivity characteristics of those firms going bust and specifically on their levels of debt. As Chart 25 shows, there is a U-shaped relationship between firms' productivity and debt, with both high-productivity ("gazelles") and low-productivity ("zombie") companies having high debt ratios. Higher interest rates hit both types of company and so the net effect on productivity is an empirical question.

If we assume all firms have the same solvency threshold, more of the firms going bust are zombies than gazelles - there is more creative destruction than destructive destruction (Chart 24c). Nonetheless, the positive impact of higher interest rates on aggregate productivity is significantly tempered by the bankruptcy of some high-leverage, high-productivity companies. The overall effect of higher interest rates in the simulation is to boost the level of productivity by around 1 or 2% relative to the baseline.

Nevertheless, Chief Economist Haldane was willing to exchange low productivity for higher job growth (as well as higher inflation):

This is a significant productivity gain. At the same time, it does not account for the majority of the productivity shortfall since the crisis. Moreover, it comes at a hefty employment cost. Should monetary policymakers have sacrificed 1 ½ million jobs for the sake of an extra 1 or 2% of productivity? Hand on heart, I can tell you this one would not knowingly have done so.

Some in the Public would view this as a negative policy outcome in hindsight, but Mr. Haldane and his colleagues at the BOE, as well as Federal Reserve policymakers during the crisis era would have likely persisted with the same view if they had to make the same decisions again, because doing so would better meet central bank objectives as mandated by public officials (in the case of the Federal Reserve, the U.S. Congress), rather than other views of better economic outcome.

Finally, the following phenomena are also side-effects of ultra-stimulative policies; as mentioned before, a number of policymakers would be willing to accept these byproducts if the policy in question would hasten the progress toward policy mandates, while many in the Public would view them as "a bridge too far:"

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Published on: May 31, 2017