Does QE Finance Government Spending?

by: Cullen Roche

There’s been some good discussion in recent days about QE and whether it is actually legal or not. Frances Coppola, the Telegraph and researchers at the University of Sheffield have all touched on the topic. The legality of QE is a very murky discussion and one that only courts have the answers for. But we can begin to get some clarity here by asking whether QE finances government spending? I say it depends.

In the USA one could argue that QE is an indirect financing of the government’s spending because the Fed is using the Primary Dealers as a conduit through which it can purchase US government bonds. In this sense, QE very much looks like a backdoor financing operation. Then again, that’s how monetary policy is primarily implemented – by having the Central Bank purchase bonds to alter the private sector’s balance sheet. QE is just a big time version of what the Fed has always done. So there’s no reason why this debate shouldn’t have occurred long ago except that people care more about the debate now because QE is so much more publicized.

But there’s a more important point here. The idea that the Fed is financing the deficit implies that the US Treasury could not otherwise sell the bonds at the current rates. I find this very hard to believe given that demand for US Treasury bonds actually INCREASED before QE was implemented during the financial crisis and the fact that inflation has remained extremely low in the USA. Could there come a time when inflation is spiraling out of control and demand for US government bonds declines to a point where the Fed must intervene just to bolster demand? Of course. But that time is not now and hasn’t occurred in the last five years. So, until then, I am inclined to say that QE in the USA is just a big time version of monetary policy and not a direct financing of US government spending.

As for Europe – well, none of the nations in the Euro are actually issuers of the Euro so in this sense the ECB’s OMT backstop and any form of outright QE is even murkier. It would be very similar to the Fed buying municipal bonds in the USA which I do not think would go over well as it would be viewed as direct financing of state governments. So there’s a much stronger argument to be made, that, in the case of Europe, the OMT and QE walk a very fine line that makes the deficit financing and illegality argument a much more reasonable one.