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How QE may be doing more harm than good

Bank Of England Governor Mark Carney
Jason Alden | Getty Images
Bank Of England Governor Mark Carney

I've spent the last few weeks talking almost entirely about the Bank of England's (BoE) latest research findings – and that we're headed toward what could be the most almighty economic and market meltdown ever seen unless we embark on drastic changes in economic policy.

The default reaction to this has tended to be a mixture of incredulity and confusion, with most people wondering "What's Gambles going on about now?" This piece is an attempt at proclaiming a pivotal moment in economic understanding at a key time for the global economy.

The findings in question are contained in the BoE's Quarterly Bulletin. The paper's introduction states that a "common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called 'money multiplier' approach."

This "misconception" is obviously shared by the world's policymakers, including the U.S. Federal Reserve, the Bank of Japan and the People's Bank of China, not to mention the Bank of England itself, who have persisted with a policy of quantitative easing (QE).

Read More Fed's Plosser 'very worried' about QE consequences

QE is seen by its adherents, such as former U.S. Federal Reserve Chairman Ben Bernanke, as both the panacea to heal the post-global financial crisis world and also the factor whose absence was the main cause of the Great Depression. This is in line with their view that central banks create currency for commercial banks to then lend on to borrowers and that this stimulates both asset values and also consumption, which then underpin and fuel the various stages of the expected recovery, encouraging banks to create even more money by lending to both businesses and individuals as a virtuous cycle of expansion unfolds.

The theory sounds great.

However it has one tiny flaw. It's nonsense.

Back in June 2011, when CNBC's Karen Tso asked me why I was so critical of Ben Bernanke, an acknowledged academic expert on The Great Depression, I explained that I couldn't justify the leap of blind faith demanded by Bernanke's neo-classical monetarist theories.

Professor Hyman Minsky was one of the first to recognize the flaw in those theories. He realized that in practise, in a credit-driven economy, the process is the other way round. The credit which underpins economic activity isn't created by a supply of large deposits which then enables banks to lend; instead it is the demand for credit by borrowers that creates loans from banks which are then paid to recipients who then deposit them into banks. Loans create deposits, not the other way round.

Read More ECB to get drastic? QE could be on the table

In the BoE's latest quarterly bulletin, they conceded this point, recognizing that QE is indeed tantamount to pushing on a piece of string. The article tries to salvage some central banker dignity by claiming somewhat hopefully that the artificially lower interest rates caused by QE might have stimulated some loan demand.

However the elasticity or price sensitivity of demand for credit has long been understood to vary at different points in the economic cycle or, as Minsky recognized, people and businesses are not inclined to borrow money during a downturn purely because it is made cheaper to do so. Consumers also need a feeling of job security and confidence in the economy before taking on additional borrowing commitments.

It may even be that QE has actually had a negative effect on employment, recovery and economic activity.

This is because the only notable effect QE is having is to raise asset prices. If the so-called wealth effect -- of higher stock indices and property markets combined with lower interest rates -- has failed to generate a sustained rebound in demand for private borrowing, then the higher asset values can start to depress economic activity. Just think of a property market where unclear job or income prospects make consumers nervous about borrowing but house prices keep going up. The higher prices may act as either a deterrent or a bar to market entry, such as when first time buyers are unable to afford to step onto the property ladder.

Dr Andrea Terzi, Professor of Economics at Franklin University Switzerland, also suggests that many in the banking and finance industry, who often have trouble with the way academics teach and discuss monetary policy, will find the new view much closer to their operational experience. "The few economists who have long rejected the 'state-of-the-art' in their models, and refused to teach it in their classrooms, will feel vindicated," he adds.

Read More Will Yellen take the chill off markets?

Foremost among those economists is Prof Steve Keen: a long-time proponent of the alternative view, endogenous money. Having co-presented with Prof. Keen, I've been taken with the way that his endogenous money beliefs stand up to 'the common sense test.' The proverbial 'man on the Clapham omnibus' knows that borrowing your way out of debt while your returns are dwindling makes no sense. Friedman and Bernanke couldn't see that.

Ben Bernanke positioned himself as a student of history who had learned from the mistakes of the past. Dr. Terzi questions this, "This view that interest rates trigger an effective 'transmission mechanism' is one of the Great Faults in monetary management committed during the Great Recession."

"The reality is that the level of interest rates affects the economy mildly and in an ambiguous way. To state that monetary policy is powerful is an unsubstantiated claim."

For a central bank to recognize that its economic understanding is flawed is a major admission. However, unless it takes the opportunity to correct its policy in line with this new understanding then it will repeat the same old mistakes.

Read More Carney: Strategic shake-up at Bank of England

The world's central banks are steering a course unwittingly directly towards a repeat of the 1930s but on a far greater scale. It's not yet clear that there is any commitment to change this course or indeed whether there is still time to do so. Either way, it will be very interesting to see what future economic historians make of Ben Bernanke's contribution to economic policy.

Paul Gambles is the Co-Founder of MBMG Group

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