Quantitative easing
What is it?
Put most simply, quantitative easing is when a central bank like the US Federal Reserve starts 'printing money.'
Put less simply, Willem Buiter, Professor of European Political Economy, at the London School of Economics and a columnist in the Financial Times, describes quantitative easing as "the expansion of the balance sheet of the central bank keeping constant the liquidity and (credit) risk composition of its assets, by increasing the stock of base money."
Quantitative easing and qualitative easing
Buiter points out that quantitative easing is often accompanied by 'qualitative easing.' Qualitative easing is when central banks change the mix of assets on their balance sheet in favour of higher risk assets which are less easy to sell on again.
In practice, qualitative easing might involve central banks swapping low quality assets such as mortgage backed securities for high quality assets such as government bonds.
In practice, quantitative easing might involve central banks lending money to companies, or even giving money directly to consumers in a so-called 'helicopter drop.'
Quantitative easing becomes increasingly inevitable once interest rates hit zero per cent. When interest rates are zero, central banks will have to keep on creating money so that they can buy up government bonds - if no one wants to buy government bonds, the interest rate paid on them will have to rise steeply to encourage private investors towards government bond ownership.
Alternatively, quantitative easing might also involve 'under-funding' a government's budget deficit. In this circumstance, the government doesn't issue government bonds to fund its deficit - the central bank simply prints the cash that the government requires.
Inflation and deflation
The big argument against quantitative easing is that it causes inflation - as more money is pumped into the system, money becomes devalued and more of it is required to buy daily goods. This is what happened in the Weimar Republic and what is happening in Zimbabwe.
However, exponents of quantitative easing point out that inflation won't necessarily result. This is because the supply of money is a function of two things:
- The monetary base: bank reserves and currency in circulation
- The money multiplier: the number of times the monetary base is multiplied by banks who lend out multiples of bank deposits to borrowers as part of the
fractional banking system.
If banks aren't lending nearly as much as they used to (which is the case under the credit crunch), it's argued that the money multiplier effect is reduced and that even if the monetary base increases it won't cause inflation. Japanese banks practiced quantitative easing in the early 2000s and it didn't cause inflation for this reason.
If quantitative easing is risky, why is it used at all? It's central banks' weapon of the last resort and is employed only to combat deflation, ie. a sustained falls in the price of key goods and services. Deflation is bad because as prices of goods and services fall, wages and salaries will fall. However, debts stay the same and become more and more difficult to pay back.
What's it got to do with the financial crisis?
As a result of the financial crisis, deflation has become an issue and central banks are turning to quantitative easing to try and make amends. The US Federal Reserve cut interest rates to
a range between zero and 0.25% in December 2008 and promised to use 'all available tools' to get the economy started again.
In practice,
The Economist says the Fed has been practicing quantitative (or at least qualitative easing) for a while. For example, it guaranteed $306bn of assets belonging to Citigroup, created a $200bn facility to purchase asset-backed securities, and promised to buy up to $500bn of mortgage-backed securities issued by Fannie Mae and Freddie Mac, and to buy up to $100 billion-worth of their direct debt.
For a very good graphical representation of the Fed's actions, click here.
It was argued that quantitative easing wouldn't work because we are in a liquidity trap and that even if banks are given additional cash they won't lend it out and restore the money multiplier because they need to rebuild their reserves.
Those fears turned out to be well-grounded. Hyper inflation has swept many countries. Buiter has argued that 'printing money' is helpful when credit is tight and markets are illiquid -- meaning that there is not enough trading going on. But he points out that quantitative easing is of little to no use when the problem is lack of capital or impending insolvency among many companies, as is the case as of 2009. Telegraph economics editor Edmund Conway has pointed out that the Bank of England's quantitative easing program has been, contrary to plan, a boon to foreign investors rather than domestic banks. As much as 50% of the BOE's programme benefited foreign investors.
Last updated 7 September 2009.
