Basic guide to Quantitative Easing
This is an article that I could have written a few months ago, when the Bank of England stated its intention to begin ‘queasing’. But it has become rather more relevant now that one of the pronouncements of the G20 summit is that the International Monetary Fund (IMF) will itself begin to ‘print’ additional SDRs (Special Drawing Rights, effectively the IMF’s own currency) which its contributor countries can draw down in the shape of dollars, euros, etc.
Note my use of the word ‘print’ in the above paragraph. The days when first world countries used the printing press to increase the volume of money in circulation have long gone, assigned to eras such as Weimar Germany. Paper and ink are still heavily in use in Zimbabwe, of course, but for countries like the UK, where the notes and coins in circulation account for only about three percent of the total ‘money’ in the system, we’re really talking about digits on a computer screen.
Even so, while the phrase ‘quantitative easing’ sounds nice and strategic, in reality it has a similar effect to printing additional bank notes and throwing them out of the Bank of England’s window into the street.
To take a step back for a moment, let’s look at the main blunt instrument used by policy-makers to control the velocity of money and the rate of growth of an economy: interest rates. Set the base rate low, goes the received wisdom, and people will ‘invest’ their money rather than leaving it idle in a bank account earning nothing (or, depending on the level of true inflation, less than nothing). If the economy starts to run away from itself and bubbles form in a particular investment market, interest rates can be raised, increasing the appeal of saving and reducing the relative gains to be made by investing in speculative markets.
So much for the theory. This only works if interest rates are used properly, if they take into account all asset classes in which inflation is occurring and if the Bank of England or the government is seen as credible when it warns about the need for rates to rise. Quite obviously, in the past ten years that has not been the case, with the property asset class hitting bubble territory and being stoked ever larger by unrealistically low interest rates.
I’m not expressing my opinion here: it doesn’t matter what I think about property prices. It’s now widely accepted by economists and politicians (though perhaps not the property-ramping mainstream media) that interest rates were far too low for far too long, and that the resulting inequilibrium and subsequent bursting of the bubble led directly to the current financial crisis.
Aha. But at this point, as per the ‘Idiot’s Guide to Being a Central Banker’, all we have to do is slash interest rates, right? That’ll reduce the viability of savings and force people to invest in companies and other markets in order to get a better return on their money.
Well, potentially yes. But only if there’s anything out there worth investing in. The problem over the past year is that regardless of the probably negative true yield on cash savings, they are still losing value more slowly than pretty much anything else out there. Sure, Sterling has slumped, but houses priced in Sterling have slumped further and so has the stock market. I’ve no doubt that some investment classes have ‘bucked the trend’, but at the moment potential investors are feeling scared having had their fingers burned, and are quite happy to leave their money in the bank.
This is further compounded by the massive write-downs that lending institutions have suffered as a result of the value of their clients’ investments plummeting on the open market. Leverage works both ways, and banks’ balance sheets have been hit hard over the past 18 months. Since there are regulations in place to prevent banks overstretching themselves, this means that even if they’d like to lend more money to households and businesses, they can’t.
Why not change those regulations? Well, they were put in place to prevent dangerous levels of borrowing that could destabilise the financial system. Obviously they didn’t work, and even now a rule-change in the US is helping pummelled banks to mark their remaining assets to a model rather than directly to market (in other words, they can name their own price for the securities they hold) which may give them more leeway to lend. That to me looks prone to massive unintended consequences (and I’m being polite here), but then so does much of the policy action over the last few years.
Back to quantitative easing. If you can’t slash interest rates any lower, what you can do is give banks free money in order to replace their losses. And that’s what quantitative easing does. It generates ‘debt-free’ money that can be used to replenish banks’ coffers, allowing them to meet their statutory requirements and again increase their levels of lending.
What it also does, if left unchecked, is diminish the value of ‘the pound in your pocket’. While that’s not such a problem if the economy is truly shrinking (as long as the Bank immediately destroys the money once it’s no longer needed), the CPI measure of inflation in the UK is currently 3.2%, or 60% above target. The Bank of England is predicting inflation to drop, but printing money at a time when inflation is already so far above target has led more than a few observers to say, “Hang on a minute…”
Which is, arguably, also part of the point. If the Bank can convince savers that it is ‘inadvertently’ destroying the value of their savings still further, it might persuade them to take their money out and spend it rather than watch it all evaporate. There is more politics and psychology here than actual economics. It’s anybody’s guess what the endgame will be.
(c) Alex Cruickshank 2009
The author has his doubts about the likelihood of deflation in the UK.