http://www.moneyweek.com/news-and-charts/economics/what-is-quantitative-easing-42309.aspx
What is quantitative easing? By Associate Editor David Stevenson Feb 20, 2009
The Bank of England is relying on quantitative easing to kickstart our flagging economy. But what is it? And can it work? David Stevenson explains.
What is quantitative easing?
The smart new term for printing money, although these days that extra cash isn't produced in the form of newly minted coins and bank notes. Rather, quantitative easing (QE) involves electronically expanding a central bank's balance sheet. So under its Asset Purchase Facility, similar to that used by the US Federal Reserve, the Bank of England will now buy directly from commercial banks "high-quality assets, broadly comparable to investment grade". These will range from fixed-income sovereign debt and corporate bonds to 'asset-backed' securities built on property loans. On the flipside, the Bank will also sell fewer of its own IOUs – gilts – to institutions such as pension funds. The two measures combined should release extra liquidity into the economy.
Quantitative easing: are there alternatives?
The Bank has other options to get cash flowing again. It has already cut interest rates sharply to a record low level of 1%. Another option is lowering the bar on how much capital lenders have to hold on their books. The trouble is, the first option isn't working because bankers are reluctant to advance any more credit to anyone after so much of their recent lending has gone bad. Indeed, fearful of not recovering the cash, lenders such as banks won't even lend freely to each other, as evidenced by high inter-bank lending rates. And regulators have so far shied away from the second option given the number of recent bank failures. So the Bank is now opting for the 'last resort' of quantitative easing – for the first time since the 1970s.
What's the plan?
'Monetarist' theory says that both economic activity and price levels are set by the amount of money available multiplied by the speed at which it moves around ('the velocity of money'). Bank of England Governor Mervyn King noted last week that "the supply of money is not growing fast enough". So, by physically upping the cash that commercial lenders have at their disposal – by buying assets from them that other banks may be reluctant to accept as security for loans – the idea is that quantitative easing will directly boost interbank lending and raise the flow of credit through the economy as banks regain the confidence to make other loans to, say, small businesses and homeowners.
Will quantitative easing work?
We won't know for several months, if not years. Since banks still don't know the full extent of the damage that's been done to their own balance sheets by years of high risk lending, they may simply continue to hoard whatever money they can lay their hands on. This means that any extra cash injections from asset sales to the Bank of England are just as likely to reduce the 'money multiplier' (the speed at which money circulates) as kick-start new lending. What's more, there's a risk that even some of the 'high-quality assets' that the Bank will be buying turn out to be worth rather less than it forks out for them. Thus the taxpayer could eventually end up taking yet another hit when they are sold.
Has it worked elsewhere?
The Americans have been going hammer and tongs at quantitative easing, with the US Fed more than doubling the size of its balance sheet within the last six months. But so far this hasn't translated into any economic improvements. Meanwhile, the European Central Bank has decided against trying quantitative easing for now. The classic recent test case for the policy is Japan, which tried quantitative easing between 2001 and 2006 in a bid to drag its recession-bound economy out of the mire. Re-capitalising its banks may have stopped Japan collapsing into a slump, and the economy did enjoy its longest post-World War II expansion between 2002 and 2007. But as John Richards said on FT Alphaville, "QE was nearly irrelevant" because growth "was largely self-financed by corporations' free cash flow and not constrained by an absence of banks' lending". So the jury's out.
Could quantitative easing herald the return of inflation?
Falling prices are a more immediate concern. "QE won't eradicate the threat of deflation," says Capital Economics. But deflation may not be a problem for long. A recession-induced mix of stalled house-building, widespread retail casualties and factory closures has cut output back hard. Too much fresh cash pumped into the economy would chase this reduced supply of goods, which could re-ignite price rises earlier than expected. Further, global prices are currently weak. But they won't stay down forever, and with the plunging pound raising import costs, retailers will have to hike their selling prices to survive. An inflation spike would force the Bank to raise rates sharply – a QE U-turn.
Would a 'bad bank' help?
Critics of quantitative easing point out that it ignores the really toxic 'non-prime' loans that are all over bank balance sheets. Until this problem is sorted, lenders will keep shying away from lending again. Chancellor Alistair Darling has said he "wouldn't rule out a bad bank" – a separate entity that would buy these assets from the banks. Further, the idea has worked before. The Lloyds insurance market was threatened 15 years ago by a*****estosis claims and was "on the verge of collapse", says Lloyds chairman Lord Levene. "The only real chance of salvation lay in making a clean break". So Equitas was created to absorb these liabilities. Unfortunately, lenders could be sitting on some £200bn of toxic assets, says The Daily Telegraph. A bad bank would have to be underwritten by the taxpayer. So full-scale nationalisation seems more likely.
What is quantitative easing? By Associate Editor David Stevenson Feb 20, 2009
The Bank of England is relying on quantitative easing to kickstart our flagging economy. But what is it? And can it work? David Stevenson explains.
What is quantitative easing?
The smart new term for printing money, although these days that extra cash isn't produced in the form of newly minted coins and bank notes. Rather, quantitative easing (QE) involves electronically expanding a central bank's balance sheet. So under its Asset Purchase Facility, similar to that used by the US Federal Reserve, the Bank of England will now buy directly from commercial banks "high-quality assets, broadly comparable to investment grade". These will range from fixed-income sovereign debt and corporate bonds to 'asset-backed' securities built on property loans. On the flipside, the Bank will also sell fewer of its own IOUs – gilts – to institutions such as pension funds. The two measures combined should release extra liquidity into the economy.
Quantitative easing: are there alternatives?
The Bank has other options to get cash flowing again. It has already cut interest rates sharply to a record low level of 1%. Another option is lowering the bar on how much capital lenders have to hold on their books. The trouble is, the first option isn't working because bankers are reluctant to advance any more credit to anyone after so much of their recent lending has gone bad. Indeed, fearful of not recovering the cash, lenders such as banks won't even lend freely to each other, as evidenced by high inter-bank lending rates. And regulators have so far shied away from the second option given the number of recent bank failures. So the Bank is now opting for the 'last resort' of quantitative easing – for the first time since the 1970s.
What's the plan?
'Monetarist' theory says that both economic activity and price levels are set by the amount of money available multiplied by the speed at which it moves around ('the velocity of money'). Bank of England Governor Mervyn King noted last week that "the supply of money is not growing fast enough". So, by physically upping the cash that commercial lenders have at their disposal – by buying assets from them that other banks may be reluctant to accept as security for loans – the idea is that quantitative easing will directly boost interbank lending and raise the flow of credit through the economy as banks regain the confidence to make other loans to, say, small businesses and homeowners.
Will quantitative easing work?
We won't know for several months, if not years. Since banks still don't know the full extent of the damage that's been done to their own balance sheets by years of high risk lending, they may simply continue to hoard whatever money they can lay their hands on. This means that any extra cash injections from asset sales to the Bank of England are just as likely to reduce the 'money multiplier' (the speed at which money circulates) as kick-start new lending. What's more, there's a risk that even some of the 'high-quality assets' that the Bank will be buying turn out to be worth rather less than it forks out for them. Thus the taxpayer could eventually end up taking yet another hit when they are sold.
Has it worked elsewhere?
The Americans have been going hammer and tongs at quantitative easing, with the US Fed more than doubling the size of its balance sheet within the last six months. But so far this hasn't translated into any economic improvements. Meanwhile, the European Central Bank has decided against trying quantitative easing for now. The classic recent test case for the policy is Japan, which tried quantitative easing between 2001 and 2006 in a bid to drag its recession-bound economy out of the mire. Re-capitalising its banks may have stopped Japan collapsing into a slump, and the economy did enjoy its longest post-World War II expansion between 2002 and 2007. But as John Richards said on FT Alphaville, "QE was nearly irrelevant" because growth "was largely self-financed by corporations' free cash flow and not constrained by an absence of banks' lending". So the jury's out.
Could quantitative easing herald the return of inflation?
Falling prices are a more immediate concern. "QE won't eradicate the threat of deflation," says Capital Economics. But deflation may not be a problem for long. A recession-induced mix of stalled house-building, widespread retail casualties and factory closures has cut output back hard. Too much fresh cash pumped into the economy would chase this reduced supply of goods, which could re-ignite price rises earlier than expected. Further, global prices are currently weak. But they won't stay down forever, and with the plunging pound raising import costs, retailers will have to hike their selling prices to survive. An inflation spike would force the Bank to raise rates sharply – a QE U-turn.
Would a 'bad bank' help?
Critics of quantitative easing point out that it ignores the really toxic 'non-prime' loans that are all over bank balance sheets. Until this problem is sorted, lenders will keep shying away from lending again. Chancellor Alistair Darling has said he "wouldn't rule out a bad bank" – a separate entity that would buy these assets from the banks. Further, the idea has worked before. The Lloyds insurance market was threatened 15 years ago by a*****estosis claims and was "on the verge of collapse", says Lloyds chairman Lord Levene. "The only real chance of salvation lay in making a clean break". So Equitas was created to absorb these liabilities. Unfortunately, lenders could be sitting on some £200bn of toxic assets, says The Daily Telegraph. A bad bank would have to be underwritten by the taxpayer. So full-scale nationalisation seems more likely.
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