What You Should Know About Quantitative Easing?

The term quantitative easing has some sort gain a wider publicity in the recent weeks. It is now standing on par with horrifying economic terms like recession, depression & deflation. In the very near future, I strongly believed that many economics textbook will be rewritten. Economics authors will need to consider whether to still classify US as a capitalist-based economy. Also unconventional monetary tools such as quantitative easing will probably be absorbed into the new curriculum

The Bank of England (BOE) has in the recent announced its effort in increasing the monetary base by £75 billion. Somehow Chancellor Alistair Darling has given green light to extend it to £150 billion

What is actually quantitative easing?

Basically, if we view it from the layman term, it means something like “easing the economy by increasing the quantity of money”. The BOE will use those money it created ‘out of thin air’ to finance the purchase of government bond & corporate bond. Financial institutions such as commercial banks & insurance companies will sell these bonds, hence flushed with ample of liquidity in their account. In theory, they should be able to resume to lending as usual & this should kick start the economy then

Why such a desperate measure?

(1) Sharp contraction. UK is now facing its worst ever financial shock & recession ever since the 1929 Great Depression. Economic activities have slowed down markedly & these translate to lower aggregate demand (AD). Price level falls at its fastest rate triggering the potential risk of deflation, something that all economies will always try prevent. This is because deflation will create a cycle of frugality that will lead to a greater contraction in economic activities when people keep on delaying spending. The Japanese economy has experienced it from 1990s to early 2000s

(2) Low interest rate doesn’t work. In theory, lower base rates should be able to revive the economy since the costs of borrowing had fallen. Rates had been cut for 6 consecutive months & are now standing at 0.5%, the lowest in 315-years. Unfortunately, there is no sign of increase in lending-borrowing activities. Banks have been quite reluctant in passing down the lower rates to customers. The main reason is because they want to protect their thinning margin, reshuffle their balance sheet & of course to attract savers. On the other hand, borrowers are afraid to enter into large commitment in period of uncertainty

(3) Running out of ammo. In the period of rising price level, interest rates can be increased indefinitely to slow down the movement of AD. However, in recession like now there is not much the monetary authority can do since interest rates cannot be slashed below 0%. Also, since the base rates is already low at 0.5%, MPC will probably soon be running out of ‘bullet’

How does it work?

(1) The liquidity effect. BOE will purchase corporate bonds & government bonds from banks, thus increasing the amount of money available in banks’ account. This may increase the willingness of financial institutions to lend to companies & individuals

(2) Interest rate effects. Increase in demand for bonds will send the prices of these bonds to a higher level. Since bond yields & bond prices are inversely related, these mean the interest rates (yields) will be pushed down, thus encouraging borrowing

Will it work this time?

I’m sort of pessimistic. Quantitative easing is something very new to UK policymakers. As can be seen, UK is actually consulting both Japan & US pertaining this policy. At the moment, anything can go wrong. But if judging from history, quantitative easing showed very little success in uplifting the Japanese economy. Having said so, some economists argue that its absence would probably prolong the stagnation

UK is actually facing twin problems here. First is the liquidity within the financial system. Secondly, the rapid-falling consumer confidence which largely explains for the slowdown in various economic activities. Therefore, I argue that even commercial banks may have restored their accounts, but who will be the borrowers? So it is not the issue of how much money the system is being flushed with, but rather its velocity of circulation. In other word, how rapid is money exchanging from one hand to another? The analogy is:

“I may have more money now, but if I choose to be frugal still there will be no spending & the recession will stay as it is or probably worse. So what’s the difference with before & after having more money?”

What are the potential problems?

(1) Lower value of pound. Quantitative easing will set to increase the money supply within the economy, causing the value of pound to fall. Another way of seeing this will be, rise in demand for bonds will cause interest rates to fall (negatively related). As such, it will be less attractive for some wealthy foreigners, pension funds etc to save in UK. Demand for pound will fall

(2) Inflation. Depends on how much the BOE inflate the economy with. If the money supply is more than necessary, soon it will be the problem of ‘too much money chasing too few goods’. In other word, increase in money supply is not match by the increase in real output. Goods will have to be priced higher then. Worse case scenario will be something like hyperinflation in Weimar, Germany back in 1923 when German government resort to printing money for reparations to Allies. It could also be something more recent like hyperinflation in Zimbabwe. A bunch of banana cost several millions Zimbabwean dollar!

(3) Fled of foreign investors. Investors are discouraged from investing in an erratic environment. In period of fast-rising inflation, costs & profits will becoming increasingly difficult to predict

(4) Bond bubble burst. Quantitative easing causes the demand for bond to increase & its supply to fall. This in effect leads to increase in its prices. Investors will soon join the mania, thus potentially driving its price to record high. High prices are often unsustainable. It will soon fall again, but driving interest rates up harming the economy at point of recovery