Un-eased by quantitative easing?
September 2009
Since the credit crunch hit the global community in 2008,
countries around the world have continually been looking for ways
to ease the effects of the financial downturn. Having taken
interest rates to historic lows, governments have been looking for
extra firepower to help combat the global recession. Many have
turned to their central banks to pursue quantitative easing (QE) to
help address the dangers to the economy caused by the credit crunch
by easing the pressure on the banks' balance sheets and increasing
the flow and amount of money in circulation.
Also referred to as ‘printing money’, QE is an
extreme form of monetary policy used to stimulate an economy where
interest rates are either at, or close to, zero. QE is a
solution when the normal process of increasing the money supply by
cutting interest rates is not working. In practical terms, central
banks purchase financial assets, including government and corporate
bonds, from financial institutions (such as banks) using money it
has created out of nothing. In turn, the banks are encouraged to
lend out this fresh money supply, rather than keep it on reserve,
thus stimulating the economy through lending to businesses and
individuals. When a loan is made, the money supply expands by the
size of the loan and this new money encourages banks to lend
further still, ultimately reducing the cost of borrowing and
eventually feeding back into the economy through spending.
QE does not come without risks. There is no
guarantee, without forced intervention, that banks will increase
lending despite strengthened balance sheets. More importantly, QE
can also run the risk of going too far. An increase in money supply
to a system has an inflationary effect by diluting the value of a
unit of currency. People who have saved money will find it is
devalued by inflation; this combined with the associated low
interest rates will put people who rely on their savings in
difficulty. The devaluation of a currency can affect the
international credit rating of the country which in turn can lower
the likelihood of foreign investment. The proverbial ‘vicious
circle’.
At some stage, QE will have to be reversed.
The plan is for central banks to sell the financial assets
(government and corporate bonds etc) when economic conditions
improve. Presumably this will be when markets have stabilised and
inflation has returned, however, these market conditions may not be
favourable for selling bonds. Bonds are preferred in a deflationary
environment and only through the use of derivative techniques can
they make investment returns in inflationary times. The central
banks must therefore have confidence in their plans.
Since the Bank of England announced its QE
strategy at the beginning of the year, £125 billion has been poured
into the UK economy via its activity in bond markets. The Bank of
England has recently authorised a further £50 billion, over and
above the £150bn ceiling of the initial agreement. The bank’s
latest move is despite the attacks on the strategy as ineffective
and arguments against further action. Further afield, QE strategies
have been deployed in the G7 countries, and others such as
Switzerland and Sweden. And at the recent G20 meeting, the finance
ministers from the 16 countries who share the euro agreed the
stimulus measures should be sustained to maintain fragile
recoveries. Officials are pledging to press ahead with their
recession-fighting programs and follow through on their stimulus
pledges even if they face resistance from the public made nervous
by mounting debt and inflation fears.
Despite the widespread adoption of QE,
opinion is very much mixed as to its
success rate. In the past, the last major country to attempt such a
feat was Japan where the policy took years to have a measurable
impact. Doubts are perhaps justified due to little evidence
of increased borrowing and credit flows, and fears of constricted
credit could stifle any economic upturn. However the apparent
failure of QE is not solely due to the banks reticence to lend.
Many consumers are wary of borrowing in the current climate, due to
fears over job security and their desire to reduce their own
debt.
Those seeking evidence that QE is having an
immediate effect are perhaps looking at it the wrong way and the
question that should be asked is: “What would have happened if QE
had not been implemented?” The majority of banking results of
quarter four last year were poor and it could be argued that they
would have gone on being as bad or even worse. The Bank of England
has said the results of the exercise will not be known until at
least nine months from the start of the plan, which began in March
2009. Therefore, the impatient amongst us will have to wait until
December, at the earliest, for any evidence of success.
To perhaps answer the critics, the Bank of
England has recently produced the first apparent statistical
evidence that their QE programme may now be successfully boosting
the amount of money flowing around the economy and in people’s bank
accounts. The bank’s Governor, Mervyn King, is putting some
emphasis on this evidence as a sign of the success of QE.
The best test for QE for the foreseeable
future may not be how quickly the economy improves but how it does
not get any worse. Fans of the 1990s Japanese QE policy say it
stopped the Japanese economy sliding deeper into trouble. Only time
will tell if the same can be said for the current QE
programmes.
Perhaps the end of the QE tunnel is in sight,
as nations are now being invited to work hard on developing
credible exit strategies from the fiscal, monetary and financial
sector support applied over the last year. While not being
implemented any time soon, for fear it would disrupt the still
fragile economic recovery, the idea is rather to convince markets
that everything is under control. And that when the time is
appropriate, after the economic recovery has become self
sustaining, the necessary action will be taken to unwind today's
potentially toxic mix of easy money and burgeoning public debt.