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Quantitative Easing - what is it and what is it supposed to be achieving?

Quantitative Easing - what is it and what is it supposed to be achieving?
The US FED has been engaging in systematic quantitative easing since the financial crisis hit US stock markets requiring the bailout of most US banks and failure of one in 2008. Why is this helpful to the economic system and what are the negative side effects?
The US FED has been engaging in systematic quantitative easing since the financial crisis hit US stock markets requiring the bailout of most US banks and failure of one in 2008. (The crisis actually commenced in 2007 but that is another story). Why is this helpful to the economic system and what are the negative side effects?

There are many sides to this story but the four most important issues which I’ll focus on are inflation, Government budget deficits, interest rates and currency effects.

The financial crisis in 2008 followed a massive credit expansion of unprecedented scale, fuelled by ultra low interest rates of the Greenspan era and financial innovation in “asset backed” instruments driven by distorted incentives inside banks which were unconstrained by sound regulation. When the asset bubble burst, these instuments ‘ value came crashing down and the assets supporting them were so remote that the holders had no transparent view of their real, physical value. Accordingly no-one was willing to purchase thrm and whole markets ceased to function, including those which did have transparent values.

What this amounted to for banks was an inability to perform their day to day business, as banks depend on these markets to lend to businesses to keep the economy going. It was a massive credit contraction that threatened to collapse the economy in on itsself. The Government had no choice but to step in and bail the banks out, not because of any law or contract, but because of the economic consequences if it didn’t. The consequences for the Government, of course, were a massive increase in borrowings, almost to unmanagable levels. These borrowings are raised by the Federal Reserve issuing US Treasury Bonds.

So we have bond investors facing massive losses, banks unable to borrow or lend leading to a massive transfer of funds from the Government, which in turn is funded by Government bonds in the Treasury market. So who is buying the bonds?

The answer is, in part, the Fed. And it is doing so specifically to inject money into the financial system. That is, not to make people more wealthy, but to change the prices of things. This is called Quantitative Easing.

The Fed does not have to pay for the money it makes. It is the only body which can literally legally print money. In the Monetarist school of economics, prices are determined by the quantity of money. For example, the Fed printing more money does not influence the amount of products and services being sold evey year. so if we assume this volume of things does not change, more printed money would mean that the prices must on average be higher. Here, finally, we get to the effect in inflation.

Higher prices is, by definition, inflation. In this instance it is not necessarily a bad thing (depending on your perspective), but may be useful. Firstly it is useful because it prevents prices from dropping, or deflation, which is a probable side effect of a massive credit contraction. Deflation is very damaging to an economy because it discourages consumption, as the value of a dollar today is worth less than it will be tomorrow. Deflation tends to beget more deflation. This is also likely to fan unemployment and drive economic conditions to a worseplace than they started.

Another benefit of inflation is that the amount of debt owed by Government and consumers alike is usually limited to the amount actually borrowed at some time in the past. If that amount doesn’t increase, rising prices and incomes make it easier to repay that debt. Since the expansion in the amount of money is not in this instance based on growing economic activity, it has a similar effect as a tax on lenders. However the lends may be happier to accept that tax rather than see allthe borrowers default. So the effect on Government borrowing is positive for the economy, in that it is reduced in real terms.

The effect on currency is, in theory, similar to any inflationary impact. As prices rise, the value ofthe currency reduces. This has a positive effect on goods traded when priced in the local currency. It makes exports cheaper,and stimulates local production. This effect is included in recent articles about “currency wars”.

We are now approaching he nuts and bolts effect on interest rates, but firstly I’d like to note something about the discussion so far. The question that should be asked is, has the above theory worked? Arguably yes, the effect on currency is as expected. However, the main lever forthis effect was supposed to be inflatin, which has however been vey benign. Is thatbecause it wouldhave otherwise been negative? The answer is more likely that the excess money has not pushed up the cost of goods and services alone (the extent to which deflation would have occurred is not examined here) but also pushed up the prices of assets, specifically stocks and bonds. But this is not such a bad thing in the case of bonds, as we shall see.

Interest rates are affected by monetary easing both directly and indirectly. The indirect effect ofreducing rates by inflating bond prices through providing liquidity to the entire economy is discussed in the preceeding paragraph. But the direct effect is also significant, in that the Fed is a market participant, specifically acting as a buyer of Government bonds, and this pushes bond prices higher and interest rates lower. In turn the lower interest rates reduce the cost of debt for businesses, improving profitabiliity and stimulating investment.

In conclusion, Quantitative Easing is a relatively benign way to provide stimulation and support to the economy, easethe cost of borrowing to businesses and Government and that applies whether the impact is via general price increases or via interest rate relief.

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