Quantitative easing. Oh what financial times we are going through. So to coin a phrase for all those people who are now thinking it…just what is this all about?
It’s simple, well very complicated.
Central banks use interest rates to regulate their economy. In our case that’s the Bank of England. Low interest rates boost borrowing and spending, higher rates boost saving and depress borrowing.
That’s the theory. Rates obviously cannot go below zero.
We are currently in a scenario where excess debt is in the system and people are fearful of spending even though interest rates are at an all time low. This affects the economy negatively and causes recessions.
The knock on effect of a recession is considerable. Governments lose out on taxation and have to borrow more. The currency weakens, this affects the cost of imported goods, which could cause inflation, which takes money out of your pocket and the potential for a myriad of consequences unfolds.
So, central banks aim to control money flow through normal measures. When they don’t appear to be working i.e. banks don’t pass the savings on, other measures are considered.
Some banks for instance are using the low interest rate opportunity to say ‘if base rates are 0.5%, and we are lending at 4.5% its still cheap money’. Granted, but it’s a massive margin that shouldn’t exist and it’s not what is needed. Banks however are under pressure to keep solvent and are of the view that it’s a risky time so the margin equates to the risk.
And so we introduce quantitative easing. Quantitative easing still aims to bring the rate at which companies are borrowing down. Only central banks can create new money (not ‘print it’ as some commentators incorrectly describe) as their money is accepted as payment by everybody.
The central bank simply gives itself more money by typing that simple fact into its computer, which creates new money in its own account – what a joy. They can now choose to buy what they want with it. If as in this instance of quantitative easing they buy corporate bonds and gilts, the price of these will rise and the yield will fall.
Lets pretend you are ‘x’ company. If a willing central bank is happy to buy x’s bond, they will be able to offer a lower yield for their bonds. A bond is the equivalent of company ‘x’ borrowing money. So now companies are borrowing cheaper. Cheaper borrowing should equal greater spending and in turn greater demand which pulls us out of a recession. As the money eventually ends up in bank’s deposits they can now lend more, which has a multiplying effect on the economy.
The key to its success is whether or not it eases money supply i.e. banks begin to lend again. There are numerous risks to this strategy. If the bank of England purchases the wrong assets it could lose money (that’s not good). If too much money is created and spending goes too far you can create inflation if not hyper inflation, destroying the value of the currency and in turn creating a whole host of other problems.
There is the other worry that a bank in creating quantitative easing could actually create panic rather than confidence and as such we are all in for a very sorry ten years.
One of the biggest issues with quantitative easing is that no-one really knows how much is good and how much is bad. And so we have a ‘suck it and see’ approach. First we will have £75bn injected into the system and hope that works. If it doesn’t work soon, it will probably not work and if it doesn’t, time to inject the other £75bn.
The truth is quantitative easing eventually has to work as it did in Japan, as the bank can just keep giving itself money until it does, but when that tyre thread eventually bites, they better have the steering wheel firm and every handbrake and parachute available to avoid the prospect of the economy running away, so lets hope it works sooner rather than later.