Cat’s Credit Crunching: What is quantitative easing?

Regular Robin asks: What is quantitative easing?

Dear Robin,

Quantitative easing is an economic policy measure used in recessions.  It stems from the belief that the key problem during an economic crisis is lack of money in circulation. For example, when banks refuse to lend money, investors are cautious to buy stocks and bonds. Consumers are not able to spend.

Central banks respond by effectively printing more money, which means they ease the economic situation by temporarily increasing the quantity of money in circulation. Hence the name Quantitative Easing (QE).

Quantitative Easing is often described as printing money, but it is more complicated because the central bank doesn’t simply hand out the additional amount of money equally among the population. A central bank usually conducts QE by buying bonds from states or companies.

A bond is a certificate of debt that the bond issuer holds, like an IOU. Both countries and companies can issue bonds, which are then traded on the bond market. If buyers believe that the bond issuer is in a good position to repay the debt, it will be cheaper for the issuer to borrow. For example, the German government can effectively borrow money for free while the Greek government has to pay a high yield (interest) for borrowing money.

Because central banks are the institutions in charge of money supply, they can decide to print more money if they think that is necessary.

In today’s world, a bank doesn’t need to physically print money, it just adds a few zero’s to its balance sheet. Although the cash isn’t physically there money has still been created. In the US, the Federal Reserve has bought more than $4.5trillion (£2.9 trillion) worth of debt, the Bank of England has bought around £375 billion, the Bank of Japan is currently purchasing about 80 trillion Yen per year and as of March, and the European Central Bank promised buy €60 billion per month, amounting to more than €1 trillion until next year.

The central bank purchasing these bonds is effectively buying up other people’s debt, which means it becomes cheaper for the owners of bonds to borrow.

Because central banks have just bought up all this debt, in most cases we are talking about bank debt, banks should in theory become more generous with giving money to consumers – the famous trickle-down effect.

But of course banks are not that stupid, they know that the economy isn’t recovering and that consumers will have a hard time paying back the loans. There also isn’t much point in lending money to governments, because as a result of QE, bond yields, the interest on bond loans, is very low.

The key effect of QE is that investors are driven into riskier investments, such as gambling on the stock market. This explains why stock markets in many economies are at an all-time high, while the real economy is still in crisis. One danger of QE is, therefore, that it can lead to bubbles in the stock market, which will eventually burst.

Overall, a rather risky way of getting out of a recession.