Quantitative Easing - What is it and why is it important?
We are familiar with the normal Bank of England policy of changing interest rates, which deals with the price of money. When the price of money falls there is typically an increase in demand for it, and thus an increase in the volume of money in the economy. Unfortunately, in the current state of nervousness about financial conditions, the volume of money in the economy has been contracting, despite falling interest rates. It is hoped that "quantitative easing" might resolve this.
Thus the Bank of England is starting "quantitative easing" on Wednesday, 11th March. This will involve the Bank purchasing gilts or high quality, non-financial, corporate sector assets in the market. The Bank has been authorised to buy up to £150 billion, of which £50 billion should be private sector bonds. £75 billion will be used within three months. The Bank will create the money itself and the proceeds of its purchases will be new money injected into the economy, largely in the hands of the banks. It is hoped that this will at least replace the credit which has been withdrawn from the system. £150 billion represents 10% of UK GDP, 7.5% of total money in the economy, or 12% of money held by households and non-financial companies (source: Deutsche Bank). This is a substantial intervention.
The UK and the US are both debt laden economies, and a brake needs to be put on asset price deflation. US households’ net wealth fell by $10 trillion in 2008 (source: PIMCO). Without a brake, existing and potential borrowers are penalised as collateral becomes inadequate. Many businesses prefer to cut inventories or staffing than to surrender to the banks’ credit terms. US household net borrowing is contracting for the first time in 50 years. UK household money is still increasing, albeit very slowly, but money is contracting among non-financial businesses.
In many ways it seems that the tight credit restrictions imposed by banks must be self-defeating, so why are they making the availability of credit so difficult? At the political level they have been blamed for the crisis and are therefore under pressure; moreover questions about nationalisation and control are likely to have made senior managers more risk averse. Financially they do not know if they have enough capital to cover losses, so they are choosing to hold higher levels of capital relative to their loans; they are also looking to improve the profitability of new loans. The Bank has decided to attempt to circumvent some of these issues by using "quantitative easing".
The contraction of credit is not an issue for our high street banks alone. Other earlier suppliers of credit have left the scene. Foreign banks are repatriating capital. The so-called "shadow banking system", driven by the complex instruments which packaged loans, has vanished. These represented trillions of dollars in the US alone, and probably provided about 50% of the debt created in peak years (source: PIMCO). Central banks must intervene, but they do not know if they will be successful. Japan’s banks merely hoarded cash, but that was a different scenario.
The Bank of England, the Federal Reserve, and all other central banks need to make such dramatic intervention. The vagaries of analysing how much money will need to be injected are such that it is not possible for the authorities to state with conviction how much is required. We can see that the numbers being committed are substantial in the UK, and in the US the Federal Reserve’s programmes add up to some $2 trillion. China’s fiscal stimulus equates to about 20% of their GDP over several years. No one knows whether this will be adequate or excessive, but the authorities would rather deal with inflation than with deflation, when enormous amounts of debt are outstanding. The risk of future inflation is not relevant to the current crisis. Inflation can be dealt with another time, but this is not Weimar or Zimbabwe. The organs of state seek to provide adequate, not excess, money. We are starting to protect portfolios against future inflation.