What is Quantitative Easing?
Quantitative Easing, or QE, is a form of unorthodox monetary policy that is used by governments in times of crisis in order to increase the supply of money in the economy. QE is typically only used as a last resort when traditional methods, such as reducing the price of money, i.e. interest rates, have failed.
How does QE work?
A central bank, for example the Bank of England (BoE), gets permission from the Treasury to create new money. It does this by crediting its own account electronically at the touch of a button.
The BoE then uses this newly created money to buy assets such as government bonds from commercial banks and other financial firms such as insurance companies and pension funds.
The hope is that because these financial institutions now have new money in their accounts, they will be willing to use the money to invest in other companies or to lend to individuals.
If they are willing to do this then as the money makes its way out into the economy and boosts the supply of money in circulation.
What is QE supposed to do?
The BoE’s programme of QE is designed to have two effects. The first is to tempt the banks into increasing lending to businesses and individuals, and therefore increase the amount of activity in the economy. The second is to lower the cost of borrowing.
When the BoE buys bonds, it reduces the supply of those bonds in the market which should increase the demand for new bonds and, at the same time, reduce the cost of borrowing.
Theoretically, when the economy has recovered, the Bank of England can then sell the bonds it has purchased and destroy the money it receives for them, thereby reversing its policy of QE.
If everything goes according to plan, QE should increase the availability of credit within the economy and therefore businesses should find it easier to borrow. That, in turn, should help to stimulate the economy.
QE, together with zero interest rate policy (ZIRP) form part of a collection of government policies that contribute to financial repression, which is designed to destroy the value of our debt.
Why has QE failed to stimulate growth?
Since the financial crisis hit in 2008, the Bank of England, the US Federal Reserve, and other central banks around the world have created more than $12 trillion. However this huge amount of new money has not found its way into the economy, because, understandably, banks are reluctant to make new loans. Instead, for the most part, they are just leaving the new money on deposit at the central bank and collecting interest.
With so much money just sitting idle in the banking system, money velocity, which is the rate at which money changes hands, has fallen dramatically and is now at the lowest level in more than 50 years.
The problem is that banks are hoarding the money, in part because of the very real risk that new loans may not be paid back and in part because of new rules that require banks to hold a larger percentage of reserves.
If the new money isn’t lent into the wider economy then the supply of money is not boosted and the policy of QE fails to stimulate growth.
If policymakers are able to persuade (or coerce) banks into lending the newly created money into the economy then the supply of money in the real economy will begin to rise. The problem however, is that creating money is not the same thing as creating wealth. In fact, when you increase the amount of money in an economy, but don’t increase the amount of goods, you end up with more money chasing the same quantity of goods, which, sooner or later, leads to inflation.
So, by reducing the value of the money already in circulation, quantitative easing, or money printing as it’s known colloquially, simply raises the cost of living and takes money out of people’s pockets. So although QE creates GDP growth, it can not bring about economic prosperity.