Quantitative Easing 101 - or the art of creating money

Business Times - 09 Jan 2009

DESPERATELY ill patients are willing to try drugs that have not been shown to be either effective or safe. Even dodgy medicines look better than the alternative. As countries' financial systems remain immobile in the face of standard monetary policy treatment, more are turning to 'quantitative easing' as a therapy of last resort. The US Federal Reserve is already trying it out. The Bank of England is likely to follow. The European Central Bank probably won't because it doesn't seem to have the authority to.

Quantitative easing is the modern way to print money. The central bank doesn't actually have to use a four-colour press to spew out crisp notes. There are more sophisticated ways to boost a nation's money supply. But ultimately the impact is not very different from dropping dollar bills from a helicopter as Ben Bernanke once described this policy before he became the Federal Reserve's chairman.

So what exactly is quantitative easing, what disease is it supposed to cure, how is it supposed to work and what are the possible side effects?

The theory

Quantitative easing is a method of boosting the money supply. Its aim is to get money flowing around an economy when the normal process of cutting interest rates isn't working - most obviously when interest rates are so low that it's impossible to cut them further.

In such a situation, it may still be possible to increase the 'quantity' of money. The way to do this is for the central bank to buy assets in exchange for money. In theory, any assets can be bought from anybody. In practice, the focus of quantitative easing is on buying securities (like government debt, mortgage-backed securities or even equities) from banks.

Where, one might ask, does the central bank get the money to buy all these securities? The answer is that it just waves a magic wand and creates it. It doesn't even need to turn on the printing presses. It simply increases the size of banks' accounts at the central bank. These accounts held by ordinary banks at the central bank go by the name of 'reserves'. All banks have to hold some reserves at the central bank. But when there is quantitative easing, they build up 'excess reserves'.

If banks swap their securities for reserves, the size of their own balance sheets shrinks just as the central bank's balance sheet expands. Assuming they want to keep their own balance sheets static - admittedly a big assumption in the current climate - they will then start lending to end-borrowers and so start putting more liquidity into the economy.

To some extent, central banks have been engaging in quantitative easing for the past year. The Fed, for example, has had a range of programmes and ad hoc initiatives that have resulted in it acquiring securities from the banking system and more recently from the US government. The Fed may not have justified these under the rubric of quantitative easing. But its balance sheet has certainly mushroomed: it is up 18-fold in the past four months to US$820 billion.

Does it work?

Such quantitative easing certainly hasn't yet done the trick so far in this recession. Credit conditions have continued to tighten in the US. Things, of course, could have been even worse if there hadn't been any easing. Equally, although an 18-fold increase in the reserves on the Fed's balance sheet sounds impressive, it is still below 6 per cent of GDP. It may therefore only be once quantitative easing properly gets going that the benefits will flow through.

Similarly, history isn't much use in judging the therapy's effectiveness. There has been only one significant trial - in Japan between 2001 and 2006. Excess reserves held by banks at the Bank of Japan rose from 5 trillion yen to 35 trillion yen (S$552 billion), roughly 6 per cent of GDP.

Scholars cannot agree whether the technique worked. On the positive side, Japanese GDP didn't shrink. On the negative side, GDP growth was moderate and not sustained after quantitative easing ended. Also, the experiment coincided with a big programme of government spending, so no one can tell whether it was the unusual monetary policy or the intense fiscal policy that kept the wolf from the door.

Almost no one would argue that Japanese quantitative easing was an unqualified success. But some economists think the Japanese were too slow and too half-hearted in applying the therapy. What's more, the Japanese record isn't necessarily all that meaningful for the US and the UK. Quantitative easing may work better - or worse - in a country like Japan with a cultural preference for savings and a huge trade surplus than in lands where borrow-and-spend has been the rule for years.

Unintended side effects

Even if quantitative easing isn't necessarily effective, it would certainly be worth a try if it carried no danger. But its safety is far from certain. It could theoretically lead to the debauchment of a nation's currency and inflation.

Again history doesn't provide much of a guide. Japan hasn't suffered any bad side effects - inflation is low and the yen is strong. However, in some more extreme examples of old-fashioned money printing, the results were disastrous. Witness the assignats of the French Revolution, Confederate dollars in the Civil War, Reichsmarks in Germany after World War I, Russian roubles after the fall of communism and the current hyper-inflation in Zimbabwe.

The US and UK are, of course, in a far healthier state than revolutionary France or the Weimar Republic. So there isn't a danger of such alarming consequences. But central banks might lack the will to engage in 'quantitative tightening' when the economy starts to pick up.

In theory, reversing the policy should be quite easy. The central bank could just sell the excess assets on its balance sheet, sucking money out of the system. In practice, the political pressure to keep the party going might be too hard to resist.

This is particularly so because, in order to engage in quantitative easing in the first place, some central banks may well need the permission of their governments. The more they work in cahoots with politicians, the more their independence will come under threat. Already, Alastair Darling, the UK Chancellor of the Exchequer, has made it clear that the government - not the Bank of England - will play an active role if quantitative easing proves necessary.

It is therefore essential that both central banks and finance ministers commit themselves to reverse quantitative easing when the good times return - before they go wild and open the spigots. Quantitative easing is risky. It needs to be practised safely.