The Bank of England today announced that it was commencing a programme of “Quantitative Easing” designed to stimulate the economy.

For a few weeks now the term quantitative easing has been bandied about. Sometimes this is also referred to as “printing money”. Now I don’t know about you but I can’t see why just printing money will make any difference. Unless we all get given some more in order to spend it how is it going to help?

So I decided to ask a couple of colleagues who work for a hedge fund. They must know all about it I thought. But no, they weren’t clear about it either. So I was left to do a bit of research on my own.

The Theory

I found that quantitative easing is the creation of new money out of “thin air” by a central bank, which then injects it into the banking system by buying government bonds, lending it to commercial banks or buying assets from commercial banks. The aim is to increase the amount of deposits in the banking system so that, by way of deposit multiplication, they can increase the money supply by increasing debt (lending).

Now that makes some sense because as well all know despite the measures taken by Gordon Brown in the past few months banks are still not lending and the economy is not improving. So, if it is that simple why hasn’t it been done before?

For the record the bank doesn’t actually print new notes, it just creates money out of thin air by establishing debt and it does it at the press of a button -electronically. Hmm. Isn’t that what everyone said led to the credit crunch when commercial banks did it?

The Risks

Quantitative easing is a high-risk strategy. If it is not done aggressively enough, banks will remain unwilling to lend and the crisis could drag on. To some extent that is what happened in Japan when this was tried 10 years ago.  However if it is done too aggressively and the bank pumps too much money into the economy, you get high inflation – even hyperinflation – as seen in 1920s Weimar Germany and modern-day Zimbabwe.

However in those cases, the government was actually printing money simply to pay the government’s bills. They were not responding to the risk of deflation as the Bank of England is today.

There is also the risk that the UK may breach the Maastricht Treaty, which forbids EU member states financing their public deficits by printing money. But the hope is that so long as the Bank of England buys government bonds from financial institutions, rather than directly from the government, this won’t cause a breach. But it remains to be seen if that will be acceptable or be considered an artificial strategy.

How do we know if it has worked?

The biggest problem for businesses and house buyers is the lack of credit. Banks simply are not lending. There are lots of technical as well as commercial reasons for this but the theory is that quantitative easing will lead to a growth in credit borrowers will find it easier to get credit.

One that happens the economy should start to revive and the climb out of depression should begin. But it is a high risk strategy. Watch this space!

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Category: Guide to City Jargon 

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