Saturday, December 5, 2009

Quantitive Easing

The term quantitative easing describes an extreme form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero. Normally, a central bank stimulates the economy indirectly by lowering interest rates but when it cannot lower them any further it can attempt to seed the financial system with new money through quantitative easing.
In practical terms, the central bank purchases financial assets (mostly short-term), including government paper and corporate bonds, from financial institutions (such as banks) using money it has createdex nihilo (out of nothing). This process is called open market operations. The creation of this new money is supposed to seed the increase in the overall money supply through deposit multiplication by encouraging lending by these institutions and reducing the cost of borrowing, thereby stimulating the economy. However, there is a risk that banks will still refuse to lend despite the increase in their deposits, or that the policy will be too effective, leading in a worst case scenario to hyperinflation
Quantitative easing is sometimes described as 'printing money', although the central bank actually creates it electronically 'out of nothing' by increasing the credit in its own bank account.
Examples of economies where this policy has been used include Japan during the early 2000s, and the US and UK during the global financial crisis of 2008–2009.
Banks use a practice called fractional-reserve banking whereby they abide by a reserve requirement, which regulates them to keep a percentage of deposits in 'reserve'. The remainder, called 'excess reserves', can be used as a basis for lending. The increase in deposits from the quantitative easing process causes an excess in reserves and private banks can then, if they wish, create even more new money out of 'thin air' by increasing debt (lending) through a process known as deposit multiplication and thus increase the country's money supply. The reserve requirement limits the amount of new money. For example a 10% reserve requirement means that for every $10,000 created by quantitative easing the total new money created is potentially $100,000. The US Federal Reserve's now out-of-print booklet Modern Money Mechanics explains the process.
'Quantitative' refers to the fact that a specific quantity of money is being created; 'easing', according to Guardian, the British newspaper, refers to reducing the pressure on banks. However, another explanation of 'easing' is the Japanese-language expression for 'stimulatory monetary policy', which uses the term 'easing' (see the section below on the Origin of Q.E.).
A central bank can do this in a number of ways: by using the new money to buy government bonds (treasury securities in the United States) in the open market (this is also referred to as monetizing the debt), by lending the new money to private banks, by buying assets from banks in exchange for currency, or by any combination of these actions. These have the effects of reducing interest yields on government bonds and reducing interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying bodies.
In very simple layman's terms, the central bank creates new money out of thin air. It then uses this money to buy what is essentially an IOU, usually from the government. This money is credited to the bank account of the seller of the IOU. The bank can then use this money as a basis for creating more new money by increased lending.
A state must be in control of its own currency if it is to be able to unilaterally employ quantitative easing. Countries in the eurozone (for example) cannot unilaterally use this policy tool, but must rely on theEuropean Central Bank to implement it.
The aim of quantitative easing and the follow on process of deposit multiplication is to increase the amount of money in circulation by an increase of credit and thus stimulate the flow of money around the economy by increased spending. The usual method of regulating the money supply is by setting interest rates. Quantitative easing is a solution when the normal process of increasing the money supply by cutting interest rates isn’t working. Most obviously when interest rates are essentially at zero and it is impossible to cut them further.
© 2009 m3, ltd. All rights reserved.