Every so often we hear that the Bank of England has indulged in another bout of “quantitative easing” which is explained as a clever way to increase liquidity in the economy and thus encourage economic growth. QE is one of those terms that make one’s eyes glaze over, except for a nagging feeling that the Bank is printing money.
Last week I attended a fascinating briefing on the economy for local businesspeople by one of the Bank of England’s regional agents. A member of the audience asked him to explain quantitative easing in words of one syllable. What follows is my best recollection of his answer, so it’s not meant to be a direct quote and any errors are wholly my own!
Various institutions, not just banks, hold government bonds, otherwise known as gilts, which are sold to finance the national debt. In quantitative easing, what the Bank of England is doing is buying those gilts for cash from those institutions that wish to sell - in the most recent exercise, the Bank bought some £50 billion worth.
The institutions can decide how to use this cash which they have suddenly been paid – they might just put it on deposit but that is not at all profitable at current rates or they can invest it more productively – it’s up to them.
The government bonds haven’t gone away, they are now owned by the Bank, which receives interest from the Government like any other holder of government debt. As the economy picks up and public finances get back into order with the government no longer having to add to debt and even starting to pay it down, the Bank can then sell the government debt which it has bought back into the market, thus balancing out the whole process.
So it is not a one-way process of “printing money”.
I hope I have understood the exercise correctly – the explanation seemed very lucid when I heard it! Happy to have corrections, or any further illumination – my days of studying macro-economics are in the very distant past.
Still seems lucid. Thanks. The problem comes with “The institutions can decide how to use this cash which they have suddenly been paid”. What they seem to do is rebuild their capital base and pay bonuses. How much reaches the rest of the economy ?
Comments via Facebook:
John Leston:
Why do I have nagging feelings like – If you hold government debt that is paying, say, 5% you would want an amount of cash (that will pay close to 0%) that is significantly greater than the par value of the gilt – so, the Bank pays a lot of cash, that it has printed, to buy a lot less nominal debt. If, when the process ‘unwinds’ and it sells back the debt, interest rates are higher, then the value’ of the gilts it is selling back will have fallen. So, the Bank ends up with less cash than it paid out. A possible reason to sell your gilts for cash at a less ‘punitive’ cost to the Bank would be to use the extra liquidity provided to pay down other debt on which you are paying high interest rates. Almost the last thing you would do with it at the moment is to ”invest’ in the ‘real’ economy. So, as David says, how much of this cash will actually find its way into the economy in a way that will stimulate growth rather than inflation? QE sounds like a free lunch. I haven’t done macro economics for years either (as the above may demonstrate!) but I’m sure Macro 101 said there was no such thing as a free lunch ….
Peter Emery:
Sounds interesting Sandy. The bit I would like further explained is the grey area that distinguishes the Bank of England from the government. The bank after all is not an independent corporation acting in the retail banking marketplace, any loss its sutains on these deals is presumably absorbed by the government (i.e. taxpayers).
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Daniel Olive:
David, it isn’t just money from heaven, they sold something of equal value to get it. Selling bonds can’t rebuild your capital base, because to get cash you have to sell high quality bonds. Using that money to pay bonuses (which are part of the wage bill) would be quite silly. John, all but one of the conventional gilts are going for less than 30% above their issue price, and that one is unusual in paying 6% so was trading above it’s issue price long before QE. Peter, the BoE is a seperate organisation, legally and for accounting purposes. Money only passes to the government in the form of a small payment in recognition of the profits from seigniorage.
Sandy Walkington:
Hurrah for young Albanians. I could not have put it better myself. (Actually I could not have put it at all. My Macroeconomics 101 did not get as far as this)
Daniel Olive:
Hurrah for Verulam Economics Department, who took me all the way to Macroeconomics 102.
And yet more via Facebook – this is turning into a fascinating discussion:-
David Grace:
Daniel, I think I understood all that. The question which remains is what are the banks doing with the cash ? Is there evidence that the economy is benefitting ? I only ask, because I don’t know the answer. Cambridge Economics Tripos Part 1 was a very long time ago and I don’t think we covered this.
Daniel Olive:
I think it probably is benefiting. It puts more money out there which has to go somewhere, and it drives down the return on gilts and other safe investments so anyone wanting a real return has to invest in something else. It also makes the financial system more robust by putting liquid money into the system in place of less liquid bonds. This reduces the risk of a bank coming up short of money at the end of each day (when they have to settle up their intra-day liquidity positions) or of CHAPS freezing up (where too much of the liquidity is held by a small number of the participants, so CHAPS payments can’t settle).
The key question is, where did the Bank get the 50billion from to do this?
The answer is that is just typed a number into an account and magicked the money from no where, or in the traditional sense, ‘printed it’.
Thus diluting the money in your pocket/house/pension, so all prices will now rise, and we will be left blaming retailers.
Once this process has started, it can’t really stop. So hold on every one, its gonna get kind of ‘Wiemar republic’, around here.