Wednesday, March 18, 2009

Quantitative Easing

"Quantitative easing" is a term that has been tossed about blogs, mainstream media, and formal discussions of financial policy. For as long as I've been hearing the term, I've been waiting for a clear definition, and have been waiting now long enough I'm skeptical one exists. But I've seen it in enough contexts now that I will hazard a general introduction of it here.

When money supply needs to be increased to stimulate economic activity, the banking industry, which includes central banks, prefers to do it by credit, rather than printing. Printing devalues currency if it outpaces economic growth; credit is only a temporary debasement of currency that reverses as the loans are paid off. So, the way the banking industry stimulates credit is for the central bank to lower the interest rates such that credit is less costly to accept. That is the primary way credit is expanded, until prime interest rates are lowered all the way to zero.

The Bank of Japan was the first to lower interest rates to zero, many years ago. At the end of last year, the Fed did the same, and now the Bank of England has reached that point, and the European Central Bank is not far behind.

If overnight interest rates are at zero, and the economy is still sluggish and requires more stimulus (or so policy makers believe), then "quantitative easing" is the next step. Here, any bonds can be purchased by the central bank with newly minted cash. Typically it would be treasury bonds, but any bond will do. Bonds are wealth and cash is wealth; but bonds yield their wealth only over time—in buying them with cash, however, the wealth is available immediately right now. In quantitative easing, money over time is replaced with newly minted money here and now. The central banks now hold the bonds, and the cash released on to the economy through quantitative easing slowly reverses as the bond matures.

(UPDATE 5/19/10: To rephrase the above paragraph, if a private entity or government sells a bond, there is no net influx of money into the economy. Cash is shifted from the buyer to the seller of the bond, and then re-shifted back to the buyer with interest over time as the bond matures. Cash shifts hands but is neither created nor destroyed. But if the Fed prints money to buy a bond, then that newly printed money IS an expansion of the money supply, reversed over time as the bond is paid off to the Fed.)

So quantitative easing is like defibrillating a dying credit bubble with shocks of sudden cash infusions. It's okay in theory. Japan has been doing this now for some time with no apparent reversal of their economic fortune, nothing one can clearly point to, other than the possibility things might have been worse had they not done it. Though the Bank of England has trailed the Fed in arriving at zero interest rate policy, now just having reached it they are about to embark right away on 75B pounds of quantitative easing.

The Fed has not ruled out the possibility of it, but no specific statements have been released as of yet.

UPDATE: Now wasn't that written moments too soon. Today the Fed announced it will buy $1.2 trillion in securities. Details to follow in upcoming posts as the news of this settles.

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