Politics and Economics

What is Quantitative Easing (QE) and why is Europe trying it now?

Europe’s QE (quantitative easing) initiative, planned for an initial 18 months, involves buying bonds to a value of as much as €1.1 trillion, or about 10% of Eurozone GDP. That is still well below the 25% of American GDP reached when the US Federal Reserve printed money to help revive the country’s economy after the 2007-9 financial crisis. The ECB is leaving the door open to expand its programme further.

What does Europe hope to gain from this initiative? And why are they doing it now?

Base rates are low (the rate the central bank lends to other banks) but the banks are not lending cash to its customers (businesses and individuals).  This may be because there is not enough “lendable” cash in the banking system because banks are trying to repair their balance sheets after the financial crash. They must also now comply with  the new international capital holding requirements to prevent another banking meltdown similar to the one we saw in 2008-9.  To a bank a “loan” is the same as an “asset” because they make their money by lending out money.   So the banks want to increase the proportion of low risk assets that they own. Government bonds (loans to governments) are seen as low risk because the chance of default (not paying back the loan) is low compared to say a loan to a business or an individual. When they do lend to businesses and individuals the banks are reserving their loans for ultra-safe investments and charging higher interest rates.

This lack of credit causes an economic slowdown as businesses cannot borrow money to fuel their investment for future growth.

Quantitative easing (QE) is a mechanism where the central bank “prints” new money and uses this to buy the Government Bonds (Government debt) held by the banks.  The idea is that banks take the new money and buy other assets to replace the ones they have sold to the central bank. These assets could be new loans or company shares. This raises stock prices and lowers interest rates, which in turn boosts investment. Interest rates initially may come down because QE injects new money into the banking system, which will encourage banks to lend more.  As other banks also have more cash through selling Government Bonds to the central bank the extra competition should ensure that their interest rates fall.  After all, banks make money by lending money rather than paying interest to depositors.

Some of this extra money will find its way to businesses and households because banks are more likely to lend due to the extra cash they have.  This extra credit is expected to stimulate economic growth in Europe.

What other benefits to economists believe Europe will get from QE?

Economists like inflation to be around 2% – the “goldilocks” theory. This ensures economic growth is sustainable i.e. not too hot and not too cold.   Economists use changes in interest rates to deliver this 2% inflation target. If the economy overheats, causing high inflation, they increase interest rates, which reduces the amount of money in the economy to slow it down and reduce inflation.  If the economy slows down they can boost it by lowering interest rates, which injects more cash into the system, which increases growth and inflation.

Economists are terrified of deflation (negative inflation) because there is a limit to how far they can reduce interest rates to boost the economy.  That limit is obviously zero.  Deflation causes a spiral of economic malaise because consumers will delay buying goods and services if they think they will be cheaper at a later date because they anticipate further price decreases.  This causes a further economic slowdown, which further depresses prices, which causes consumers to further delay purchases…….. Economists hate this because if there is low growth and zero interest rates they cannot use their main tool (interest rates) to further stimulate the economy because they cannot reduce interest rates below zero.

Japan had a decade of lost growth due to deflation.

QE is seen as the answer to deflation because the extra money in the system causes inflation irrespective of interest rates.

Whilst the initial effect of QE may be to reduce interest rates eventually all this new money in the economy will drive consumption and increase prices, ultimately increasing inflation and therefore requiring an upward adjustment of interest rates.  This will then signal the need to end QE, which was implemented to head off deflation.

So QE is seen as the solution for Europe because it has no growth and low or negative inflation.  As QE causes inflation it can only be safely used when deflation is a serious risk.

There are further perceived benefits for QE. The extra “printed” Euros in the system will reduce their value on currency markets, which makes European products cheaper for the rest of the world to buy (driving exports) and imports become more expensive (causing European consumers to buy home grown products).  Both of these further help to boost the economy of Europe.

Finally, the eurozone’s national central banks will be buying their own government bonds from pension funds, banks and other financial institutions.  As central banks are part of government machinery this effectively reduces government debt by using printed money to buy it back.  This should reduce these Governments’ future interest payments to the financial markets.

This is the theory of QE anyway.  But economists have been wrong before……

This type of monetary easing has already been tried in Japan, America and Britain, with mixed results.

Japan first began printing cash in 2001 after interest rate cuts failed to create growth.   Arguably despite QE they have still not recovered.

America followed, creating $4.5 trillion of new money, while Britain issued £375bn.

There are questions over how and if QE works, although in America and Britain growth has returned and unemployment is continuing to fall.   Inflation unexpectedly fell in the UK despite QE but the theory is it would have fallen even more without QE.

Germany has resisted QE until now because the Euro is already relatively cheap for their economy (although perhaps still too expensive for Greece, Italy and Spain) and they historically worry about inflation after they experienced catastrophic inflation after the world wars.

As QE prints “new money” many worry that some of this “cheaper” money will be borrowed at a low rate and used to buy other assets such as property and shares – pushing those prices even higher. This could create another asset price bubble with shares and property becoming overvalued and causing another future economic crash.

Many also worry that QE will stop the other Governments in the Eurozone making the structural changes they need to implement to be more competitive.  QE could cause the weaker economies in the Eurozone to become complacent in reducing their spending, reducing their deficits and loosening up their restrictive labour markets.

Germany has reluctantly agreed to QE because the serious threat of deflation is now a real risk.

So QE is a desperate measure to breath some life back into the Eurozone economies as they cannot reduce base rates further.  It is a last resort.