Quantitative Easing for Beginners

Quantitative Easing, or QE as it also has become known as, has become a popular theme in media. But what is really quantitative easing? Will it make things better or worse? Is QE something you should worry about? Here is an article about quantitative easing for beginners, explaining basics.

Lately, quantitative easing has become popular. It simply means that the central bank buys assets with money it has created out of thin air. In essence, the central bank prints money to buy assets from financial institutions. But in today’s world, the money is typically electronic rather than physical bank notes.

Quantitative easing pumps new money into the economy. Previously, central banks adjusted interest rates to either slow down or speed up the economy. But now many central banks have already cut their interest rates almost down to zero. Cutting the interest rate is not working any more. Therefore some central banks, especially Bank of England and Federal Reserve in the US, are testing QE.

The central banks typically buy government bonds from commercial banks and other financial institutions. This improves the balance sheets of the banks. It also pushes up the price of government bonds, which makes them less attractive as investment. The idea behind this is that banks would be more interested in lending money rather investing them in government bonds. This increased lending would boost the economy.

Note that if the central bank would buy the government bonds directly from the government, it would be financing the government debt by printing money. This quickly leads to very high inflation since the central bank is expanding money base. By buying the government bonds from financial institutions, the central banks are technically not monetizing the debt. Many central banks are not allowed to buy government bonds directly from the government.

The Federal Reserve in US also buys mortgage-backed securities in huge quantities. Other assets, or rather debts, are also purchased by the central banks but mostly in much smaller volumes than government securities.

Does quantitative easing work? While the central banks are confident that QE is working, most economists point out that nobody knows what will happen. Quantitative easing has not been tested before so it is simple an experiment on a huge scale. It is quite possible that QE will work but it is also possible that it will not generate any significant results. Even worse, some people are worried that QE may work too well and create hyperinflation. It is worth noting that some experts are worried that the central banks will not be able to stop quantitative easing. They believe that if QE would be terminated, assets prices would fall and a long depression would follow. In essence, if this scenario is true, QE can’t be controlled any longer, the central banks have lost control.

It is still too early to judge how well QE works. In the UK, officials have hinted that QE and low interest rates have not produced the desired results but without QE the situation would be much worse. Most mainstream economists say similar things. QE may not be the perfect solution but without quantitative easing, the situation would be much worse. Like so much else in economics, it is impossible to verify if this is true or not. We simply don’t know how things would have looked like without QE. But a lot of people have noticed that banks have not significantly increased their lending, which was originally the main purpose of QE.

Who are the winners and losers of quantitative easing? The most obvious winners are the banks and other financial institutes, their balance sheets get a healthy boost. Strictly speaking, this is the only proven advantage of QE so far. The risk of banks collapsing has been significantly reduced. Since QE inflates asset prices, assets holders are also winners. The combination of QE and low interest rates makes it very attractive to borrow money to buy assets. Unfortunately, QE also produce losers, at least in relative terms. Savers and people living on fixed income, which include many pensioners, are suffering from higher inflation without getting any compensation. Some people even say that anyone being financially responsible is being punished by QE.

If it is difficult to judge how efficient QE has been so far, it is impossible to know what will happen in the future. The central banks are, officially, very confident that they will be able to withdraw any excess money once the economies start show a healthy growth. Otherwise the excess money would produce inflation. Not everyone is confident that the central banks will be able control the money supply. But as mentioned earlier, a bigger concern is if the central banks actually are still in control. Quantitative easing may have got out of control and can’t be stopped, without crashing the economy.

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