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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 created ex 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 Japanmarker during the early 2000s, and the USmarker and UKmarker during the global financial crisis of 2008–2009.

Concept

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 the European Central Bankmarker to implement it.

Aims

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.

History

Quantitative easing was used notably by the Bank of Japanmarker (BOJ) to fight domestic deflation in the early 2000s. During the global financial crisis of 2008, policies announced by the US Federal Reserve under Ben Bernanke to counter the effects of the crisis are a form of quantitative easing. Its balance sheet expanded dramatically by adding new assets and new liabilities without "sterilizing" these by corresponding subtractions. In the same period the United Kingdom used quantitative easing as an additional arm of its monetary policy in order to alleviate its financial crisis.

The European Central Bank has used quantitative easing (without referring to it as such) through a process of expanding the assets that banks can use as collateral that can be posted to the ECB in return for Euros. This process has led to bonds being 'structured for the ECB' . By comparison the other central banks were very restrictive in terms of the collateral they accept: the Fed used to accept primarily treasuries (in the first half of 2009 it bought almost any relatively safe dollar-denominated securities); the Bank of England applied a large haircut.

In Japan's case, the BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. With quantitative easing, it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage. The BOJ accomplished this by buying more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities and equities, and extended the terms of its commercial paper purchasing operation.

Risks

Quantitative easing is seen as a risky strategy that could trigger higher inflation than desired or even hyperinflation if it is improperly used and too much money is created.

Some economists argue that there is less risk of such an outcome when a central bank employs quantitative easing strictly to ease credit markets (e.g. by buying commercial paper), whereas hyperinflation is more likely to be triggered when money is created for the purpose of buying up government debts (i.e. treasury securities) which in turn can create a political temptation for governments and legislatures to habitually spend more than their revenues without either raising taxes or risking default on financial obligations.

Quantitative easing runs the risk of going too far. An increase in money supply to a system has an inflationary effect by diluting the value of a unit of currency. People who have saved money will find it is devalued by inflation; this combined with the associated low interest rates will put people who rely on their savings in difficulty. If devaluation of a currency is seen externally to the country it can affect the international credit rating of the country which in turn can lower the likelihood of foreign investment. Like old-fashioned money printing, Zimbabwe suffered an extreme case of a process that has the same risks as quantitative easing, printing money, making its currency virtually worthless.

Origin

The original Japanese expression for ‘quantitative easing’ ‘ryouteki kinyu kanwa’ (量的金融緩和), was used for the first time by a Central Bank in the Bank of Japan’s publications. The Bank of Japan has claimed repeatedly (see, for instance, http://www.imes.boj.or.jp/english/publication/edps/2002/02-E-03.pdf) that the central bank adopted a policy with this name on 19 March 2001. However, the Bank of Japan’s official monetary policy announcement of this date does not make any use of this expression (or any phrase using ‘quantitative’) in either the Japanese original statement or its English translation (http://www.boj.or.jp/en/type/release/zuiji/kako02/k010319a.htm). Indeed, the Bank of Japan had for years, and until only a month earlier (February 2001) claimed that ‘quantitative easing … is not effective (p. 98)’ and rejected its use for monetary policy (reference and link: http://www.imes.boj.or.jp/english/publication/mes/2001/me19-1-4.pdf). Speeches by the Bank of Japan leadership in 2001 gradually – and ex post – hardened the subsequent official Bank of Japan stance that the policy adopted by the Bank of Japan on 19 March 2001 was in fact ‘quantitative easing’. This became the established official view especially after Toshihiko Fukui was appointed governor in February 2003. The use by the Bank of Japan is not the origin of the term ‘quantitative easing’ or its Japanese original (ryoteki kinyu kanwa). This expression had been used since the mid-1990s by critics of the Bank of Japan and its monetary policy.

The earliest written record of the phrase and concept of "quantitative easing" has been attributed to the economist Dr Richard Werner, Professor of International Banking at the School of Management, University of Southampton (UK). At the time working as chief economist of Jardine Fleming Securities (Asia) Ltd in Tokyo, and noted for his 1991 warning of the coming collapse of the Japanese banking system and economy (reference: Richard A. Werner, 1991, The Great Yen Illusion: Japanese foreign investment and the role of land related credit creation, Oxford Institute of Economics and Statistics Discussion Paper Series no. 129), he coined the expression in an article published on 2 September 1995 in the Nihon Keizai Shinbun (Nikkei) (reference: Richard Werner, Keizai Kyoshitsu: Keiki kaifuku, ryoteiki kinyu kanwa kara, Nikkei, 2 September 1995;

According to its author, he used this phrase in order to propose a new form of monetary stimulation policy by the central bank that relied neither on interest rate reductions (which Werner claimed in his Nikkei article would be ineffective) nor on the conventional monetarist policy prescription of expanding the money supply (e.g. through ‘printing money’, expanding high powered money, expanding bank reserves or boosting deposit aggregates such as M2+CD – all of which Werner also claimed would be ineffective). Instead, Werner argued, it was necessary and sufficient for an economic recovery to boost ‘credit creation’, through a number of measures. He estimated in this article that the incipient bad debt problem of the Japanese system (i.e. including future bad debts) amounted to about Y100 trillion, or 20% of annual Japanese GDP, and that this had increased banks’ risk aversion. The subsequent slowdown in bank credit extension was the major problem, because commercial banks are the main producers of the money supply, through the process of ‘credit creation’. He thus recommended as a solution policies such as direct purchases of non-performing assets from the banks by the central bank, direct lending to companies and the government by the central bank, purchases of commercial paper (CP) and other debt, as well as equity instruments from companies by the central bank, as well as stopping the issuance of government bonds to fund the public sector borrowing requirement and instead having the government borrow directly from banks through a standard loan contract. All of these, Werner claimed, would stimulate credit creation and hence boost the economy. Many of these policies have recently been adopted by the US Federal Reserve under Chairman Bernanke, who was familiar with the debate on Japanese monetary policy, under the expression ‘credit easing’.

However, while Werner used and explained the concept of ‘credit creation’ in his article, he chose not to use it in the article’s title, as too few readers would be familiar with it and alternative expressions were associated with flawed or failed policy prescriptions. Werner preferred to coin a new phrase. In his subsequent writings, including his bestselling book on the Bank of Japan (‘Princes of the Yen’, M. E. Sharpe, and his 2005 book ‘New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance’, Palgrave Macmillan), Werner argues that the Bank of Japan’s usage of his expression ‘quantitative easing’ may be misunderstood. While suggesting it was adopting the policy suggested by a leading critic, the Bank of Japan implemented the standard monetarist expansion of bank reserves and high powered money, which Werner had predicted would fail. It is not obvious why the Bank of Japan chose to use Mr Werner’s expression, and not the already existing and widely used expressions ‘expansion of high powered money’, ‘expansion of bank reserves’ or, simply, ‘money supply expansion’, which more accurately describe its adopted policy at the time.

Qualitative easing

Willem Buiter has proposed a terminology to distinguish quantitative easing, or an expansion of a central bank's balance sheet, from what he terms qualitative easing, or the process of a central bank adding riskier assets onto its balance sheet:

See also



References

  1. Quantitative easing explained, FT.com
  2. The Unthinkable Has Happened
  3. ‘Bernanke-san’ Signals Policy Shift, Evoking Japan Comparison, Bloomberg.com, 2008-12-02
  4. Bank pumps £75bn into economy, ft.com, 2009-03-05
  5. [1], IFLR, 2009-20-02
  6. Easing Out of the Bank of Japan's Monetary Easing Policy (2004-33, 11/19/2004)
  7. PIMCO/Tomoya Masanao interview
  8. BBC Q&A: Quantitative easing


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