QUANTITATIVE EASING

Quantitative easing is all the rage at the moment. But what exactly is it?

Before answering the question, it is worth remembering that central banks are not supposed to finance a Government's budget deficit, and in some cases are prevented by law from doing so. Such financing is called "printing money", and is a bad thing, since it increases the money supply and eventually leads to inflation. Governments are instead supposed to finance their deficits by issuing bonds (Treasury Bills, gilts etc) to the general public. When I lived in Tanzania, the Government had a perennial deficit, and no means of issuing bonds. Aid flows filled part of the gap; but the rest was financed by the central bank. This policy of necessity duly led to repeated tut-tutting and finger-wagging in the annual IMF reports.

OK, back to QE. Since Governments in the rich world are all currently running huge budget deficits, their economies' demand management cannot be boosted by fiscal policy. That leaves monetary policy, which is generally in the hands of the country's central bank. The main tool in their toolbox is control of the short-term interest rate (eg the "Fed funds rate") at which they lend to the financial system; by reducing that rate, they can boost liquidity and thereby demand. However, the tool has two problems associated with it. First, short-tem interest rates are almost zero already, so there is little or no scope for further reduction. Secondly, the tool has been likened to a string. It is easy to tighten the string when inflation is sprouting, since if the financial system has to borrow at higher rates from the central bank, then it will automatically raise its rates to its own end-customers (otherwise it starts making losses). But the converse is not true. If the central bank reduces its rate, then the financial system may or may not reduce its rates to its end-customers. It may well in fact say "thank you very much" and do nothing, preferring instead the higher interest rate margin (i.e. increased profits). There is quite a lot of evidence that that is exactly what has been happening recently.

So, with only a blunt tool in the toolbox, central banks have been looking around for something else. In comes QE. Under QE the central bank bypasses the financial system and buys Government bonds directly in the market place. Since demand for those bonds has now risen, their price will rise; which means (this being bonds) that their yield will fall. Which in turn will lead to falls in all bonds, which are generally priced to yield the Government bond rate plus a risk factor. By purchasing bonds in this way, the central bank has managed to reduce the economy's long-term interest rates, which should in turn stimulate demand.

Hang on a second. If the bonds were first issued to finance a Government budget deficit, and the central bank pays for these bonds by creating money (which it does), isn't the QE mechanism merely a 2-stage version of the "printing money" scenario outlined above, and therefore also a bad thing? There is one difference, in that under QE, the central bank can in theory sell the bonds back to the market at a later stage. But that effect is in the future; surely the current effect under the two mechanisms is the same?

Plenty of clever people seem to think exactly that. They incude Axel Weber, the head of the German Bundesbank and the front-runner to succeed Jean-Claude Trichet as head of the European Central Bank, when the latter steps down later this year. Mr. Weber has publicly criticised the ECB's decision to buy Greek and Portugese bonds in the market place, an action which is the European version of QE. Since European Governments have just agreed a Euro500 billion permanent bail-out, which will be used to do more of precisely that sort of thing, his views were at odds with the politicians'; following a meeting with German Chancellor Angela Merkel, it was announced last week that he would be stepping down from the Bundesbank at the end of April for "personal reasons". But Mr. Weber is not the only German who thinks this way; ex-Finance Minister Peter Steinbrück ruled himself out of the ECB job for exactly the same reason.

The differences between QE (good) and printing money (bad) remind me of the "angels dancing on the pin of a needle" arguments. The fact that politicians and otherwise sober central bankers feel compelled to try and emphasise them merely confirms that the world's rich economies are in a very deep hole indeed.

Walter Blotscher