The idiot's guide to Quantitative Easing
Do you remember when you were a child and you thought the money that came out of cashpoints was just free money? And that your parents were obviously mean spiteful individuals who refused to buy you The Best Toy Ever just because they could? Phrases like “money doesn’t grow on trees” and “you can’t just print money you know” were used to explain away their skinflintedness. Well, since 2009, the Bank of England has been doing exactly that, printing money, in an effort to stimulate the economy and get inflation back to its target of 2%. But what exactly is ‘quantitative easing’, as it is known, what happened to the last £200 billion of freshly printed notes and just how does it help you and me?
Quantitative easing (QE) is literally the creation of new money. It doesn’t necessarily have to be actually printed, but the Bank of England’s bank balance will miraculously go up by the small sum of £75billion tonight. It’s a bit like Gus in Superman 3, when he pressed the button that transfers all the ha’pennies into his own bank account.
Fortunately, the Bank of England is not controlled by a sinister Robert Vaughn-type figure * and so the central bank decides to go on a spending spree with all its lovely new money. But don’t worry, it doesn't go and fill its trolley with flatscreen tvs and iPads, it buys gilts.
Gilts are essentially loans to the Government, but by strolling into the virtual market for gilts and flashing a wad of cash around, the price of buying these gilts rises. See the idiots guide to supply and demand if you are getting lost at this point. While this might seem like a bad thing, after all the Bank of England will now be getting fewer gilts for its money than it might have done, it is actually A Good Thing. It is good because the high selling price means that gilt-holders will be more likely to sell the gilts, and the yield (rate of interest paid as a function of the amount paid for the gilt) means gilts become an unattractive investment for anyone other than the Bank of England.
Of course the Bank of England doesn’t describe this process as gilt shopping, it prefers the rather more enigmatic ‘asset purchase programme’. The bank doesn’t have to just buy gilts either, although mindful of its responsibility to the nation, it will not invest directly in risky equities, but could consider some steady corporate bonds. This round of QE began on 5 March 2009 and the latest announced increase was on 5 November 2009 when the total was increased by £25 billion to a total of £200 billion. According to the Bank of England’s own figures, out of the £199.4bn it has spent so far, the vast majority – £198.3bn –has been spent on gilts.
Normally, banks are the biggest sellers of gilts and the fall in yield is supposed to encourage banks to lend the money they would have invested in gilts to first-time buyers to buy homes and other higher yielding assets. However, the Bank of England has suggested that some banks may simply use the extra cash to prop up their own finances, rather than lending out, so they would look to buy more gilts from other sources, such as insurance companies and private firms.
Again, the idea is that, with loads of cash from selling overpriced gilts, these other gilt sellers will also invest in other things and spend more money. Overall this will bring the cost of borrowing down for the ordinary man on the street, who will then have more cash in his pocket to spend in shops and thereby boost the economy. It’s really very simple. In theory.
If you are still struggling, or can’t read, then you can watch a pretty purple and magenta video of how QE works on the Bank of England website here .
Sir Mervyn King, the governor of the Bank of England, is convinced the first £200bn was well spent. An internal report found the programme, which was equivalent to about 14% of GDP, between March 2009 and January 2010, boosted the economy by as much as 2% and argued this was equivalent to dropping interest rates by between 1.5 and 3 percentage points. Which was of course impossible, being as the interest rate is only 0.5%
Of course the downside we have seen over recent years is that QE, which necessarily increases the price of gilts, when combined with higher commodity prices and tax increases has meant inflation has jumped sharply, and even the lower CPI measure at 4.5% is well over the Government’s target of 2% .
So will it work? Although the (internal) report suggested that QE was effective in boosting growth, it also said the effects of QE may be different the second time around.
"The economic circumstances in which further asset purchases or sales are made may be very different from those that prevailed in early 2009, so it cannot be assumed that the magnitude of the effects will necessarily be the same."
So we’ll have to wait and see what good, or bad, actually printing new money will do.
* No. We have Mervyn King. Who looks much less sinister.