What Is Quantitative Easing?

Bernanke Drops Money From Helicopters

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A quick refresher from Wikipedia, in case you’re not quite sure but don’t want to sound dumb by asking… We published this originally back in August.

Quantitative Easing
The term quantitative easing (QE) describes a form of monetary policy used by central banks to increase the supply of money in an economy when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

A central bank does this by first crediting its own account with money it has created ex nihilo (“out of nothing”).[1] It then purchases financial assets, including government bonds and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money by the process of deposit multiplication from increased lending in the fractional reserve banking system. The increase in the money supply thus stimulates the economy. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio.[1]

“Quantitative” refers to the fact that a specific quantity of money is being created; “easing” refers to reducing the pressure on banks.[2] However, another explanation is that the name comes from the Japanese-language expression for “stimulatory monetary policy”, which uses the term “easing”.[3] Quantitative easing is sometimes colloquially described as “printing money” although in reality the money is simply created by electronically adding a number to an account. Examples of economies where this policy has been used include Japan during the early 2000s, and the United States and United Kingdom during the global financial crisis of 2008–2009.


[edit] Concept
Ordinarily, the central bank uses its control of interest rates, or sometimes reserve requirements,[citation needed] to indirectly influence the supply of money.[1] In some situations, such as very low inflation or deflation, setting a low interest rate is not enough to maintain an adequate money supply, and so quantitative easing is employed to further boost the amount of money in the financial system.[1] This is often considered a “last resort” to increase the money supply.[4][5] The first step is for the bank to create more money ex nihilo (“out of nothing”) by crediting its own account. It can then use these funds to buy investments like government bonds from financial firms such as banks, insurance companies and pension funds,[1] in a process known as “monetising the debt“.

For example, in introducing its QE programme, the Bank of England bought gilts from financial institutions, along with a smaller amount of high-quality debt issued by private companies.[6] The banks, insurance companies and pension funds can then use the money they have received for lending or even buying back more bonds from the bank. The central bank can also lend the new money to private banks or buy assets from banks in exchange for currency.[citation needed] These have the effect of depressing interest yields on government bonds and similar investments, making it cheaper for business to raise capital.[7] Another positive side effect of this is that investors will swap to other investments, such as shares, boosting the price of these and increasing wealth in the economy.[6] QE can also help in reducing interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying bodies.

More specifically, in terms of the lending undertaken by commercial banks, they 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”,[citation needed] which can only be used to settle transactions between them and the central bank.[7] The remainder, called “excess reserves”, can (but does not have to be) be used as a basis for lending. When, under QE, a central bank buys from an institution, the institution’s bank account is credited directly and their bank gains reserves.[6] 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.

A state must be in control of its own currency and monetary policy 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 Bank to implement it.[citation needed] There may also be other policy considerations. For example, under Article 123 of the Treaty on the Functioning of the European Union[7] and later Maastricht Treaty, EU member states are not allowed to finance their public deficits (debts) by simply printing the money required to fill the hole, as happened in Weimar Germany and more recently in Zimbabwe.[1] Banks using QE, such as the Bank of England, have argued that they are increasing the supply of money not to fund government debt but to prevent deflation, and will choose the financial products they buy accordingly, for example, by buying government bonds not straight from the government, but in secondary markets.[1][7]

[edit] History
Quantitative easing was used unsuccessfully[8] by the Bank of Japan (BOJ) to fight domestic deflation in the early 2000s.[9] 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.[10][11][12]

The European Central Bank (ECB) has used 12-month long-term refinancing operations (a form of 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”[13]. By comparison the other central banks were very restrictive in terms of the collateral they accept: the US Federal Reserve 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.[14] 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.[15]

[edit] How

  1. The national bank declares an extremely low rate of interest, for example 0.5%.
  2. The national bank credits its own bank account with money created from ‘thin air’ through lending interests.
  3. The newly created money is then used for buying government bonds from financial firms such as banks, insurance companies and pension funds.

[edit] 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[who?] 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.[1]

[edit] Origin

[image url="http://upload.wikimedia.org/wikipedia/en/thumb/9/99/Question_book-new.svg/50px-Question_book-new.svg.jpg" link="http://en.wikipedia.org/wiki/File:Question_book-new.svg" caption="" source="" alt="" align="left" size="xlarge" nocrop="true" clear="true"]
This section needs additional citations for verification.
Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (July 2010)The original Japanese expression for “quantitative easing” (量的金融緩和, ryōteki kin’yū kanwa), was used for the first time by a Central Bank in the Bank of Japan’s publications. The Bank of Japan has claimed that the central bank adopted a policy with this name on 19 March 2001.[16] 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.[17] Indeed, the Bank of Japan had for years, and in an article published in February 2001 had claimed that “quantitative easing … is not effective” and rejected its use for monetary policy.[18] 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 March 19, 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 September 2, 1995 in the Nihon Keizai Shinbun (Nikkei).[19]

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 ¥100 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 of “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.

[edit] Comparison with other instruments
[edit] 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:

Quantitative easing is an increase in the size of the balance sheet of the central bank through an increase it is [sic] monetary liabilities (base money), holding constant the composition of its assets. Asset composition can be defined as the proportional shares of the different financial instruments held by the central bank in the total value of its assets. An almost equivalent definition would be that quantitative easing is an increase in the size of the balance sheet of the central bank through an increase in its monetary liabilities that holds constant the (average) liquidity and riskiness of its asset portfolio.Qualitative easing is a shift in the composition of the assets of the central bank towards less liquid and riskier assets, holding constant the size of the balance sheet (and the official policy rate and the rest of the list of usual suspects). The less liquid and more risky assets can be private securities as well as sovereign or sovereign-guaranteed instruments. All forms of risk, including credit risk (default risk) are included.[20]

[edit] Credit easing
In introducing the Federal Reserve’s response to the 2008-9 financial crisis, Fed Chairman Ben Bernanke was keen to distance the new programme, which he termed “credit easing” from Japanese-style quantitative easing.In his speech, he announced:

” Our approach—which could be described as “credit easing”—resembles quantitative easing in one respect: It involves an expansion of the central bank’s balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank’s balance sheet is incidental. Indeed, although the Bank of Japan’s policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve’s credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses.[21]

[edit] See also

  • Fiat currency
  • Debasement
  • Economic history of Japan
  • Economy of Japan
  • Open market operations
  • Money supply
  • Money creation
  • Inflation hedge
  • List of economics topics
  • List of finance topics
  • ZIRP

[edit] References

  1. ^ a b c d e f g h “Q&A: Quantitative easing”. BBC. 9 March 2009. http://news.bbc.co.uk/1/hi/business/7924506.stm. Retrieved 29 March 2009. 
  2. ^ Elliott, Larry (8 January 2009). “Guardian Business Glossary: Quantitative Easing”. London: The Guardian. http://www.guardian.co.uk/business/2008/oct/14/businessglossary. Retrieved 19 January 2009. 
  3. ^ Voutsinas, Konstantinos, and Richard A. Werner, “New Evidence on the Effectiveness of ‘Quantitative Easing’ in Japan”, Centre for Banking, Finance and Sustainable Development, School of Management, University of Southampton.
  4. ^ “Quantitative easing: A therapy of last resort”. The New York Times. 1 January 2009. http://www.nytimes.com/2009/01/11/business/worldbusiness/11iht-views12.1.19248009.html. Retrieved 12 July 2010. 
  5. ^ Stewart, Heather (29 January 2009). “Quantitative easing: last resort to get credit moving again”. The Guardian. http://www.guardian.co.uk/business/2009/jan/29/question-and-answer-quantitative-easing. Retrieved 12 July 2010. 
  6. ^ a b c “Quantitative Easing explained”. Bank of England. pp. 7-9. http://www.bankofengland.co.uk/monetarypolicy/pdf/qe-pamphlet.pdf. Retrieved 20 July 2010. “(page 7) Bank buys assets from … institutions … credits the seller’s bank account. So the seller has more money in their bank account, while their bank holds a corresponding claim against the Bank of England (known as reserves … (page 8) high-quality debt … (page 9) … such as shares or company bonds. That will push up the prices of those assets,” 
  7. ^ a b c d Bean, Charles (July 2009). “Ask the Deputy Governor”. Bank of England. http://www.bankofengland.co.uk/monetarypolicy/qe/askqa.htm. Retrieved 12 July 2010. 
  8. ^ http://news.bbc.co.uk/1/hi/8517760.stm
  9. ^ Mark Spiegel. “FRBSF: Economic Letter – Quantitative Easing by the Bank of Japan (11/02/2001)”. Federal Reserve Bank of San Francisco. http://www.frbsf.org/publications/economics/letter/2001/el2001-31.html. Retrieved 2009-01-19. 
  10. ^ Alloway, Tracy, The Unthinkable Has Happened, ft.com, 10 November 2008. Retrieved 9 August 2010.
  11. ^ ‘Bernanke-san’ Signals Policy Shift, Evoking Japan Comparison, Bloomberg.com, 2 December 2008
  12. ^ Bank pumps £75bn into economy, ft.com, 5 March 2009
  13. ^ Evans, Rachel, Unsellable bonds structured to abuse ECB scheme, IFLR, 2 February 2009
  14. ^ Easing Out of the Bank of Japan’s Monetary Easing Policy (2004-33, 19 November 2004)
  15. ^ PIMCO/Tomoya Masanao interview
  16. ^ Shirakawa, Masaaki, “One Year Under ‘Quantitative Easing'”, Institute for Monetary and Economic Studies, Bank of Japan, 2002.
  17. ^ Bank of Japan, New Procedures for Money Market Operations and Monetary Easing, 19 March 2001. Retrieved 9 August 2010.
  18. ^ Hiroshi Fujiki et. al., Monetary Policy under Zero Interest Rate: Viewpoints of Central Bank Economists, Monetary and Economic Studies, February 2001, p.98. Accessed 9 August 2010.
  19. ^ Richard Werner, Keizai Kyoshitsu: Keiki kaifuku, ryoteiki kinyu kanwa kara, Nikkei, 2 September 1995.
  20. ^ Willem Buiter (2008-12-09). “”Quantitative easing and qualitative easing: a terminological and taxonomic proposal””. http://blogs.ft.com/maverecon/2008/12/quantitative-easing-and-qualitative-easing-a-terminological-and-taxonomic-proposal/. Retrieved 2009-02-02. 
  21. ^ Credit Easing versus Quantitative Easing

[edit] External links
[image url="http://upload.wikimedia.org/wikipedia/commons/thumb/f/f8/Wiktionary-logo-en.svg/37px-Wiktionary-logo-en.svg.jpg" link="lightbox" caption="" source="" alt="" align="left" size="xlarge" nocrop="true" clear="true"]
Look up quantitative easing in Wiktionary, the free dictionary.

  • Stimulus Watch Tracking all measures taken by the Federal Reserve and other government agencies to address the financial and economic crisis
  • Deflation: Making Sure “It” Doesn’t Happen Here, 2002 speech by Ben Bernanke on deflation and the utility of quantitative easing
  • Modern Money Mechanics Federal Reserve Document Explaining How Money Is Created
  • Quantitative easing explained (Financial Times Europe)
  • A Fed Governor Discusses Quantitative Easing Among Other Topics
  • Quantitative Easing Explained Pamphlet Putting More Money Into Our Economy To Boost Spending

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