Thursday, 22 September 2011

Quantitative Easing for Dummies

On Wednesday, the US Federal Reserve announced another round of quantitative easing (QE), only they called it Operation Twist, because they've tried quantitative easing twice before and it didn't work, so they're hoping a change of name might bring better luck. This is intended to boost a flagging economy, so the markets predictably responded with blind panic. The UK is also set to follow the same strategy soon. In case you're wondering what this is all about, I've put together a handy little Q&A about QE:

A brief pictorial explanation by Eric Lewis

Q: What is quantitative easing?
A: It's when a central bank 'prints' money and then uses it to buy government bonds (government debt).

Q: You mean the government prints money in order to purchase its own debt? That sounds fishy.
A: Yes. Pretty cool, though, huh? Bet you wish you could do that.

Q: Quite. Also, when you say 'print', what exactly do you mean? Do they actually print banknotes?
A: No, silly. They just electronically credit the accounts of the people they buy the bonds from. They just conjure the money out of thin air, because money is imaginary stuff; it doesn't really exist. That's the beauty of it and it requires no thought whatsoever: just press a button and it's done! Even George Osborne can do it.

Q: OK. Who are the people they buy the bonds from?
A: Whoever happens to own them. In practice, it's mostly banks who already hold government bonds (gilts). It can also be pension funds or just wealthy individuals. Often, the government simply issues new bonds and promptly buys them from itself.

Q: 'Buys them from itself'? Presumably, the issuing bank also gets a cut on the deal?
A: Yes and yes.

Q: Wow! Aren't the banks doing rather well out of this?
A: Stunningly, awesomely well. They get a price premium on the bonds they already own and they get a commission on the deals for bonds they don't own. It also helps turn somewhat risky sovereign debt into risk free cash reserves. Win-win-win! For the banks.

Q: Great. How is this supposed to help the wider economy?
A: Hmm. Good question. Well, the hope is that the banks will use the new cash reserves wisely by lending it to businesses or to consumers for spending, so that will stimulate both investment and demand and get the economy growing. It also helps keep long term interest rates down by raising the price of gilts.

Q: What if the banks don't use the money wisely? What if they just gamble it in the commodities or derivatives markets? What if they just stoke up another asset-price bubble? What if their executives just use it to pay themselves multi-million dollar bonuses to buy yachts and villas in Aruba? What if they just sit on it?
A: Don't be silly. Banks are always wise and always do the right thing by the rest of us.

Q: I see. Haven't we done this before?
A: Yes. Twice in the US and once already in the UK since 2008.

Q: Did it work?
A: Are you kidding? Why do you think we're doing it again?

Q: Why ARE we doing it again?
A: Well, if a thing didn't work three times, do it a fourth time just to make really sure. Seriously, I don't know. The banks seem to love it, though.

Q: Is there any alternative?
A: No. Absolutely not. Never. I resent that suggestion.

Q: Are you sure there's no alternative?
A: Well, maybe. Instead of boosting banks' cash reserves, one could print money and invest it directly in the domestic economy. I suppose we could build much needed housing, improve the rail network, provide vocational training, invest in renewable energy, communications infrastructure, education, health care, get people back into work, etc etc. If you like that sort of thing. We could even create a mutualised National Investment Bank out of the banks we already own and give it a mandate to lend to small business and community projects.

Q: Why the hell don't we do that, then?
A: You just don't understand economic theory, do you? Private sector good, public sector bad. Private sector good, public sector bad. Private sector good, public sector bad. Thatcher is God! Baaaaah. Baaaaah. Wibble.

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