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).
Normally, a central bank stimulates the economy indirectly by lowering the discount rate or reserve requirements, but when it cannot lower them any further it can attempt to seed the financial system with new money through quantitative easing.
The process of purchasing financial assets with ex nihilo money is referred to as 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 Japan during the early 2000s, and the US and UK 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.
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 The 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 issued earlier by the government, and held by a bank.
This money is credited to the account of the bank selling the IOU. The bank can then use the 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 Bank 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. 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 Japan (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 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. 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. Risk Management
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.
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. Indeed, the Bank of Japan had for years, and until only a month earlier (February 2001) claimed that ‘quantitative easing … is not effective (p. 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.
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.
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. 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.
Quantitative vs.
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). All forms of risk, including credit risk (default risk) are included.
Quantitative vs.