2010 quantitative easing

Quantitative easing (QE) is a monetary policy used by some central banks to increase the supply of money by increasing the excess reserves of the banking system, generally through buying of the central government's own bonds to stabilize or raise their prices and thereby lower long-term interest rates. This policy is usually invoked when the normal methods to control the money supply have failed, i.e the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero. It has been termed the electronic equivalent of simply printing legal tender.

This has been tried in the past to limited effect (as described below). In 2010, the US Federal Reserve began to implement the biggest round of quantitive easing in history. Its effects are unknown and commentators have widely differing views on its effectiveness in resuscitating the stalled US economy.

A central bank implements quantitative easing by first crediting its own account with money it creates ex nihilo ("out of nothing"). All fiat money is created out of nothing: out of thin air. It is, however, backed by all - the sum total of - the underlying value systems in an economy, namely sound governance, sound economic policies, sound monetary policies, sound industrial policies, sound commercial policies, etc. Annual inflation above the central bank´s inflation target indicates the excess of fiat money created in the banking system. The central bank then purchases financial assets, including government bonds, agency debt, mortgage-backed securities 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, and thus hopefully induce a stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system.

Risks include the policy being more effective than intended or the risk of not being effective enough, if banks opt simply to sit on the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio.

"Quantitative" refers to the fact that a specific quantity of money is being created; "easing" refers to reducing the pressure on banks. However, another explanation is that the name comes from the Japanese-language expression for "stimulatory monetary policy", which uses the term "easing". Quantitative easing is sometimes colloquially described as "printing money" although in reality the money is simply shifted from member bank dollar deposits to financial instruments. Examples of economies where this policy has been used include Japan during the early 2000s, and the United States, the United Kingdom and the Eurozone during the global financial crisis of 2007–the present, since the programme is suitable for economies where the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

Concept
Ordinarily, the central bank uses its control of interest rates, or sometimes reserve requirements, to indirectly influence the supply of money. In some situations, such as very low inflation or deflation, setting a low interest rate is not enough to maintain the level of money supply desired by the central bank, and so quantitative easing is employed to further boost the amount of money in the financial system. This is often considered a "last resort" to increase the money supply. The first step is for the bank to "borrow" from the member bank reserve accounts, creating a depository liability. It can then use these funds to buy investments like government bonds from financial firms such as banks, insurance companies and pension funds, in a process known as "monetising the debt". The net impact on the central bank balance sheet is zero.

For example, in introducing its QE program, the Bank of England bought gilts from financial institutions, along with a smaller amount of relatively high-quality debt issued by private companies. The banks, insurance companies and pension funds can then use the money they have received for lending or even to buy 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. These have the effect of depressing interest yields on government bonds and similar investments, making it cheaper for business to raise capital. Another side effect is that investors will switch to other investments, such as shares, boosting their price and thus creating the illusion of increasing wealth in the economy. QE can reduce interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying and financially weaker bodies.

More specifically, the lending undertaken by commercial banks (excluding Swedish banks: the Riksbank does not require reserves from Swedish commercial banks) is subject to fractional-reserve banking: they are subject to a regulatory reserve requirement, which requires them to keep a percentage of deposits in "reserve", these can only be used to settle transactions between them and the central bank. The remainder, called "excess reserves", can (but does not have to) 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. 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 unilaterally employ quantitative easing. Countries in the eurozone (for example) cannot unilaterally use this policy tool, but must rely on the European Central Bank (ECB) to implement it. There may also be other policy considerations. For example, under Article 123 of the Treaty on the Functioning of the European Union and later the 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, for example, in Weimar Germany and more recently in Zimbabwe. 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.

History
Quantitative easing was used unsuccessfully by the Bank of Japan (BOJ) to fight domestic deflation in the early 2000s. Something similar was used by Zimbabwae and the Weimar Republic and other failed regimes in the past and excessive amounts of quantitative easing have in the past resulted in bouts of hyperinflation. During the global financial crisis of 2008–the present, 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. This process has led to bonds being "structured for the ECB". 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. 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.

Risks
Quantitative easing can trigger higher inflation than desired or even hyperinflation if it is improperly used, and too much money is created. It can fail if banks are still reluctant to lend money to small business and households in order to spur demands. Quantitative easing can effectively ease the process of deleveraging as it puts pressure on yields. But in the context of a global market, home printed money can flood abroad and spark asset bubbles in developing economies.

Only an increase in money supply in excess of what is required in an economy or monetary union has an inflationary effect (as indicated by an increase in the annual rate of inflation) by eroding the real value of each unit of the functional currency as well as the real value of the accounting unit of account. Inflation and hyperinflation have no effect on the real value of non-monetary items. People who have saved money or are holding any monetary item will find its real value eroded by inflation; however those who have negative savings (debt) will see the real value of that debt decline. Those who own homes will see the nominal value of the home increase (while the real value of the home will most probably stay the same - all else being equal) as more real value eroded dollars are needed to purchase the same home which still has the same real value. The real value of the capital amount of the debt on that home will decrease as the nominal number of dollars needed to settle the mortgage will remain constant and can be paid with future real value eroded dollars only in the case of fixed mortage repayment rates. This combined with the associated low interest rates will put people who rely on their fixed incomes from fixed monetary savings in difficulty unless those savings are kept in an investment vehicle with an inherent value (e.g. Gold or shares in companies that grow during good and bad times). 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.

Inflationary risks are mitigated if the system's economy outgrows the pace of the increase of the money supply from the easing. If production in an economy increases because of the increased money supply, the value of a unit of currency will increase even if there is more currency available. For example, if a nation's economy were to spur a significant increase in output at a rate at least as high as the amount of debt monetized, the inflationary pressures would be equalized. This can only happen if member banks actually lend the excess money out instead of hoarding the extra cash. During times of high economic output, the Fed always has the option of restoring the reserves back to higher levels through raising of interest rates or other means, effectively reversing the QE steps taken.

As a practical example, if a member bank makes a loan to a private company that develops oil and gas fields, and that company finds a major strike of oil, the additional commodities generated would offset any inflation that might occur.

Additionally, maintaining near zero interest rates over long periods can result in deflation. The risks associated with deflationary curves often outweigh the risks of inflation. QE is seen as a way to increase the money supply to banks when the interest rates cannot be lowered further.

On the other hand, in economies when the monetary demand is highly inelastic with respect to interest rates, rates close to zero, or a depressed money market (symptoms which imply a liquidity trap), QE can be implemented in order to further boost monetary supply, and assuming that the economy is well below potential (inside the production possibilities frontier), the inflationary effect would not be present at all, or in a much smaller proportion.

Origin
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. 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, including as late as February 2001, claimed that "quantitative easing … is not effective" and rejected its use for monetary policy. 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 1994 during his numerous presentations to institutional investors in Tokyo. It is also, among others, in the title of an article published on September 2, 1995 in the Nihon Keizai Shinbun (Nikkei).

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 at the time 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" (see below).

However, while Werner used and explained the concept of credit creation in his speeches and articles, he often chose not to use it initially or in the titles of articles, as too few listeners or 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.

QE2
The expression 'QE2' has become a "ubiquitous nickname" in 2010, usually used to refer to a second round of quantitative easing by central banks. It was first employed by Richard Werner in a live CNBC program on 22 September 2009. The name implies a pun on the famous ship RMS Queen Elizabeth 2 - Richard Werner is a professor of International Banking at the University of Southampton, the port in which the ship was based through most of its history. However, from Prof. Werner's comments in this CNBC program it is apparent that the reason why he employed the expression was because he argued that the policy that was being called 'quantitative easing' by central banks and in the media - base money expansion and open market purchases of securities from banks - was not 'true' quantitative easing as originally defined by him, and hence likely to remain insufficient to deliver sustainable, productive and hence non-inflationary growth. Instead, he argued, 'true quantitative easing' was needed, namely an expansion in productive credit creation. This required a second attempt by central banks, "a kind of QE2". Meanwhile, the expression is today mainly used to refer to a second round of what Prof. Werner would consider the 'wrong type' of QE.

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."

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.

Links

 * Stimulus Watch Tracking all measures taken by the Federal Reserve and other US 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
 * Bank of England - Quantitative Easing
 * Bank of England - QE Explained Pamphlet
 * 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
 * Brown, Ellen; "How to Reverse a Deflation", Counterpunch, September 9, 2010
 * New $600B Fed Stimulus Fuels Fears of US Currency War - video report by Democracy Now!
 * The Downside of Monetary Easing by William F. Ford, PhD, and Polina Vlasenko, PhD, July 2011