Controversial Tool for Boosting the Economy
Do you remember 2007? The global financial crisis that began that year in July threatened to bring down banking systems in all major economies. Interest rates went down to zero, and it was crystal clear that in order to prevent a possible collapse of the world financial system something must be done. The crisis was followed by a global economic downturn. Hoping to get back on track during the long recovery from the recession, central banks around the globe turned to a new monetary policy tool — large scale purchases of assets, also known as quantitative easing (QE).
Japan was the first country to use quantitative easing. It was one of the key instruments in country’s monetary policy in the period from 2001 to 2006. When S. Abe was selected as a Prime Minister for the second time, the usage of QE in Japan was restarted again. What about the rest of the world? Well, the story of QE and the US is an interesting one.
11 years ago, the US was in a deep financial crisis and Fed funds target rate (the rate that is charged by commercial banks to other banks who are borrowing money) was already close to zero.
So, the US Central Bank used QE, adding almost 2 trillion dollars to the country’s money supply and that right there is known to be the largest expansion from any economic stimulus program in history. As a result, the Fed’s balance sheet doubled from 2.106 trillion dollars in November 2008 to 4.486 trillion dollars in October 2014.
Fed officials claim that their “unconventional policy actions saved the US from a crisis worse than the Great Depression”. Europe’s Central Bank started using QE in January 2015, after 7 years of implementing austerity measures that were supposed to help lower budget deficits and avoid a debt crisis. The Central Bank agreed to purchase 60 billion in euro-denominated bonds, lowering the value of the euro and increasing exports. However, in the end, the bank increased purchases up to 80 billion euros a month. At the end of last year, December 13, the European Central Bank announced that the QE program is going to an end in the Euro zone.
Experts say that such decision indicates that Eurozone’s health after a decade of recessions and financial crisis is finally improving. M. Draghi, President of the ECB, commented on this decision, saying that “at times quantitative easing was the only driver of this recovery“. In total, QE’s program added 2.94 trillion dollars into Europe’s economy.
Let’s get technical for a second. You already know that quantitative easing is used to stimulate economies with increasing the money supply when standard monetary policies become ineffective. Basically, central bank implements QE by buying financial assets from commercial banks and other private institutions, using money it has simply created out of thin air. But there’s more to it; in order to regulate the economy, central banks across the world would set the price of money using official interest rates. These rates are certain guidelines to the economy, as they affect the cost of loans paid by the companies, the cost of mortgages for households, and also the return on saving money. Higher interest rates make borrowing less attractive, because taking out a loan becomes more expensive. At the same time, they also make saving seem more attractive. And vice-versa: lower interest rates have the reverse effect.
There’s one subtle catch to it: interest rates cannot be cut below zero. And so, when official rates get close to zero, the whole game changes and the effect of regulating the economy simply stops.
As you can imagine, even at times like these banks still need to make profit. However, if times are troubled, lenders usually show a desire of having a greater return for the additional risk of granting a loan. The gap between the official interest rates and the rates faced by companies and households can rise.
Here’s the trick: when these interest rates are close to zero, there is actually another way of effecting the money. Yes, it’s the quantitative easing. The aim remains the same: to bring down interest rates faced by companies and households. The most important thing when using QE is that the central bank can create new money and use them in the economy.
However, there have been many public discussions about quantitative easing, and this topic has become quite controversial between economists and politicians around the world. While some say that this tool can save a struggling economy, other disagree, noting that it can actually destroy one.
At one point yes, cheaper borrowing would allow the central bank to encourage greater spending, put an additional demand into the economy and even pull it out of recession.
New money is expected to raise consumer prices, giving people another incentive to buy now rather than later, but the risks also remain. First of all, QE can result in central bank loosing
money on its purchases and even worse — destroying the value of the currency, resulting in inflation or hyperinflation.
The biggest problem when it comes to QE is that no one truly knows how much QE is too much, and how much is not enough.
According to the University of Bath, the evidence suggests that quantitative easing was a valuable tool at the height of the financial crisis back in 2007-2008. It probably helped stabilise markets and contributed to preventing a recession becoming a depression. However, QE does not seem to be an effective policy tool for bringing major economies out of stagnation. They performed a research, and the results turned out to be pretty interesting: while QE has produced a limited, but temporary gain for the financial sector, it has been of practically no help to the wider business community or individuals and families struggling against inflation and unemployment. What is more, despite the affection investors may have for it as a financial lever, QE looks unlikely to be the answer to the economic problems of the modern age.