Quantitative easing is a phrase that has been tossed around frequently in the United Kingdom over the past year or so. This vogue has been caused by the fact the Bank of England has been forced to engage in the activity, but nevertheless there does not seem to be a widespread understanding of what the term means. This is a shame, because it is not that difficult a concept to understand, and it illuminates many of our current economic problems.
Quantitative easing is something typically embarked upon by central banks when they feel there is not enough money in the economy: this is what the phrase means, an "easing" of the quantity of money in the economy; to coin another similar phrase, it is a "loose" policy. A lack of money in the economy causes all sorts of problems, but the most apparent one is the difficulty everybody experiences in borrowing money.
This is why the first phase of the global economic crisis was called the "credit crunch": money, or credit, became more difficult for everyone - from banks and companies to individuals - to borrow. This severely restrains economic activity. The first thing central banks do when credit becomes difficult to obtain is that they lower interest rates, which means they will themselves lend money to other banks at very low rates of interest. It is hoped that this will make commercial banks more willing to borrow money, which will in turn increase the amount of money in the economy and make borrowing cheaper for everyone. However, sometimes this is not enough, and credit still remains stubbornly hard to obtain because commercial banks are still unwilling to lend money at reasonable rates. This is when quantitative easing comes in.
Under a programme of quantitative easing, a central bank literally creates money (not by printing it, merely by electronically adding it to its own balance sheet) and then uses it to buy things from other banks. Typically it buys government bonds or various other things with which we need not concern ourselves. By doing this, it adds yet more money to the overall supply of money in the economy, which it is hoped will contribute to making credit more cheaply available. If you imagine quantitative easing as being a process whereby the central bank throws money out the window to the people below to stimulate spending and hence the economy, you won't be far from the truth.
If this doesn't seem logical to you, just consider the simple laws of supply and demand: when something is in short supply, it is very expensive, whereas if something abounds then it is cheap. Money is the same. If the overall money supply is large, then the cost of borrowing will be low, because everyone is trying to lend you money and you can shop around for the best deal. If money can be lent easily, economic activity like starting a business or buying a car becomes easier. Like low interest rates, quantitative easing is supposed to reduce the cost of borrowing and hence stimulate the economy by making banks feel more confident about lending money. However, the risk is that the banks will simply absorb the money themselves rather than increasing lending, as appears to have happened in the United Kingdom.
There are other risks. The opposite of a credit crunch is a credit boom. If quantitative easing is too successful, then it could lead to a massive surge in the availability of money, which will in turn lead everyone to increase their prices because they know their customers have easier access to credit. This causes inflation. Quantitative easing causes inflation not just by increasing the overall amount of money and hence decreasing the value of every unit of that money, but also because it makes credit much more easily available. This can in turn cause your currency to become less valuable on international currency markets, which dissuades people from investing in your economy because they are worried that they will lose money as inflation renders your currency less valuable.
One perceived upside of quantitative easing is that it can be used to lend money to governments who are having difficulty financing their deficits. In Britain, the Bank of England "printed" hundreds of billions of pounds and then used them to buy government bonds - effectively lending the government money. At a time when the government faces the prospect of finding it increasingly difficult to borrow money because investors are worried that the budget deficit is large enough to make it increasingly unlikely they'll ever get their money back, the added advantages of this are clear.
The European Central Bank, responsible for the euro, has just embarked on a programme of quantitative easing to artificially make it easier for countries like Greece to borrow money.1 This might be attractive in the short-term, but it risks allowing governments to postpone the difficult decisions they need to take to reduce their debts to a level where they can borrow money on their own merits. Furthermore, quantitative easing is not sustainable because of the risk of inflation, and hence while it may be necessary or at least beneficial for a while, eventually its beneficiaries have to learn to stand on their own two feet. Otherwise, the negative consequences will quickly outweigh the positive. How countries like Britain manage their "exit strategy" from quantitative easing will determine how soon they can again achieve some measure of sustainable prosperity.
1. The ECB claims that it is not increasing the overall amount of money because it will sell assets at the same rate it buys them; this is called "sterilization". It is yet to be explained precisely how this will be accomplished, however, leading many to suspect it is pursuing simple and inflationary quantitative easing .