What “quantitative easing” means

Submitted by Anon on 13 March, 2009 - 8:47 Author: Martin Thomas

The Bank of England’s move in early March to a new monetary tactic — “quantitative easing” — came alongside much economic-disaster news.

The banks “bailed out” so lavishly last year still need more bailing out. Lloyds TSB, which was supposed to be a “strong” bank capable of saving HBOS by buying it out with Government aid, turns out to be as much a basket case as any other.

In the USA, giants like Citigroup are in deep trouble, and conservative politicians talk about nationalisation.

World trade has shrunk very rapidly: the Financial Times reported on 8 March that “countries with trade data for January [2009] show on average a 31 per cent fall over January 2008”. Thirty-one per cent!

What does “quantitative easing” mean?

Technically, it is a simple matter. In our individual day-to-day dealings, it seems to us that the stock of money in the economy is a fixed quantity — if we gain money, it is because we have sold something, or received a payment or similar, from someone else who now has less money to exactly the same degree that we have more money. From the point of view of the economy as a whole, it is far from fixed.

Most money is not notes and coin. Probably you get your wages in the form of a bank credit rather than notes and coin, and convert the wages to notes and coin only bit by bit. In fact, most money is created by commercial banks, not central banks.

If you have £1000 credited to your bank account for your month’s wages, then the bank does not hold on to all of it. It lends out some of it, say £800. The person getting the £800 loan also does not keep the £800 in notes and coin. They put it into another bank account. Then most of it can be lent again... and so on.

The limit to this multiplication of money is the banks’ decision to keep some reserves, either because they are legally obliged to or out of business prudence.

If banks become more reluctant to lend (or individuals decide to keep more of their money in the form of ready cash, which is also happening), then the total of money in the economy shrinks. Many people have less money, without any counterpart of someone else having more money. Actual money — as distinct from shakier “financial assets” — becomes scarce.

Usually central banks regulate the total of money in the economy by changing the official interest rate (“Bank Rate”) at which the central banks lends to commercial banks. If a series of other relationships are fairly stable — the relationship of other interest rates to “Bank Rate”, the willingness of the banks to lend, the speed at which households and firms spend their cash — then “Bank Rate” tweaking can more or less control both the total of money and the general movement of prices.

In the early 1980s, central banks in both Britain and the USA pushed their official interest rates sky-high in order to beat down inflation — smashing union organisation, driving less-competitive employers out of business, and running mass unemployment in the process.

Since then, over the last twenty years or so, it has become capitalist conventional wisdom that economies can be managed by fine-tuning interest rates to keep somewhere near a pre-set, moderate target for average price inflation, regulating financial markets, and leaving most other things to the supposed magic of global market mechanisms.

Now that conventional wisdom is shattered. In particular, “Bank Rate” is about as low as it can possibly go — 0.5% — and yet credit remains scarce. So the Bank of England is acting more directly to increase the total of money in the economy, by buying financial assets from the commercial banks. (Doesn’t that mean that the Bank of England loses money to exactly the same degree that the commercial banks gain it? No, because pounds are just IOUs from the Bank of England. If the Bank of England holds an IOU to itself, that is not money).

The immediate effect is to increase the commercial banks’ account balances at the Bank of England. As and when the commercial banks draw on those balances, the Bank of England may have to print fresh notes to pay out. (Thus the description of “quantitative easing” as “printing money”).

So that is what it means technically. What will its economic impact be?

I don’t know. No-one knows. The Bank of England hopes it will ease the general cash famine, and so get lending and spending up again, but possibly it will have not much effect of that sort.

Won’t it fuel inflation?

It may well do so, but probably with a delay (between 18 and 36 months seems the best estimate). The ultra-low interest rates of the Bank of England and other central banks, and the huge government support for commercial banks, are also likely to have an inflationary effect in the longer term.

For the last six months or so, central banks have been doing everything they previously described as destructive, stupid, and likely to wreck the economy by generating inflation!

Their current worry is deflation — seriously falling prices, which have a deadly effect on capitalist economies — and for now they see all worries about future inflation as very secondary. But it doesn’t follow that all their previous calculations were entirely wrong.

The conclusion for workers to draw is that we should beware of bosses telling us that we don’t need pay rises, because prices are stabilising or falling. In fact, food prices are still rising fast, and may continue to do so. And general price levels may be rising fast within a couple of years.

What is the ideological significance of the shift to “quantitative easing”?

Huge. It is another public admission that, as Martin Wolf of the Financial Times put it when introducing a big FT series on “the future of capitalism”: “Another ideological god has failed. The assumptions that ruled policy and politics over three decades suddenly look... outdated...”

It depends on us, as socialists, to get serious alternative ideas heard in place of those failed assumptions.