Quantitative Easing: What's In A Name?

IF there were awards for the most controversial investment terms, “quantitative easing” (QE) would win top prize. Experts disagree on nearly everything about the term – its meaning, its history of implementation, and its effectiveness as a monetary policy tool.

Despite this, there are some things investors and consumers should know about this term. If you’ve been hearing it in the news, you can find out what you need to follow the story here.  

The Basics

Popular media’s definition of quantitative easing focuses on the concept of central banks increasing the size of their balance sheets to increase the amount of credit available to borrowers. To make that happen, a central bank issues new money (essentially creating it from nothing) and uses it to purchase assets from other banks. Ideally, the cash the banks receive for the assets can then be loaned to borrowers. The idea is that by making it easier to obtain loans, interest rates will drop and consumers and businesses will borrow and spend.

Theoretically, the increased spending results in increased consumption, which increases the demand for goods and services, fosters job creation and, ultimately, creates economic vitality. While this chain of events appears to be a straightforward process, remember that this is a simple explanation of a complex topic. (For a closer look at how they print money and seek to control inflation, check out The Fed’s New Tools For Manipulating The Economy.)

 

In the United States, the Federal Reserve serves as the nation’s central bank. To learn about the tools the Federal Reserve uses to influence interest rates and general economic conditions, see Formulating Monetary Policy and Understanding The Federal Reserve Balance Sheet.

The Challenges

Closer analysis of QE reveals just how complex the term is. Ben Bernanke, renowned monetary policy expert and chairman of the Federal Reserve, draws a sharp distinction between quantitative easing and credit easing: “Credit easing resembles quantitative easing in one respect: It involves 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.” Bernanke also points out that credit easing focuses on “the mix of loans and securities” held by a central bank.

Despite the semantics, even Bernanke admits that the difference in the two approaches “does not reflect any doctrinal disagreement.” Economists and the media have largely disregarded the distinction by dubbing any effort by a central bank to purchase assets and inflate its balance sheet as quantitative easing. This leads to more disagreements. (For more read The Federal Reserve’s Fight Against Recession.)

Does Quantitative Easing Work?

Whether quantitative easing works is a subject of considerable debate. There are several notable historically examples of central banks increasing the money supply. This process is often referred to as “printing money”, even though it’s done by electronically crediting bank accounts and it doesn’t involve printing.

While spurring inflation to avoid deflation is one of the goals of quantitative easing, too much inflation can be an unintended consequence. Zimbabwe (in the 1920s) and Germany (in the 2000s) engaged in what many scholars refer to as quantitative easing. In both cases, the result was hyperinflation. However, many modern scholars aren’t convinced that the efforts of these countries qualify as quantitative easing.

In 2001-2006, the Bank of Japan increased its reserves from 5 trillion yen to 25 trillion yen. Most experts view the effort as a failure. But again, there is debate over whether or not Japan’s effort can be categorized as quantitative easing at all.

Economic efforts in the United States and the United Kingdom during 2009-10 also met with disagreement over definitions and effectiveness. European Union countries are not permitted to engage in quantitative easing on a country-by-country basis, as each country shares a common currency and must defer to the central bank.

There is also an argument that QE has psychological value. Experts can generally agree that quantitative easing is a last resort for desperate policy makers. When interest rates are near zero but the economy remains stalled, the public expects the government to take action. Quantitative easing, even if it doesn’t work, shows action and concern on the part of policy makers. Even if they cannot fix the situation, they can at least demonstrate activity, which can provide a psychological boost to investors.

Of course, by purchasing assets, the central bank is spending the money it has created, and this introduces risk. For example, the purchase of mortgage-backed securities runs the risk of default. It also raises questions about what will happen when the central bank sells the assets, which will take cash out of circulation and tighten the money supply. (For more on this, check out When The Federal Reserve Intervenes (And Why).)

When Was Quantitative Easing Invented?

Even the invention of quantitative easing is shrouded in controversy. Some give credit to economist John Maynard Keynes for developing the concept; some cite the Bank of Japan for implementing it; others cite economist Richard Werner, who coined the term.

The Bottom Line

The controversy surrounding QE bring to mind Winston Churchill’s famous quip about “a riddle wrapped in a mystery inside an enigma”. Of course, some expert will almost certainly disagree with this characterization. Investopedia