Quantitative Easing
Posted September 14th, 2012
What is it and is it working?
To answer the second question briefly, no, it isn’t working. It does give you a reason as to why annuity rates are so pitifully low at the moment though.
So, what is Quantitative Easing?
It’s basically monopoly money. No, really. Anyone that has played the snatch n grab property bored (pun intended) game has inevitably at some point said (or at least heard someone say) “wouldn’t it be great if all this fake money was real!!??” Great indeed. But, if you think about it, those little funny coloured bits of paper have only marginally less intrinsic value than the paper or “fiat” money that (for many of us all too briefly) occupies our wallets.
Without really getting in to a history of how paper money came to be, it used to be many eons ago that those bills actually meant something.
I have ten cows in a field. You have some land that I would like to purchase. You tell me that the cost of that land is, coincidentally, ten cows. Now, my bovine acquaintances are quite happy in their little field and neither you nor I wish to move them. So, I give you a bit of paper, signed by me and a witness(presumably) that says you now own the cows in such and such a field. You own them, yet they never actually go anywhere. You then have ten cows with which to trade. In fact, theoretically, those cows could change hands ad infinitum without actually going anywhere. And there you have a ridiculously naïve and simple illustration to back up how and why paper money was born. The point is, the value on a bill meant something of true value be it, cows, gold, silver, cotton………..whatever. So, what does a £10 note actually give you today? In short, nothing. There is no asset to back it up anymore. It used to mean that there was gold held in the BOE vaults that you would be entitled to ask for in exchange for your bank note. The link between gold and bank notes was broken in 1931 so the only thing that props up the value of your bank notes is trust. It’s worth £10 because you believe it is and so do the receiver and the issuer. It’s as straight forward and stupid as that.
So, you may think “what’s to stop them making more money during a recession? Especially since it isn’t backed up by any tangible asset.” In steps Quantitative Easing. This is precisely what the government is doing. Just printing extra money in an attempt to support the current price index, amongst other things. Then you say “well I wasn’t serious….surely just making money out of thin air can have a drastic effect on an economy. Particularly one that’s in recession!”
The idea behind quantitative easing is to “flood the economy” with money in an attempt to jump start it. The government uses this money to buy financial assets, and in turn, the banks are then supposed to lend that purchase money to the consumer. The cons are that interest rates are set low in order to encourage consumers to borrow. This means that savers lose out because of low interest rates. Also, gilt yields are reduced which in turn affects pensions and annuity rates. However, once the economy jolts back in to life then things are supposed to eventually equalise and things like gilt yields should return to normal. The alternative is to let prices drop but this in turn can lead to a lower output from manufacturers which then leads to rationing and so on.
There are pros and cons and no quick fixes. Granted. However, the principle behind quantitative easing is that the extra dosh finds its way in to the consumers bank account. A loan it may be, but with interest rates so low it’s a loan that can be met generally speaking. This isn’t what is happening. Perhaps it wouldn’t be right to eschew opinion on where the money is actually ending up on its short, virtual jaunt, but it isn’t finding its way on to the high street.
I wonder, what would happen if prices were allowed to drop? Yes this can have its own ramifications, but it needn’t be a long term solution. It may just encourage consumers back on to the high street as the money is his pocket may feel weightier. Prices wouldn’t have to drop to ridiculous levels either.
Well anyway, no point debating that as it’s unlikely to happen. Not anytime soon anyway. But that is one of the problems with quantitative easing in that it devalues the “real” money that you and I have. It didn’t work in Japan, and it’s not really cutting it in Europe.
When Japan found its boom bubble bursting (a move that was deliberately orchestrated) and recession hit very hard, the eyes of the financial and economic world focused on how this unorthodox exercise would pan out. The Japanese Bank did the exact same thing that is being tried in the UK – dropping the base rate and attempting to stimulate the economy with cash.
Wouldn’t it be an idea to simply cut spending everywhere from government level to the household, let prices drop slightly and let things settle down? Again, it may seem naïve but these things do ebb and flow. Trying to stimulate the economy when it seems at the moment it just doesn’t want to be woken up could cause headaches further down the line. Yes it’s painful and yes people may lose out for the time being. Such is the nature of finance.
The old adage of “drastic times call for drastic measures” is a little well-worn and not a prudent course of action. Drastic times call for prudence and common sense.
Image Credits:
Monopoly Cat – flickr.com/anamalous4
Cow – flickr.com/JelleS
