24 Nov 2009 | UK

Quantitative Easing - Money Money Money 

David Smith asks whether or not we should feel queasy about quantitative easing.

Seldom has the Bank of England created more controversy than when it embarked on quantitative easing (QE) in March 2009. Cutting interest rates to a record low of 0.5 per cent was dramatic enough; accompanying it with an untested policy of pumping tens of billions into the economy took us into new territory. When comparisons were drawn with Zimbabwe’s road to hyper-inflation, the Bank knew it had a job on its hands to convince the sceptics.

This it has done pretty well, overcoming the disadvantage of selling a policy with an appalling name. Charlie Bean, the deputy governor, went on a national tour in July to explain QE in speeches and interviews. The Bank’s website explains that once the rate had fallen to 0.5 per cent and for practical purposes could not drop further, it was necessary to move from acting on the price of money to influencing its quantity.

“The Bank supplies extra money directly,” it says. “This does not involve printing more banknotes. Instead, the Bank pays for… assets by creating money electronically and crediting the accounts of the companies it bought the assets from. This extra money supports more spending in the economy to bring future inflation back to the target.”

All clearly explained, so why is QE still so controversial? First is the Zimbabwe connection. The Bank may not be printing banknotes but it is creating money in other ways. Will not this be inflationary? It depends on degree. At the time of writing, the Bank’s Monetary Policy Committee has authorised £17bn of QE, about 12 per cent of Britain’s national income, or gross domestic product. It says this is needed to reverse a decline in the money supply and get it growing by around 9 per cent annually, which in the past has given us economic growth alongside inflation in line with the 2 per cent target.

Second is the Bank’s method. Early on it decided the most effective way of injecting money into the economy would be mainly buying UK government bonds and gilts. Some are uneasy about this. Is not one arm of government, the Bank, buying the debt created by the Treasury? Should not the Bank buy private sector assets? The Bank’s response is that only the gilt market was big and liquid enough for the policy to be introduced quickly without creating huge distortions.

Third, how do you get out of this? At some stage, the Bank will have to sell the gilts it has bought under QE back into the market. As long as the budget deficit is coming down and Britain’s guaranteed debt rating has escaped being lowered in value, there may be no problem. If not, assets that took months to purchase could be hanging around on the Bank’s balance sheet for years.

Finally, is it working? As with interest rates, there is a lag between a policy change and its effect.

Knowing what would have happened without it is also impossible. We will never know if the recovery, as it comes through, was due to QE or other factors. For me, ineffectiveness is a bigger worry than QE being inflationary. Recessions are good at destroying inflation; banking crises are good at stopping the flow of credit the economy needs. Only if QE succeeds in restoring that flow will this experiment have been worthwhile.

David Smith is economics editor and an assistant editor and policy adviser on The Sunday Times and visiting professor at Cardiff University. His latest book is The Dragon & the Elephant: China, India and the New World Order.

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

Investment markets, including currency exchange rates, can go down as well as up and market conditions can change rapidly.