Printing money

Those of you who are serious about your Economics will already have read articles about 'quantitative easing'. In fact if your main source of knowledge is the Daily Mail you'll have read:

"The prospect of what is known as ' quantitative easing' - printing money - emerged after Mr Darling gave a clear sign that the recession will be worse than expected. Such a step would mark a dramatic moment in British economic history, ending decades of trying to limit the growth of the money supply. It would also mean an end to the decade-old independence of the Bank of England as ministers took charge of what would be a politically-sensitive policy.

And it would risk driving down the value of the pound, which is already under intense pressure in the money markets in the face of low interest rates and fears of soaring Government borrowing.....Zimbabwe is an example of an economy where reckless printing of money has led to stratospheric levels of inflation, with a loaf of bread costing millions of dollars. Weimar Germany in the 1930s was a similar story.

If base rates fall to near zero the Treasury and the Bank of England will have lost one of their only weapons for stimulating growth. Printing more money would generate cash which would be used to buy so-called toxic assets - bad loans - from ailing banks, allowing them in turn to start lending to businesses and homebuyers again..."

Source: The Daily Mail

The more enthusiastic among you will therefore be pleased that on David Smith's blog he writes authoritatively about quantitative easing and how it is NOT 'printing money':

"Quantitative easing is often described as "printing money", though it is not....he Bank limited itself to a half-point cut to 1.5% last week, though taking us, as every schoolboy knows, to the lowest rate since 1694. That seemed sensible, despite figures on Friday showing an alarming plunge in manufacturing output. It leaves shots in the locker and time to think about other measures.

"Printing money", to be clear, is not the same as printing money. This is not a cash economy. The value of notes and coins in circulation is £51.6 billion, less than 3% of £1.9 trillion of "broad" money in Britain, M4, consisting of bank deposits and the corresponding lending. Printing money means getting broad money growing faster through so-called quantitative easing.

How? One way is for the Bank to buy government bonds or commercial securities from banks or their customers. This creates a credit in the central bank's reserve account, which can then be the basis for increased bank lending. It also drives down interest rates throughout the economy.

Or, in a situation where the government is borrowing large amounts, as now, it can "underfund" its budget deficit by issuing fewer gilts than needed, or by selling them direct to the Bank. The effect is to boost broad money, M4. Or, if none of this works, the central bank can lend directly into the economy, using the banks as its agents."

Having read the above, now read through this...

Of course if you read the Financial Times over Christmas (as you were advised to do) then you'd already know all this:

What is quantitative easing? Central banks normally regulate the quantity of money in the economy by altering its price in the form of the interest rate, which makes demand expand or contract. Once interest rates get down towards zero, they cannot be cut any further. (Unless, that is, the central bank starts charging people for holding money, for example by putting expiry dates on currency, but that would be difficult to pull off.)

So the only way to get more money into the economy is to pump it in by other means. In an economy that ran entirely on banknotes, this would just mean setting the printing presses going. In a credit-based financial system it means taking actions such as buying long-term government bonds. This means taking less liquid financial assets out of the system and holding them on the central bank’s balance sheet, and replacing them with cash.

What is the aim of this? The scenario that causes central bankers to wake sweating in the night is an uncontrolled deflation – that is, a fall in the general level of prices at a time when the economy is weak. If interest rates are already at zero, falling prices mean that the real rate of interest starts rising. This hurts companies and consumers who have borrowed money. Since consumers’ wages, and the prices of goods and services that companies sell, are actually falling, they will struggle to pay back loans. Pushing cash into the economy is intended to keep up demand and prevent deflation taking hold.

If the central bank wants to do it this way, it can essentially create money and give it to the government to spend, forcing up the demand for goods and services and preventing prices falling.

What is the US Federal Reserve up to? Rather than say in advance precisely what it will do, or announce specific targets for the money supply, the Fed is basically telling everyone that it will do whatever it takes to push cash into the economy. It has already bought a lot of short-term assets issued by banks and companies. It is now suggesting it might buy a lot more longer-term assets such as bonds issued by Fannie Mae and Freddie Mac, the mortgage agencies that are now controlled by the government, or government bonds (US Treasuries) directly.

Is there a limit to this? What are the risks? Since the central bank is a monopolist which can create money without limit, it can carry on pumping out as much as it wants. The risk is not that it will run out of money but that the situation will suddenly flip and prices will start rising uncontrollably. This would almost certainly be accompanied by a collapse in the currency on the foreign exchanges.

Such currency crises and “hyperinflations” are what bedevilled Latin American countries for decades. Quantitative easing is a high-risk option, to be taken when other solutions have failed.

Source: The Financial Times

It is argued though, that quantitative easing did not work in Japan (see graphic from the Financial Times) but is that really comparing like with like?

Look at the differences:

• Consumer preferences for savings versus consumption
• The nature and volumes of foreign direct investment
• The preferences of domestic investors for domestic versus foreign assets
• The ease and speed of corporate restructurings; the ease and speed of business formation/job creation
• The nature and rate of government consumption and investment activities
• The breadth and depth of credit and insurance markets

The reason I mention this is that with Business Studies and Economics examinations approaching make sure you stress that whatever policy/remedy/decision you discuss - whetehr it be for a business or an economy - would not necessarily work for another business or economy. You will thus demonstrate evaluation if you illustrate that you haven't simply learned a list of key points to be applied without any thought.