Quantitative easing: how it may or may not help beat the recession

With interest rates approaching zero and little sign that making money cheaper is having any effect on the economy, the Bank of England has decided to make it more abundant as well.

The exhaustion of the main conventional tool for controlling the economy – cutting or raising interest rates – has left the Bank with little option but to try unconventional measures.

The main reason that slicing away at interest rates has provided no noticeable remedy so far for the recession is that the cost of money is not quite the issue: it is the unavailability of credit that is gumming up the wheels of the economy.

So the policy makers at the Bank have turned instead to a mechanism for adding money to the system: quantitative easing. In other words, adding to the quantity of money rather than simply addressing its cost.

The Bank is to introduce, by printing it, some £150 billion (£5,800 for every household in Britain) as a way of boosting the supply of cash in the system and of reversing the looming threat of debt-fuelled deflation. Once the Bank is in a position to do so, it will sell off these assets, effectively destroying the money it has manufactured.

The idea is this. An economy cannot grow at a rate greater than that at which the money in it also grows. If the banks are holding on to what they have, and consumers too, the Bank has decided to step in and to inflate the amount of liquidity in the economy.

And it works like this. The Bank uses the extra money to buy up collateral, usually corporate debt, from the high street banks and other private investors such as pension funds and insurance companies. An influx of money, it is hoped, will encourage the banks to lend to cash-starved businesses – a policy which they have been reluctant to adopt since the credit crunch – and, in doing so, ease the flow of credit on which so many firms depend. Buying up bonds should also have the effect of reducing longer-term borrowing costs.

On the plus side, the strategy adds both to the volume of cash in the system and to the respectability of bank balance sheets. On the down side, it may simply encourage the banks to bolster their books and not to step up lending rates.

There is a further risk even in the event of its success. Were too much of the extra money to leach its way into asset prices or the exchange rate, then the system becomes inflationary.

Of course, a spot of inflation wouldn’t go amiss at the moment – it would dampen the value of the debts that everyone has to repay for a start – but the danger is that printing more money can serve to prime-pump prices if the money remains in the economy for too long.

Will it be effective? No one seems really to know, although the policy has its supporters (Graham Leach of the Institute of Directors described it as “a shock and awe approach” while also conceding that “there is no guarantee of success”).

Japan had a go at quantitative easing as a weapon in its fight against a pernicious decade of deflation but enjoyed only minimal results.

At the moment we have too little money; in curing our depletion, quantitative easing raises the stakes of our having too much.