Quantitative Easing and the European Central Bank: A Primer

A logo of the European currency Euro stands in front of the headquarters of the European Central Bank (ECB) in Frankfurt am Main on June 6, 2013, 2013. The European Central Bank held its key rates unchanged, as widely expected, at its regular monthly policy meeting. The bank's new headquarter is to be finished in 2014.   AFP PHOTO / DANIEL ROLAND        (Photo credit should read DANIEL ROLAND/AFP/Getty Images)A logo of the European currency Euro stands in front of the headquarters of the European Central Bank (ECB) in Frankfurt am Main on June 6, 2013, 2013. The European Central Bank held its key rates unchanged, as widely expected, at its regular monthly policy meeting. The bank's new headquarter is to be finished in 2014. AFP PHOTO / DANIEL ROLAND (Photo credit should read DANIEL ROLAND/AFP/Getty Images)

By Andrew Abell

The European Central Bank’s quantitative easing (QE) program has it buying up 60 billion euros of assets every month, and they are likely to continue to do so until 2017. The U.S. Federal Reserve has employed several rounds of QE in the years since the 2008-2009 financial crisis. Talk of QE is everywhere in the news, but an adequate explanation of what it is seems harder to find. What is QE? Why are central banks turning to is for answers to lagging growth? Where is the money coming from?

Quantitative easing is a process by which central banks hope to stimulate economic growth by swapping assets banks hold for cash.

For credit markets to work, money has to flow freely between banks and from banks out into the economy. Citizens need access to money to expand their businesses, start new ones, buy homes, buy cars, etc. When access to money dries up, this economic activity goes with it and the economy and its financial markets contract.

Typically a central bank can keep banks lending by lowering interest rates. If you slash interest rates, it makes it cheaper for banks to lend between each other and get that capital to the citizens looking to grow their businesses, etc. In the wake of the recent financial crisis central banks did just that: slashed rates. But what they found was that near-zero rates were still not enough to encourage banks to keep lending. Banks had so little faith that they would get their money back from loaning to businesses and citizens in the weak global economy that they began taking that money that they could get at a near-zero rate and putting it in low-risk treasury bonds. In a tough economy it’s attractive to take a huge chunk of money at 0.25% and get something like a guaranteed 3% return.

Money can’t get cheaper than 0%, so central banks had to come up with something over and above low interest rates to keep banks lending out into the economy. Quantitative easing suggests that there is an answer in that central banks also control the supply of money. If central banks simply pump cash into the banks, those banks are going to have to make a new round of investments, hopefully this time giving it to those money-hungry businesses and individuals out in the economy. Central banks are getting this cash out there simply by buying up assets that the banks own like those 3% bonds. But why won’t the banks just buy more bonds like they did before? The hypothesis is that when the central banks are buying up the bonds, they are taking them out of the market and reducing supply. Reduced supply will drive demand up which drives interest rates on those bonds down, making bonds a less attractive investment. This time maybe banks will invest in the wider market through something like regular business loans.

How is somewhere like the European Central Bank coming up with sums like 60 billion euros a month? The answer is that they aren’t in a traditional sense, they’re simply creating it. What they are doing is swapping new money for an equal value in assets, so the net change in financial assets out in the economy is actually zero. All that is happening is that the value of these assets that are tied up are being ‘swapped’ for highly liquid assets (cash). No matter how the banks spend the cash, they will be replacing their old assets by buying new ones which will boost stock prices and keep interest rates low, all feeding into a macro-scale boost in investment.

There are two problems here, however. First, if QE doesn’t work then the central banks are left with a situation where they have pumped a ton of money into the economy that no one wants. A big cash influx like this devalues the currency (which admittedly can spur growth by making it cheaper for consumers to buy your products abroad). But if the value of say the euro is dropping, people begin to lose confidence in having euros because that money is just evaporating if the value continues to fall. In this situation central banks have served only to lose investor confidence with a program designed to do exactly the opposite—encourage investment. The second problem is that in buying up these assets central banks have developed rather fat balance sheets. Several rounds of QE in America, for example, has increased the Fed’s balance sheet from less than $1 trillion in 2007 to more than $4 trillion today. Eventually central banks are going to have to off these assets they’ve acquired, and it’s unclear what effect it will have when they do. It would seem like that process will drive interest rates through the roof, making lending difficult and leaving central banks back where they started, or perhaps even deeper in the quicksand. For now its effects are unclear, but a layman like myself can’t help but look at this non-traditional strategy with a hint of skepticism.

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