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Missing the Credit Crunch When the Credit Crunch leads to governments printing money – understand the terminology Quantitative Easing The term quantitative easing refers to the creation of a pre-determined quantity of new money “out of thin air” through open market operations by a central bank as the start of a process to increase the money supply. It can, more simply, be understood as an indirect method of printing money. This new money is injected into the private banking system when the accounts of the vendors of the securities purchased by the central bank through the open market operations are credited. Since quantitative easing risks devaluing the currency, quantitative easing has been proposed while currencies are experiencing deflation. Continuing quantitative easing runs the risk of inflation. “Quantitative” refers to the fact that a specific quantity of money is being created; “easing” refers to reducing the pressure on banks. A central bank can do this by using the new money to buy government bonds (treasury securities in the United States) in the open market, by lending the new money to deposit-taking institutions, by buying assets from banks in exchange for currency or any combination of these actions. These have the effects of reducing interest yields on government bonds and reducing inter-bank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying bodies. A state must be in control of its own currency if it is to be able to unilaterally employ quantitative easing. Countries in the eurozone (for example) cannot unilaterally use this policy tool. Quantitative easing was used notably by the Bank of Japan to fight domestic deflation in the early 2000s. More recently during the global financial crisis of 2008, policies announced by the US Federal Reserve under Ben Bernanke to counter the effects of the crisis have been likened to quantitative easing coupled with the issuance of new debt on the US federal balance sheet. The United Kingdom is also currently using quantitative easing as an additional arm of its monetary policy in order to alleviate its own financial crisis. The European Central Bank has been using quantitative easing (though it does not refer to it as such) through a process of expanding the assets that banks can use as collateral that can be posted to the ECB in return for Euros. Fractional Reserve Banking Banks use a practice called fractional-reserve banking whereby they abide by a reserve requirement, which regulates them to keep a percentage of deposits in “reserve”. The remainder, called “excess reserves”, can be used as a basis for lending. Deposit Multiplication The increase in deposits from the quantitative easing process causes an excess in reserves and private banks can then, if they wish, create even more new money out of “thin air” by increasing debt (lending) through a process known as deposit multiplication. The reserve requirement limits the amount of new money. For example a 10% reserve requirement means that for every $10,000 created by quantitative easing the total new money created is potentially $100,000. The US Federal Reserve's now out-of-print booklet “Modern Money Mechanics” explains the process. The aim of quantitative easing and the follow-on process of deposit multiplication is to increase the amount of money in circulation by an increase of credit and thus stimulate the flow of money around the economy by increased spending. The usual method of regulating the money supply is by setting interest rates. Quantitative easing is a solution when the normal process of increasing the money supply by cutting interest rates isn’t working - most obviously when interest rates are at zero, or so low that it is not effective to cut them further. Qualitative Easing Willem Buiter has proposed a terminology to distinguish quantitative easing, or an expansion of a central bank's balance sheet, from what he terms qualitative easing, or the process of a central bank adding riskier assets onto its balance sheet: Quantitative easing is an increase in the size of the balance sheet of the central bank through an increase it is monetary liabilities (base money), holding constant the composition of its assets. Asset composition can be defined as the proportional shares of the different financial instruments held by the central bank in the total value of its assets. An almost equivalent definition would be that quantitative easing is an increase in the size of the balance sheet of the central bank through an increase in its monetary liabilities that holds constant the (average) liquidity and riskiness of its asset portfolio. Qualitative easing is a shift in the composition of the assets of the central bank towards less liquid and riskier assets, holding constant the size of the balance sheet (and the official policy rate). The less liquid and more risky assets can be private securities as well as sovereign or sovereign-guaranteed instruments. All forms of risk, including credit risk (default risk) are included. |