At the time of writing this article (September 2012) we have just been informed that the Federal Reserve, the central bank of the USA, is going to start its third round of Quantitative Easing, or QE3. When I listen to reports in the media and to what friends and colleagues have to say about it, I cannot help but conclude that the vast majority of people do not actually know what it really is.

After QE1 and QE2, why should we believe what central bankers and the majority of politicians are telling us? If the first two rounds failed why would another round suddenly solve the problem? Could it be that Quantitative Easing is actually the problem and not the solution? In this article I will try to get to the bottom of these questions.


The Basics

Essentially, Quantitative Easing is a monetary policy that uses the resources of the central bank to bring more money into circulation. I believe that the reason it is called QE is because "printing money" or "creating inflation" are not as politically appealing to the public. It sounds much better to claim that you are providing "easing" and you are doing so in "quantity". By the end of this article you should be more aware that QE is actually a misnomer.

As already mentioned, the more accurate description would be printing money, even if done digitally, or creating inflation. I don't want to go into too much detail about what inflation is but I would suggest reading my inflation related article for a more in-depth explanation.

For the benefit of this article though, I just want to point out that when more money is created out of thin air then that is what causes the overall price level to rise. If the money in circulation was stable then the price of one good could only go up if the price of other goods went down, the overall price level would have to stay the same.

Of course no policy maker will admit to the fact that their actions are the cause of price rises, as that would be very unpopular at a time when people are struggling to make their income stretch. Their reasons for doing Quantitative Easing will be covered shortly.


Who Is Doing Quantitative Easing?

Pretty much every country, but it is safe to say that among Western countries the USA is the champion. Now entering the third round of QE, the Federal reserves balance sheet has already increased from $800 billion to over $2.6 trillion. In the next couple of years QE3 is very likely to swell the balance sheet even more to over $4 trillion.

What Is Quantitative Easing (QE)(113128)

In the UK QE doesn't even come with numbers, they are basically doing it continuously and have been for many years. The Bank of England essentially announced that it would be buying up debt based assets, mainly treasuries, at a certain amount per month until things improve. This is exactly what the Fed has announced with QE3, an indefinite monthly purchase of assets. But all that this has done for the UK is that price inflation is soaring at well over 4%.

The ECB was for a long time very reluctant to do QE, but even under the former head of the ECB, Trichet, they did get started with qualitative easing. This is where they accepted lower quality assets in return for loans, but eventually caved into quantitative easing and have introduced an unlimited bond buying program.


Is This Something New?

No, if you look at central bank balance sheets and the monetary base figures, and chart those over several decades you will see that these numbers have been constantly growing. What is new is the scale of creation of new money over very short periods of time and also the fact that a big deal is made of these events at the political level.

As our money is not backed by anything, it is very easy for central banks to create more of it. And under pressure from governments who are finding it increasingly difficult to find people who will lend them money, the monetisation of government debt has picked up. This was at first gradual for many decades, but is now running at a scale never before seen. And we are to have faith in these people and their actions, despite the fact that they didn't see any of the financial crises coming, nor do they see any connection with their actions and the prolonging of the crisis.


Why Are They Doing It?

Basically the idea has been as follows. You create a load of new money and use it to buy assets from usually financial organisations. Another way this money has entered the greater market is through short term loans at incredibly low rates of interest that have been made available to not only financial organisations but many other large corporations.

The idea is that you bring more money into banks, which then make more loans to companies and private citizens, who then go ahead and spend the money "fuelling" a boom in spending. This is what you often hear commentators referring to as stimulating demand.

Even though things have not improved in the global economies, it is too often stated that things would have been far worse than they are, if we hadn't seen QE1 and QE2. But that is a very post hoc statement. Just because QE was done does not mean that it wasn't the cause of the prolonging of the crisis rather than averting worse.


What Is Quantitative Easing (QE)

Does Their Reason Have Merit?

The question is whether demand or supply is the generator of economic activity; is it a chicken and egg type situation?

Those that believe that everything comes down to demand argue that without demand businesses do not have customers and therefore suffer from lower revenue, which then results in less employment. In the worst case scenario there is downward spiral. However appealing this analysis may seem, it leaves out some hugely important factors.

The problem is twofold. Firstly, before a consumer can buy something and thereby create demand, they have to work and earn money in order to spend it.

Secondly, when people go to buy things they don't go to a business and tell them I will want to buy a computer in six months, new shoes next months and a bag of apples tomorrow. What they do is go to businesses and ask for the goods they want and buy things that have already been produced.

Both these items point towards the fact that in order for demand to be created, the consumer first has to produce something by working and earning money, in other words creating a supply of something, and also a business has to produce the goods that are being demanded, in other words it has to create supply.

What is needed in an economy is a desire for certain goods, but it is up to businesses to figure out what people and other companies will desire, or don't even know they desire yet. Just like my two year old who demands everything she sees, people have unlimited desires. The problem we are faced with is satisfying those desires.


So What Creates Growth?

If demand is not what is needed to create growth, then what is? The answer is supply. And to increase supply you need several things. Firstly you need an environment in which entrepreneurs can easily start businesses that create new products and compete with other businesses with as little barriers to entry as possible. Secondly, there has to be capital that can be invested in factories, machinery and employees.

For these two factors to be provided, first government needs to allow businesses to operate without being protected from competition. By that I mean totally unnecessary regulations and licences that make it very difficult for new businesses to enter an industry. Secondly, saving and investment needs to be encouraged, as these are the only two ways to make real capital available for the expansion and creation of businesses.

Unfortunately, at present, governments around the world are doing the exact opposite. More regulations are created every month that create barriers to entry for new-comers, and Quantitative Easing is creating interest rates that are so low that people are simply not saving enough.



QE3, 4, 5 or 497 are not going to work. They are only going to result in ever higher rates of price inflation which affects the poor and savers to the benefit of governments and large financial organisations.

If all you had to do is create money out of thin air, to stimulate economic growth, then there would be no poverty in the world. Pretty much every poor country in the world has a central bank and the ability to create money out of thin air. What they don't have is a large enough desire for what they are able to produce and an ability to increase their productive capacity, which requires land, labor and capital. Poor countries, by the very definition, have very little surplus capital to invest in factories and machinery that would allow them to produce more. And that cannot be provided at the whim of a printing press.

Creating growth is difficult; it requires sacrificing spending today, by saving and investing, in order to have a greater return in the future. It requires lots of hard work and finding out ways to better serve customers

What our central banks are trying to tell us is akin to telling someone who wants to lose weight that they don't need to diet and exercise, they just need to continue what you are doing. Hopefully more people will wake up to these facts and put an end to these damaging monetary policies.

Image Credits: Gage Skidmore, Paul!!!

This is a very funny video explaining Quantitative Easing