Figuring out Quantitative Easing
Notes from a programmer learning macro-economy
Deflation is bad. When deflation happens people don’t spend money now — because they expect to buy more with the same money if they spend it later. That leads to a vicious circle of lower demand leading to unemployment leading to even lower demand etc.
To beat deflation we need more money, but not too much or you could get hyper-inflation — this is Quantity theory of money. If you asked a guy from the street how to increase the amount of money in the economy he would say that the government should print it. But printing money is not the only way to increase the amount of money. This is complicated — but in short the printed money is just a part of monetary base (or M0) which is part of the full money supply. Most of money in the economy is created by commercial banks when they make loans.
The central banks can influence the demand for loans by adjusting the interest rates they pay to commercial banks for their deposits at the central banks. If these rates are low — then commercial banks also can lend money at low rates and companies can borrow more and more money is created (and spent).
Economists don’t agree over much, and there is no such thing as a mainstream economic theory — but for anyone reading news it is kind of obvious that lowering the interest rates is the way to increase the money supply and it is used by governments and central banks world wide. But it is limited because rates lower than zero are kind of unnatural, difficult to keep, because people (and companies) instead keeping money at bank accounts and suffer their decrease could just stuff their mattresses with it. (This is probably what is called Liquidity Trap, after I looked up that wikipedia page it seems a bit more complicated than my simple model so am not longer sure about it).
So we are back at printing money. Maybe not exactly. What central banks do now is maybe not literally printing, there are no banknotes involved — instead the banks buy financial assets from commercial banks and create new money as a payment for them. That new money goes into accounts those commercial banks have at the central bank and it is the other part of monetary base. All of that happens by flipping some bits in a computer system without using any printing machines. This is Quantitative Easing.
Traditionally the assets bought in Quantitative Easing were government bonds (treasuries in the US) and QE was doubling as a roundabout way to finance budget deficit. But now it seems that QE was decoupled from that role and now the central banks buy also other financial assets.
One thing that I found struggling when I read about it all is why QE is new and unorthodox, when money printing is the first thing anybody naive enough would think about if you asked them what the government should do to increase the money supply? Why the mainstream info-sphere seems to be stuck with doing it via interest rates and fear liquidity trap? I am not quite sure, there must be a lot of path dependency and the current methods might have evolved from gold based monetary systems, but I have also other hypotheses. First - cutting interest rates is much simpler operation than buying financial assets (what assets? from whom? at what price?) so it might be a good first approach while it works. It is also easily done both ways — increasing interest rates is as easy as decreasing them — so if you beat the deflation too much and get too big inflation you can easily counter that. Selling the assets and then destroying the received money is technically also easy to do — but politically hard, no government wants to annihilate money — everybody tends to find better things to do with it. The coupling of QE to government debt monetization was also complicating matters. Finally base money is leveraged — it is multiplied in the fractional reserve system to result in the broad money — so manipulating it has higher risk of destabilising the system (and introducing hyper-inflation) than influencing broad money via interest rates.
