Monopoly Money

If you were playing Monopoly, Quantitative Easing would be the equivalent of helping yourself to a $100 note every time you rolled the dice and never having to pay it back


(Source: Flickr)

CENTRAL banks continue to finance government spending by easing monetary policy in order to help economies get back to “potential output”. (It remains unclear whether Grand High Priest Bernanke slaughters a lamb before proclaiming what the level of “potential output” should be for the US economy. It would be interesting to know.)

Quantitative easing (referred to as “QE”) is an unorthodox monetary policy tool that involves creating new money to buy assets, usually in the form of government bonds. The policy was introduced during the financial crisis to enable central banks to continue stimulating the economy even as interest rates approached zero (see, liquidity trap). During the crisis the policy was viewed by many people as helpful in providing liquidity to the banking system and in preventing long term interest rates from rising.

In America, the Federal Reserve pursues QE by buying US government bonds in the secondary market, which basically gives the government a blank cheque to sell as many bonds as they want to private investors in the primary market (who then turn around and on-sell these bonds to the Fed in the secondary market).

QE makes things easier for a cash strapped government in times of crisis by providing a willing buyer for their bonds.

But by allowing governments to continue running deficits, QE removes the need for fiscal discipline.

Where will it end?

The Fed already owns around $2.3 trillion of Treasury bonds, and the Bank of England owns around £375 billion of gilts. Any attempt to sell these bond could result in an unwanted rise in interest rates. And, The Economist reports that Mark Carney, Governor of the Bank of England, recently signaled that the Bank is not expecting to sell all of its holdings.

What does this mean exactly?

In effect, central banks are providing their governments with interest free loans financed by printed money. If you were playing Monopoly, this would be the equivalent of helping yourself to a $100 note every time you rolled the dice and never having to pay it back.

Or, to speak more plainly, our governments are cheating us.

Quantitative Easing

Printing money is the last refuge of failed economic empires and banana republics

QUANTITATIVE EASING is a monetary policy tool sometimes employed by central banks to stimulate the economy when conventional monetary policy becomes ineffective.

To stimulate the economy, the central bank normally carries out expansionary monetary policy by lowering short-term interest rates through the purchase of short-term government securities. However, when the short-term interest rate gets close to zero it becomes impossible to lower the short-term interest rate further and so this policy tool can no longer be used to stimulate the economy (the liquidity trap).

When faced with the liquidity trap, the central bank can shift the focus of monetary policy away from interest rates and towards increasing the supply of money (quantitative easing). To increase the money supply, the central bank buys government bonds and other financial assets with newly printed (or more correctly, electronically generated) money which will increase excess reserves in the banking system. The central bank hopes that banks will use these excess reserves to increase lending which will help to stimulate the economy.

When a government increases the money supply, this will lead to higher prices because there will be more money chasing the same amount of goods and services.  In other words, printing money (quantitative easing) causes inflation.