Quantitative Easing – G7 Prepares to Fire Up the Presses

In December of last year I wrote about the difficulties associated with managing economies when interest rate are approaching zero percent. In the three months since then, all G7 member countries have lowered their rates even further and with the exception of Japan which is at 0.1 percent, record low interest rates are now in place for all G7 jurisdictions.

As a result, the G7 now finds itself in a zero-bound state, and with no remaining headroom with which to make meaningful interest rate cuts, the central banks must now turn to quantitative easing policies to revive shrinking economies. Quantitative easing refers to any practice that provides an infusion of cash into an economy and can take the form of low-cost loans, payments to companies, or the buying of assets directly from financial institutions.

The US took its first tentative steps towards a policy of quantitative easing when it created the Term Auction Facility (TAF) in December 2007. The TAF loans were provided at a discounted interest rate called the stop-out rate, and were targeted at financial institutions unable to get credit through conventional channels. As the Bush administration was winding down, the US committed itself even further to quantitative easing through a series of emergency payouts to several financial institutions and President Obama continued on this theme with the $787 billion dollar stimulus plan and the bank rescue plan expected to cost upwards of $2 trillion.

The UK is now about to adopt quantitative easing as its official policy – Alistair Darling, the Chancellor of the Exchequer, has given the Bank of England the go-ahead to create an initial £75 billion ($105.7 USD) in “new money” to pump into the economy. This is code for “printing money” or the modern-day equivalent of electronically transferring funds into the accounts of the Bank of England from where it can be used to “buy” assets from commercial financial institutions.

By exchanging assets of questionable value for cash, the financial institutions receiving these funds should – in theory at least – now have sufficient liquidity to get back to the business of providing loans to eager consumers and businesses. The temptation for the banks of course is to hold on to all that cash for their own needs once their balance sheets have been cleansed of the toxic assets threatening to topple them.

Quantitative Easing Is Not Risk Free

You cannot expect to flood any market with a commodity – in this case, money – without some kind of repercussion. In the case of the Bank of England policy announcement, the pound immediately lost value to the other major currencies and yields on gilt yields (government-issued bonds) dropped sharply.

The Bank of Canada – which recently lowered its overnight rate to 0.5 percent – also suggested it may resort to quantitative easing as a way to manage its economy prompting one economist to refer to this as the “nuclear option”.

“It [quantitative easing] is the thing you don’t ever contemplate unless you have an economy in dire need of stimulus.”

Central Banks have resorted to quantitative easing on only a handful of occasions in the last fifty years or so, with Japan’s experience being the most recent. For this reason, it provides the best comparison we have available to asses the effectiveness of quantitative easing as an economic policy within a large, complex economy.

Japan first implemented quantitative easing in 2001, and it took nearly five years for bank lending to increase from 5 trillion yen to 35 trillion yen. Despite this increase, overall Consumer Price Index (CPI) remained low in comparison to other G7 countries and by August of 2006, Japan’s CPI only managed to climb to 0.7 before starting to decline along with overall Gross Domestic Product (GDP). Japan’s widening trade gap now sits at a thirteen-year high current account deficit of 172 billion yen or $1.8 billion USD.

It would be difficult – based on these results – to say that Japan’s use of quantitative easing was successful. The costs were astronomical coming on the heels of Japan’s “lost decade” where national debt ballooned to nearly twice the value of the country’s GDP – this is the highest debt ratio of any of the industrialized countries.

The questionable results obtained by Japan underscores the widely-held belief that quantitative easing is a policy of last resort. That’s because it is – if it does not work, there is really nothing left to turn to in the policy tool kit.