Over the years, governments and central banks have found a variety of ways to boost failing economies. One of these actions, quantitative easing (QE), is relatively new, only coming into existence in the 21st century. Today, quantitative easing is a measure which has been used by many countries throughout the world, hoping to inject capital back into their economy and maintaining growth rates.
To begin to understand quantitative easing, we must first go back in time and look at a history of currency, and how it works today.
A quick history of money
When paper money was introduced, it was backed by some sort of value. Over time the standard was that paper money be backed by gold, where a country would only print as much paper currency as it held in gold reserves. The value of the currency was therefore tied directly to the fixed price of gold at the time, and could even be exchanged for the corresponding amount of gold if desired. This concept, known as the “gold standard”, helped to control local money supply and limited the excess printing of paper money.
The gold standard became the norm across the world throughout the 18th and early 19th centuries. However, in 1931, Britain abandoned the gold standard, with the United States following closely behind, ditching the policy in 1933 (although the standard wasn’t completely abandoned until 1971). The idea was that as long as a nation was on the gold standard, there was little it’s government could do to stimulate the economy. This was made clear during the US Great Depression in the 1920s and 1930s which is when the US broke with the gold standard, ultimately saving its economy during an extremely difficult time.
This paved the way for paper money to evolve into “fiat currency”, or, currency that isn’t backed directly by gold, and instead backed by the promise of the underlying government and country issuing the currency. With the advent of fiat currency, central bank’s now had more freedom to print or restrict the flow of currency in an economy when they deemed necessary. A country’s central bank could now add debt to its balance sheet, or increase the money supply at anytime, paving the way for modern-day economic policies.
What is QE?
On its surface, quantitative easing is simple. A central bank purchases securities on the open market, thus injecting more money into an economy. As a result, the country’s money supply increases, and stimulates growth in the economy. With the increased funds on the open market, lending becomes easier and more money is spent, spurring economic growth and lowering interest rates.
This makes QE a form of expansionary monetary policy, used by nation’s looking to grow their economy in times of need. The ideal outcome from QE is for an economy to grow in a multi-step process. First, the government purchases assets from banks to give the banks more capital. This increase in capital causes the banks to lend more to businesses and consumers, which will ultimately lower interest rates. As interest rates fall, businesses and consumers have more incentive to borrow money. If all goes as planned, these businesses and consumers will borrow more, causing more money to be spent in the economy, spurring growth that would not have existed before.
QE Case Study: 2008 financial crisis
It was Japan that was the first nation to introduce quantitative easing as an option for central banks, looking for a way to combat deflation in its economy during the early 2000s. Yet, it was the United States which popularized the policy just a few years later.
In 2008 the US economy was falling off a cliff, facing a financial crisis the size of which was unprecedented at the time. Banks and financial institutions were quickly going under, and the threat of a catastrophic economic meltdown was all too real. The country’s central bank used quantitative easing to purchase assets on the open market, increasing its total assets from $900 billion to $4.5 trillion during three rounds of quantitative easing over an 8 year period.
More than 10 years removed from the financial crisis, and we can now see the QE had a significantly positive impact on the recovery of the United States economy. In fact, it is almost universally agreed upon that QE saved the US economy from further collapse. What happened? Well, for starters, a jumpstart to the economy allowed the US GDP bounced back to positive growth rates after just one year. Additionally, QE avoided runaway inflation that many economists had feared would result from the plan.
Europe saw how the United States was able to control its runaway economy and enacted quantitative easing measures in 2015 themselves. The European Central Bank (ECB) was looking to aid exports and prevent deflation in the region, so it went on the hunt to purchase assets. In four years time, the ECB added €2.6 trillion to its balance sheet mostly in the form of corporate and government debt. During that time, the central bank’s balance sheet jumped to about €4.65 trillion.
QE doesn’t come without risks
This sounds all well and good, but where does a central bank get the credit to purchase securities for quantitative easing? The truth is, they can create it out of nothing. This is the most obvious risk of QE inflation, as banks may not use the extra capital to help build economic growth. Instead, more money would be injected into the economy, but the average consumer and business wouldn’t see the benefit, making prices rise without an equivalent boost to workers.
Along with inflation, QE can negatively affect the value of a local currency against its global partners. This has the potential to hurt the local economy when it comes to trade agreements and imports. Importing goods from other countries becomes significantly more expensive when the local currency becomes devalued. This can put a financial burden on countries which are more reliant on imports to satisfy the needs of local businesses and consumers.
Why should you care?
These days, your government has the ability to change the money supply in any way they see fit. Some view this as a problem, and believe the government should be held to a monetary policy standard and not able to print money and create credit out of thin air.
Yet, history has shown that these measures, when used correctly, can be a saving grace for failing economies. The use of quantitative easing has helped economies work their way through the toughest of times, such as in Japan, the United States, and Europe over the past 20 years. Through its use, consumers and businesses have been able to obtain credit in economic conditions where that may have otherwise been impossible.
Everyone should be thankful that quantitative easing is an tactic at the disposal of governments and central banks across the world. While your local economy might not need quantitative easing right now, who knows what could happen in the future that could require a jumpstart to your local economy.