We have written about this topic in the past but we feel that we need to review it with a forward looking slant. All this mumbo-jumbo econo-jargon can get very confusing, particularly because Central Banks (and politicians) wish it to be so. To task.
QUANTITATIVE EASING - THE FAIRY TALE
To begin with, let's analyze what is the mainstream thinking about QE and what are they trying to achieve.
Managing the economy
In the Monetarist/Keynesian point of view, free markets are evil because they produce productive cycles. During the up-phase, everybody is happy because there is plenty of wealth being produced but, more importantly, there are plenty of jobs (critically, belonging to voters). Thus, during the up-phase there is little need for "managing" the economy and thus a little printing and a little borrowing to keep politicians happily spending is OK.
However, during the down-phase, the economy must be "stimulated" in order to get it out of this phase as soon as possible because wealth is diminishing (political donors are becoming scarce) and jobs are being lost (voters are out of jobs). Thus, something must be done. This something is printing. Essentially creating money out of thin air and buying stuff with it thus creating the illusion that there is demand. However, once this illusion sets-in, it becomes permanent and presto! We are out of the down-phase.
This is the oversimplified version of this process. However, for technical reasons that we won't go into, Central Banks achieve "stimulus" mostly through the manipulation of interest rates. The general idea is that if interests are low then companies will borrow, spend, expand and the economy will revive. Thus, the control of interest rates is critical.
Typically Central Banks achieve this control through buying and selling short-term government bonds (i.e. governments I.O.U's in Yank terms). The more bonds a Central Bank buys, the higher their prices and therefore the lower their yield (i.e. paid interest). This translates into lower interest rates for everybody. Through the opposite process, Central Banks can raise interest rates. Please remember that the relation between bond prices and their yield (i.e. paid interest) is inverse. The higher their price the lower their yield.
In a down-phase, Central Banks lower interest rates. However, in an up-phase which threatens to get out of control, Central Banks "cool" the economy down by raising interest rates.
Thus, in a "normal" economy Central Bank action is critical in managing the economy. They try to achieve the "sweet" growth spot, which is decided in every country by politicians.
The need for QE
This process has been going on (in one way or another) for a very long time (i.e. since modern Central Banking was invented). However, we need to understand what happens in the event of an economic crisis. In such event and true to the above recipe, the Central Bank will lower interest rates. The deeper the crisis the lower the interest rate. However, in the event of an economic catastrophe, people are too scared to take any loan whatsoever, no matter how low and appetizing interest rates get. The only thing a Central Bank can do is to keep lowering interest rates until they get some traction. Problem is, everybody is scared to death. The Central Bank is now pushing on a string while the economy is in the garbage bin. This is called the ZIRP situation (Zero Interest Rate Policy). Most "developed" nations entered ZIRP immediately after 2008, Japan being the exception since it entered into ZIRP after the 1980 debacle (in or about 2001).
Enter QE. QE was designed to operate in this situation. The problem with explaining QE is that it is one process with multiple effects.
The QE process
In QE, Central Banks print money out of thin air and buy bonds (private and government's) from banks. In so doing they raise the prices of those bonds thus lowering their interest rates. This seems identical to the "management" process previously described, albeit it is not. The "normal" management process deals with short-term government bonds (roughly 3 months to 1 year) while QE deals with long-term bonds (10+ years). So far so good. Now we need to explain the intended consequences of so doing.
CAUSES AND EFFECTS
We will now take a look at what are the intended consequences and what are the real effects. That's right! The intended consequences typically do not match the real effects on the economy. What a surprise, right? What Central Banks are doing is backfiring on them. Because this has never, ever happened before, right?
QE economic stimulus - Intended
The first effect is that as money is being created out of nothing and used to purchase bonds held by private banks, this money ends up in bank's vaults. Banks are in the business of lending money for profit and this move to exchange un-loanable assets (bonds) for loanable ones (money) fills banks' vaults with cash. Ergo, this is supposed to "incentivate" banks to loan because of the massive amounts of cash now available to them. If banks push loans this means business will borrow, spend, expand and the economy will be stimulated.
QE economic fizzling - Achieved
To a (very) minor degree, we can see some economic "stimulus" taking place. This is so because there are a handful of companies (mostly very large) that have very long term horizons and can survive for very long time in a stagnating economy. Thus, for them it makes sense to borrow now at ZIRP and do all the expansion they will need in the future, essentially at zero cost. The problem is, most companies are small to medium and they cannot survive the economic debacle, thus they neither borrow nor spend. Thus, for the most part, there is no "stimulus".
QE bank capitalization - Intended
The capitalization of a bank is the ratio between their assets and liabilities. In most countries there is a minimum ration established through regulation. Typically bank's assets will be composed by loans and bonds. Liabilities are typically represented by customers' deposits. And so, there must be a so-called "capital adequacy ratio" present for a bank to be allowed to operate.
The problem is that in an economic debacle, many of bank's assets are not worth the paper they are written in. In 2008 most bonds, loans and derivatives (i.e. assets) dropped in price to almost zero. This was so because there was no market for those assets. Banks could not sell their bonds or derivatives and they could not call their loans because the borrowers were broke! Thus, during 2008 most banks became under-capitalized and technically broke. These banks are known as zombie-banks because they are the living-dead. They operate simply because governments bent the capitalization requirement rules.
Enter QE. Central Banks have an infinite power to buy whatever they may want to buy in order to "manage" the economy. In the event of a crisis, Central Banks bought all those worthless "assets" that banks had (i.e. also called "toxic waste"), thus re-capitalizing banks overnight. Banks were no longer at risk of people going broke because they did not hold their debts any longer. These debts were passed to Central Banks. Normal banks were now flush with cash, well above and beyond capitalization requirements. Thus, they had plenty of cash to loan and no debts to worry about. Thus, they were supposed to loan and stimulate the economy.
Note: please see the Glossary if you are unfamiliar with certain words.
