author: Pascal Riché
translation: doxa-louise
Quantitative Easing Explained to a 5 Year Old. Allright, 12 Year Old.
In order to understand QE, which the European Central Bank will be resorting to,
no need for a high IQ, but merely some curiosity. And hanging in there.
The ECB Thursday January 22 disturbed a number of economists in appealing to QE: it is going to buy State debts, to the tune of 60 billion euros per month, between March 2015 and September 2016. Before this, the Central Banks of the US, Britain and Japan have made use of this method. Yet this approach is considered by many observers to be highly 'adventurous'.
What precisely is QE?
QE, or Quantitative Easing, is the fact, for a Central Bank, to make asset purchases (generally bonds) with money it is creating.
Hence it is a tool permitting one to inject money into the economy, with the hope of having it restart.
One says the Central Bank is 'printing money' which is obviously a metaphor: there is no printing press, no paper money, only a play with numbers. The Central Bank will note in its books the sum of money used to buy the security, and the deed is done.
Why is this considered an unusual procedure?
Normally, when a Central Bank wants to stimulate the economy, it does not use QE. It merely in the very short term lends a bit more money to Banks than usual, in order to lower interest rates. These savings are passed on from the banks to their clients, which stimulates borrowing. This is a stimulus to economic activity.
Where interest rates in the short term approach zero, this mechanism no longer works. One needs to turn to something else. Banks will then use less usual procedures (an 'extraordinary' measure), starting with QE.
For a Central Bank, QE consists of creating money no longer to finance the lending activities of banks, but to buy securities directly in the market. What is being bought? In general, state-backed bonds: securities which represent a debit on this or that State and which are in currency on the market, hand to hand, some long standing.
Does Qe mean we are lessening the debt load of States?
It is misleading to say that the Central Bank is 'buying the debt'. When a Central Bank acquires these bonds, initially offered by States, there is no reduction in public debt. The money created is not going to the State: it is going to bond holders, who can be individuals, trusts, insurance companies, banks, etc.
It is like buying a second-hand car: Renault never sees the money, because it is going to the person selling you the car.
Those selling these bonds to the Central Bank receive a sum of money which they will either invest or spend: these are the acts which will (theoretically) promote economic activity.
Why does the ECB think that QE is needed?
The aim, is for those selling their bonds to make loans or investments that are riskier. In effect, the bonds have become less interesting as investments. Why is this?
1- The ECB is buying bonds
2- Demand for this kind of product has thus grown
3-Their prices then go up
4- If the price of a security goes up, its yield goes down.
Point 4 is not clear? Let us just concentrate a minute, and work through the following three paragraphs.
Let us take the example of a State which borrows 100 euros (not very greedy, fine) which it promises to reward at 3% per year. This loan takes the form of offering bonds at 10 euros each, freely available on the market.
If the ECB buys these bonds, demand goes up, price goes higher: this is the result of a simple law of supply and demand. In our example, they go from 10 euros to 12
.
The interest rate stays at 3%, but to find the true yield, one has to use 12 euros instead of 10. The yield has thus gone from 3% to 2,5%.
We have thus noticed that the fact of massively buying bonds lessens their yield. Investors will then be tempted by other products than these securities which yield less than they did: banks will want to lend to companies and individuals, others will turn to more risky investments in start-ups, in small and medium businesses...
Another advantage: the lowering of bonds yields, contagious, will lead to lower lending rates. There again, we have vitamins for the economy.
What does the Central Bank do with these assets?
So long as it is in ownership, a Central Bank engaging in QE will be in receipt of the interests tied to the State bonds it has acquired. Which is somewhat startling: the snake biting its own tail.
Theoretically, once the economy is revitalized, the Central Bank sells off the bonds it has purchased. It is said to 'sterilize the operation': it destroys the money it has temporarily created, which will avoid an inflationary surge.
Owning securities has a down-side: their value can plunge. For the case before us - the program announced Thursday -, the risk has been mutualized a mere 20%: it is the ECB which carries this part of the risk. But 80% of the securities( and thus of the risks) will be in the accounts of the Central Banks of each State( for France: the Banque de France). In real terms, each Bank will be buying the bonds of its own government... European solidarity will thus carry to a mere 20% of the program!
Is inflation a concern?
Where there is too much money in circulation with respect to the level of economic activity, inflation has the nasty habit of showing up.
This risk is not much of a problem for the moment: the euro zone is threatened by deflation (which would be, when it strikes, a true nightmare), and not by inflation.
A bit of inflation is not a bad thing. It would permit a soft erosion of debt, a continuation of a falling euro ( and thus a help to exports), and certain adjustments ( the management of salaries in certain sectors, for example).
What the anti-QE economists are afraid of ( and this is true in Germany), is that inflation might snowball and distort economic policy.
Why would inflation be bad for the economy?
The answer to this question is far from obvious. Imagine that we multiply by 100 all prices,
all salaries, and the monetary mass in circulation. This would be a mere convention without real consequence for the economy ( France had indeed done the inverse in 1958, with the creation of the 'heavy' Franc).
But inflation is not a mere convention, orchestrated in advance. it is a phenomenon with winners and losers, wherein each - enterprise, employee, investor, supplier - tries to manoeuvre to his advantage, not get left behind. And this phenomenon always tends to snowball. Sooner or later, the Central Bank or the government must intervene to stop this snowballing, with hikes in interest hard on the economy and/or austerity policies.
The principle cost of inflation, is the return of the stick, which beats down growth.
The other cost, is a deformation of relative prices. Prices evolve one with respect to the other. If their evolution is not predictable, enterprises will make bad decisions. They might for example bow out of investment projects that suddenly seem too risky.
We are not there yet. For the ECB, the priority, notwithstanding the anti-QE, is to break the spiral currently pulling the euro zone into deflation.
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