The Central banks use various monetary policies to regulate the economy and maintain economic growth. Quantitative easing is one of those monetary policies. Before we try to understand what is quantitative easing and how it works, let me give you a simple definition. "Quantitative easing is a monetary policy used by the central banks in which the central bank directly pumps money into the banks and financial institutions to encourage them to lend". Now let's dig deeper and investigate quantitative easing in detail.
Central bank or Reserve bank of any country has a few primary functions as listed below.
- Issue the national currency
- Control the interest rates
- Regulate money supply
- Lend to the banking sector during a crisis
The Central bank implements monetary policy by lowering or raising the inter bank interest rates and controls these rates primarily through open market operations, wherein the central bank trades short-term government bonds and treasury securities from banks and other financial institutions. The central bank also makes or collects payment for these bonds and securities and in the process, changes the amount of liquidity in the economy. Now this liquidity in the system affects the interbank interest rates.
When the interest rates are low, people spend (and not save) and businesses borrow money, thereby the economy grows. But when in spite of low (close to zero) interest rates spending and borrowing is very low, the economy is said to be in a liquidity trap. In such a situation, central banks directly pump money into the economy using quantitative easing.
The central bank buys long term treasury securities, government and corporate bonds and other financial securities (including equities) from banks and other financial institutions using electronically created money (money created out of nothing). Now this electronically created money is available with the banks which they can lend to the borrowers.
Only the central bank, reserve bank or any other monetary authority which controls the currency of that country can implement quantitative easing. The Federal Reserve in the United States, People's Bank of China in China, Reserve Bank of India (RBI) in India and European Central Bank (ECB) in the Eurozone are some examples of the central banks which can implement quantitative easing. An interesting fact being that the Eurozone countries cannot implement quantitative easing unilaterally, only the European Central Bank (ECB) can implement quantitative easing or any other monetary policy in the Eurozone Countries.
Pros and Cons of Quantitative Easing
Theoretically, due to quantitative easing banks will have more money in their accounts which they will lend to business and individual borrowers. Businesses will invest this new found money into capacity expansion, infrastructure development, R&D and so on. Individual borrowers will spend or invest the money, thereby put the money back into circulation. All these economic activities will pull the economy out of stagnation and catalyze economic growth. Quantitative easing will also help in keeping the inflation at a minimum acceptable level, and prevent the economy from going into deflation.
On the other hand, quantitative easing can have dangerous consequences if everything does not turn out the way it should. If the amount of money in the system increases, it could lead to inflation going out of control. Also, quantitative easing will not be effective if the banks do not loan out the additional money available with them for whatever reasons.
Does Quantitative Easing Work?
So, does quantitative easing work or not is a difficult question to answer. Historically, it has worked moderately for Japan during 2001 to 2006. It also helped reduce the impact of recession during 2007 to 2010 in the United States and the United Kingdom. On the contrary, it has been disastrous for Zimbabwe in 2002 when quantitative easing led to hyperinflation.
The problem with quantitative easing is that it depends entirely on the banks, i.e., if the banks lend the additional money available with them it works, but if the banks do not lend out the money it will be ineffective.
Now the catch is that even the banks can do little to solve this problem. Loan disbursal is an independent activity. The bank's loan desk generally doesn't refer to its reserve before sanctioning a loan. The bank evaluates the loan worthiness of a borrower and if the borrower satisfies the conditions, he gets a loan. If the borrower is not creditworthy, he will not get a loan anyway, even if the bank has money to lend. And if the bank relaxes its norms to sanction loans, it can result in bad loans, which is even more undesirable.
So, all we can say is quantitative easing alone cannot do any magic if the fundamentals are not strong. On the other hand, if the investors have confidence in the growth potential of a country then monetary policies like quantitative easing can give that much-needed confidence to the investors and borrowers to dream big and aim high.