How to make £100 into £1,000...

Quantitative easing (QE) is a subject that has been must discussed but also much misunderstood in the media and believe it or not lots of people have actually asked me to explain exactly what it is, why the Bank of England is doing it and how will it help!

So here goes….

QE is basically the creation of money out of thin air. In the UK only the Bank of England has the authority to “make” money, but the government could give itself the right to and in fact it did so in world war one. It can take the form of actually printing notes, but notes are only a small part of the money supply so QE involves the Bank creating electronic money.

You may think that the Bank of England controls the money supply but this isn’t really true. In fact the banking system creates money through a process called the “money multiplier”. It works like this: if you deposit £100 in a bank account, the bank then has £100 to lend. When it lends, the £100 will deposited in the borrower’s or someone else’s bank account, giving that bank £100 it can lend and so on and so on.

The only break in this money roundabout is the bank’s need to maintain cash, because at any given time their depositors may want their money back. Most countries have regulation to maintain a minimum cash reserve and in the UK it is governed by the FSA’s liquidity requirements. In the US the limit is 10%, which means a £100 deposit can become a £90 loan, this £90 deposit then can become an £81 loan etc. etc.

Therefore in a strong economic climate electronic money is effectively created in bucket loads through normal bank lending activity, but as at today, lending has been reduced and banks, businesses and individuals are looking to pay down debts; which in turn has the effect of shrinking money supply.

QE is therefore all about increasing the level of money (bank deposits) in the economy and whilst not directly designed to increase lending, higher levels of deposits give banks the opportunity to lend more. There are a number of ways to implement QE, but the simplest and chosen route of the BOE is to buy assets from the non-bank private sector with cash it has “made”, such as gilts and some commercial bonds. This increases bank deposits and will stimulate lending if the bank chooses to lend the money.

The primary objective of QE is counter the recession, but to boost the economy it needs to increase spending on goods and services. For this to happen, the additional bank deposits need to provide additional comfort for the banks and in turn increase their lending activity and ease pressure on the inter-bank funding markets. However there are risks, if the banks don’t lend or demand to borrow does not materialise, and people’s primary focus remains to reduce debt, it will be some time before spending increases and therefore boost the overall economy. On the flip side, the additional money supply could over-stimulate spending and drive inflation upwards.

I have no doubt that the BOE will use it wisely, and if needed, reverse it once it has done its’ job and I personally think the risks of upwardly inflation spiralling out of control are minimal. But for the sake of jobs, savers and so much industry that revolves around the principle asset of the home in this country, I hope it has the desired effect.