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What is Quantitative Easing and How it Affects the Economy

Imagine you woke up this morning to find £1 billion in your bank account.  Wouldn’t that be great?  With a wage of £7.25 per hour it would only take you 66,313 years to make a billion.  The Bank of England, or any reserve bank, can create that sum of money almost instantly.

In a previous blog “all money is loaned into existence” I discussed how reserve banks will create the money through quantitative easing.  By creating money from nothing, buying bonds or other assets from banks and creating liquidity of cash.   Exactly, what happened in 2008 during the credit crunch to keep the flow of money circulating and trust within the banks.

Throughout the Great Recession 2008-2014 the reserve banks were creating a lot of money each day through quantitative easing.  In America, in 2013 the Federal Reserve Bank was creating $85 billion a month.  This had the effect of protecting bonds, keeping value in the share market and keeping interest rate low.  In other words, what you think of as a free market was totally manipulated by Reserve Banks.

 

How money is loaned into existence

When governments want money all they do is create bonds, release them on the open bond market, banks buy the bonds, receive regular interest on them and hold them as an asset until such time the bond expires or they can on sell it.

The government needs more money, the banks don’t have enough to buy more bonds so the reserve bank steps in.


The reserve bank will create money buying bonds from the banks who in turn lend the money to the consumer through overdrafts, loans and credit cards.  That the simple analogy.

In reality what happens is the Reserve Bank will announce it is looking to buy bonds to X value for Y interest rates.  The Banks will go to the Bond markets buying as many bonds as it can for a lower interest rate than the Reserve Bank is offering.  The banks then sell the bonds to the reserve bank at the interest rate the reserve bank offered to buy.  The banks who are the middle men will make money on the transaction of selling bonds to the Reserve Bank and again in lending it to the Consumer.

The process of the Reserve Bank purchasing bonds or other assets from the banks is known as quantitative easing and is how the money flows into the economy.


 

What happens when tighter money controls are needed?

When there is too much money in the market the Reserve Bank will tell the Banks they need to buy back the bonds the Reserve Bank are holding as security.  Sounds simple?  In reality it can cause major problems.

When the Banks sell the bonds to the Reserve Bank there is a value and an income generated from the bonds.  In simple economics – supply and demand – there are limited bonds on the market meaning often higher interest rates are payable on the bonds.

When the Reserve Bank decides to sell the bonds back to the Banks, there is a flood of bonds on the market.  The government are still creating bonds to generate the income it needs to operate the country and the Reserve Bank are selling the bonds it holds as securities.  In this case there is an over supply of bonds on the market and the interest rates reduce.  Banks will lose money on the transactions.  This in turn affects stock markets; bonds and house prices.

 

Why Quantitative Easy is Dangerous to the Economy?

In March 2020, many countries went into lockdown over the coronavirus.  Immediately, businesses were closed and productivity ceased.  The GDP (Gross Domestic Profit) for countries came tumbling down.  Share Markets crashed and Bond Markets crashed and many banks were on the brink of collapse.

Deemed an exceptional circumstance Reserve Banks started quantitative easing and printing billions of fiat currency.  Not just one country, but almost every country started printing money.  The money was supporting businesses who faced permanent closure; it was supporting employees and it was needed to bring in the medical supplies to support the hospitals and the sick. 

The world has never seen so much money being printed.  However, somewhere along the line, the creation of money will need to be reigned.  When that happens, there is be a surplus of bonds and securities on the market forcing the prices downwards.  The share market and housing markets will suffer.  Businesses which have been closed will not open or will be unable to pay back the loans they borrowed.  Unemployment will rise and the world will see the biggest economic collapse in history of the world will have been triggered by excessive quantitative easing.


Loss of Faith

Money, the notes and coins you use every day or the digital transfers you do within your bank accounts is built on faith.  It is a faith that the note you use to pay for your groceries will buy the quantity of food you expect.

Quantitative Easing is an experiment to control a financial market.  It provides support in difficult times but it can cause the opposite when trying to reign in the amount of cash in circulation.  A loss of faith in money which in turn has repercussions of collapsing markets and hyperinflation which is why the long term effects of quantitative easing are dangerous to the global economy.  

 

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