Friday, 14 August 2009


There's a lot of debate as to whether Quantitative Easing (QE) is actually working. The Bank of England recently agreed to increase its use of QE and will spend as much £175bn on the program.

The problem is that down at the street level, the amount of lending is falling short as banks have missed their lending targets, repeatedly. In fact, the desired effects of QE which should be a good deal more credit being offered into the market in terms of new loans, mortgages and the like have been sadly lacking. In fact, there are plenty of accusations that financial institutions are ripping off consumers and business as the cost of business loans and mortgages are several percentage points above the base interest rate of 0.5% which has remained the same for 5 months. In theory, we should have had a bonanza in new credit in the market - the effect has been pretty much the opposite.

However, banks tell us that the reason why loans appear very expensive compared to the base rate is that they have to borrow money to lend on the wholesale money markets where interest rate is a good deal higher, so their profit margins on the apparently high interest rate loans to consumers and business are not as high as we think. This does indicate that QE has not had a great deal of effect. I go back to what QE was supposed to do.

In the past, I have likened QE to champagne glasses stacked three tiers high so that there is one on the top, two on the second tier and three at the bottom. If you pour champagne into the top glass it fills and overflows and starts to fill the two glasses in tier two which subsequently fill and then overflow into the bottom tier. If you imagine that the Bank of England holds the champagne bottle and the champagne is the money they are pouring into the financial system then we see it cascade down from the institutions to banks to the public. That's the basic principle.

But what is happening, or at least there is good evidence of it in the accounts of banks, is that banks have a target to get their loans-to-deposit ratios back in order as this was a huge problem for banks like RBS. QE is the process of buying Government gilts and if we assume that most of that new money flows to banks then it is effectively 'new deposits' of the safest kind in the banks. This means that if the banks hold onto the cash then their ratios look a damn site better. If they want to make more loans, then they could get money in off the wholesale markets and theoretically this will not dilute their loans to deposit ratios too much.

It is in fact as if instead of champagne glasses in tier two of our champagne glass pyramid but two buckets which take a long, long time to fill when they are being filled by the overflow of a single glass before they overflow and cascade into the glasses below. Until the banks feel their ratios are in order, then they are not likely to offer a great deal of this new money out in terms of credit - or that's one explanation. It is probable that they would even lend this money out to other banks anyway as that is far safer lending than to the public or business anyway with all these guarantees flying around.

In a daft twist, some of the money raised by institutions in gilt sales may have also been lent to banks in the form of short-term debt securities which means that banks are getting a nice level of subsidised lending from the Government in two forms as all such debt is underwritten. Again, there is little incentive to lend this money out to less safe hands.

Finally, it seems that as the FSA has instructed banks to buy more safe debt like gilts, much of the cash flowing into the banks from QE is actually going to buy gilts again. This helps the banks' liquidity ratio by stacking up on more 'quality' liquid reserves. It provides a great killing if you sell gilts but doesn't do the economy a great deal of good - in fact, as I blogged recently, it seems that new paper money is buying a great deal of our own new debt. I am no genius, but that has to be unhealthy in the long term as you cannot keep buying high value goods with new paper money. I would like to be disproved on that as it feels like a time-bomb to me.

On the face of it, QE seems to have just pumped money into banks who have sat on the cash. It is the reason why Chancellor Alistair Darling gets so cobby with banks when they consistently miss their lending targets which was the PM's and his (along with those clever investment banks advisers) grand plan to rescue the economy. I dare say we are actually better off because of it but there is a real danger that we either put too much in and trigger rampant inflation or we put too little and we get the opposite effect. It is why QE has never been a generally sensible way of controlling an economy as Japan and Argentina found out. It's why the Bank of England has adopted this measure only for the first time in its history.

Because unlike a QED (Quad Erat Demonstratum) proof of a theory, QE is not an exact science at all. It is pure guesswork.

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