QE(D)

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.

Why We Are Not Economists

The Bank of England did two things this week. First it decided to keep interest rates at 0.5% - good news for mortgages, bad for savings. Second, it extended its practice of Quantitative Easing beyond its agreed limit of £150bn to £175bn, raising the question of will it go further?

The £175bn has been used to buy Gilts, or Government Bonds on future debt which we need to pay to off all our recent extra spending. In fact, in certain sectors of the Gilts market, the bank now owns above 70% of the available issues. On the face of it, this is econo-masterminding on a grand scale to save our economy and we feeble-minded numb skulls watching via the news articles should shut up and let the experts run the show.

You do not have to be a genius to work out this a high risk strategy. Quantitative Easing is in fact creating money out of nothing to purchase valuable things. It would be the same as you and I getting a classy money printing machine, printing off some fresh fivers, tenners, twenties and Fifties and then walking into a jewellers and buying a stack of gold. If anyone stopped us, we could say that are good for the money as we have a some savings in the bank and it is hardly likely that several jewellers would ask us to pay with real money all at the same time. Why, couldn't they just take those notes we have given them and use them to buy whatever they wanted - no one should worry as we are good for the money - and again not all vendors will come to us at the same time asking for the real money or its equivalent.

Quantitative Easing (QE) is really like that. Except of course, that we are no allowed to print our own money. But we have a way of doing so. Many of us have indeed printed new money over the years by taking some of the equity in our houses and creating new money in its place - sadly we have cannot behave like the Bank as we have to repay the loan, the Bank apparently doesn't. Another sad fact is that many of us are in a serious situation where the value of our assets have dipped below the original debt taken to buy them or we have negative equity - some 39% of all Northern Rock customers are in that mire while around 20% of Lloyds customers are.

QE is the process of conjuring cash from fresh air and buying really valuable items with it - with complete impunity. It works on the principle used by most banks which says if I have £1m in reserves in the bank then I can lend out many multiples of that as not everyone is going to ask for their money back at the same time or create a run on the bank. Meanwhile, the more 'unreal' money you put into circulation, the less the real money is worth. That means that each time you create more unreal money, prices have a tendency to rise as vendors think if there is proportionally more unreal money in circulation, then if they raise their prices they will keep the amount of real money they want for their goods.

It's a hard concept to grasp but if for every £1 in circulation, if 10p is unreal money created by QE, then each shop should raise their prices by 10p to get £1 of real money.

Very quickly, inflation can set in as it is so attractive to print more money to to apparently 'buy' your way out of economic trouble. Countries like Argentina did this and very nearly bankrupted themselves as so much unreal money bought apparently valuable things that the country nearly collapsed as inflation went into hyper-mode to try and compensate. QE, in economic terms, is the last resort of third world countries to save themselves.

Unless of course you are the experts at the Bank of England who think Britain is rich enough to do so. With our wonderful balance of trade heavily pitted against us, our manufacturing base pretty low and our rising debt after the bank bail outs set to almost double Sovereign Debt, QE makes perfect sense. Britain can afford it.

Our Sovereign Debt is based on cashflow, largely our tax receipts to pay the interest and repay the loan at some time. As with our own households, if we leverage our equity, then we have to pay for it, whether our assets rise or fall. In reality, by creating more money to buy our own Sovereign Debt, all we have done is created the need to raise more debt in the future to pay for it, as you have bought the debt with unreal money. It is the start of a very vicious cycle.

I am no genius, and better people than I will put me right, but one thing I know for sure is that you cannot buy anything for nothing. There is always a price to pay. QE is merely a postponement to pay in the future - we buy our own debt with more debt.

Pure genius.