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.

Out of Thin Air

Quantitative Easing is a funny old thing. It's effectively creating money out of thin air and it is currently seen as the method to rescue the global economies. It's such a great idea, it's a wonder that we don't do it ourselves - individuals that is.

But we have. More of that later.

The US Announcement

The theory goes that money, like matter, cannot be created or destroyed.

That's not entirely true. Today, the US Federal Reserve announced a package of $1.2trillion of Quantitative Easing in proposing to buy Government debt (Gilts or Treasuries) and mortgage backed securities over the coming months. It is effectively printing more money or creating more dollars in the economy out of nothing.

You see, the Fed does not have these dollars.

What it has is a Reserve of money or deposits and at any time it can use something known as Fractional Reserve Banking to say that at any one time not everyone will want access to that Reserve. In fact, so confident of this fact are banks, that they then create multiples of this Reserve as an amount of dollars or pounds to lend out to people. As long as they don't breach a certain ratio of circulated dollars to the Reserve then they can issue as many as they want. And this is what the Fed has done, as has the Bank of England.

Like my pyramid of champagne glasses analogy, the new money created cascades from the banks that hold the debts the Fed is buying, down to businesses and then onto consumers - and the one thing they then bet on is that like idiots we will spend this new money. We will receive it via greater lines of credit and lending from businesses and banks in the form of loans, mortgages and credit cards in the main.

Problem solved.

Not Quite

Of course, if you create more money, effectively you are reducing the value of money already in circulation and that is why the dollar took a sharp pasting from a range of foreign currencies in response to this. But it also has the effect of decreasing the yields on gilts (National Debt if you like) and again the US markets saw the sharpest ever drop on gilts yields in response. This has a big knock on effect for all people who are saving and wanting to retire as pension funds and annuities are very dependent on gilts - their value and their yields. As the Gilts market decreases, there is a large shortfall in pension funds created and in end salary pensions, the deficits sharply increase.

Quantitative Easing, just like increased long term Government borrowing, has a profound effect on the future earnings of individuals - and this time not just in tax payments but in actual retirement income. It is a short term fix which has a profound effect on the future of each and everyone of us and it is why it is a method of tackling the economy which smacks of deep desperation.

Quantitative Easing For Us

It is not quite the same but effectively in the last 10 years we, as individuals, have behaved like banks. We have leveraged our own 'reserves' which could be our property asset values, and raised more money to go and spend on other assets, lifestyle changes, holidays or consumables. As the yield on our own 'sovereign debt' was low in terms of interest, borrowing against our assets was relatively cheap and despite our own household disposal income actually shrinking over the same period, we actually made ourselves a good deal richer by releasing far more money to spend. In the wider economy this created a fantastic boost to GDP and corporate profitability and as long as our asset values remained high then there was no end to the cycle of getting more money.

The problem, of course, is that unlike the Fed our reserves were not deposits but variable value assets and their value had been artificially inflated due to the very process of releasing the locked up equity in them. The more we released, the greater their value became and the more we could release. It could not possibly be sustained - and there is a simple reason for it. The complex reasons which everyone had used to suggest it could never change was that even if there was a recession or downturn and the ability of people to repay the debt was changed, this could be accommodated for as things like unemployment could be less impactful while lots of incentives and creative lending practices could be used to keep first time buyers get in the game as someone had to be at the end of every chain.

But the simple reason was that the whole system was built on greed and that made sure that it got riddled with bad practice.

Criteria for loans went out of the window, which Gordon Brown points out was the cause or sub-prime, but it was not the primary cause as it was merely a symptom. The cause was the fact that banks were trading in debts many times over to create more profit and provide an endless supply of cash to lend for the next debt. It was the very system used to create the lending that was the problem, sub-prime became just a peripherary result that showed why the system was unsustainable. Banks had used the system of debt trading to access cash way above their own reserves which fuelled their profits and more lending and this became the principle method for growth and funding their business.

Sub-prime highlighted the folly and the availability of cash dried up immediately (The Credit Crunch) as no one had any idea who owned what asset and how much it was worth. In the UK some banks had lent 125% of asset value, some had increased earnings multiple criteria to 5 or 6 times earnings and included variable bonuses in it, some had taken external guarantees from parents or relatives, some had taken shares as security, then some had lent stupidly on the corporate market, on property - the fact was that each new loan they made had a fantastic, almost unbelievable return and this is waht produced a 162% rise in property value ove rthe 10 years.

And sure enough the whole thing collapsed.

For us, as mortgage holders who had leveraged the excess equity in our homes, the bottom quite literally fell out our world. Our money making machines - our homes - started to plummet in value and in conjunction with a lack of available credit to renegotiate the loans and a recession to threaten our abilities to repay, we saw the equity we had released turn into a massive loan with no security.

Our own version of Quantitative Easing had backfired on us spectacularly.

The Future

Real Quantitative Easing is different to how individuals raise their money but the principle of creating extra cash from thin air has real parallels. There are risks associated with Quantitative Easing as it can trigger higher inflation or even hyperinflation as Argentina has seen in its not too distant past. The Bank of Japan has used it in recent times in conjunction with zero percent interest rates to try to stimulate its economy - it has had no real tangible effect as Japan remains in a relative trough which has lasted for some years. The theory says that if this is done by Central Banks as opposed to Governments just printing money then the risks are less.

Tell that to the people who save and who are wanting to retire. They are shouldering all the burden right now to compensate for the greed of a few who could not help themselves and a set of Governments and Regulators who did not have the intelligence, gumption, fortitide and appetite to stop it.