Quantitative Easing: Does It Work?

What Is Quantitative Easing (QE)?

If there were awards for the most controversial economic terms, "quantitative easing" (QE) would win the top prize. This is a tool that central banks use to increase the money supply in a country's economy. But experts disagree on nearly everything about the term—its meaning, its history of implementation, and its effectiveness as a monetary policy tool.

The U.S. Federal Reserve and the Bank of England have used QE to weather financial crises. In fact, the U.S. has had three iterations: QE, QE2, and QE3. The Bank of Japan was the first to try it out and has been using QE for years, while the European Central Bank (ECB) has also used it to stimulate economic growth in the eurozone.

So what's the big deal about QE—and does it work?

Understanding Quantitative Easing (QE)

Quantitative easing is when a central bank issues new money and uses that to purchase assets from commercial banks. These then become new reserves held at these banks, increasing the amount of credit available to borrowers.

Ideally, the funds the banks receive for the assets will then be loaned to borrowers at attractive rates. The idea is that by making it easier to obtain loans, interest rates will remain low and consumers and businesses will borrow, spend, and invest. According to economic theory, increased spending leads to increased consumption, which increases the demand for goods and services, fosters job creation, and, ultimately, creates economic vitality.

However, there are downsides. Low interest rates can encourage companies to invest and spend more, causing price rises and eventual inflation. In order to counter these effects, central banks may reduce the money supply through quantitative tightening.

QE impacts the stock market as well as the bond market. Investors will buy shares of companies that they expect to benefit from increased spending and consumption.

QE Challenges

Quantitative easing is similar to credit easing, where the central bank acts to provide liquidity to credit markets. For example, in 2008, the Federal Reserve began buying mortgage-backed securities in its open market operations, thereby helping to support the housing market.

Ben Bernanke, renowned monetary policy expert and former chair of the Federal Reserve, draws a sharp distinction between quantitative easing and credit easing:

"[Credit easing] resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of the policy is on the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental."

Bernanke also points out that credit easing focuses on how a central bank's assets "[affect] credit conditions for households and businesses."

Despite the semantics, even Bernanke admits that the difference in the two approaches "does not reflect any doctrinal disagreement." The distinction may be lost in the media, where any effort by a central bank to purchase assets and inflate its balance sheet is often described as quantitative easing.

Effectiveness of QE

Whether quantitative easing works is a subject of considerable debate. There are several notable historical examples of central banks increasing the money supply and causing unanticipated hyperinflation. This process is often referred to as "printing money," even though it's done by electronically crediting bank accounts and it doesn't involve printing.

In 2001-2006, the Bank of Japan increased its reserves from five trillion yen to 35 trillion yen. Most experts view the effort as a failure. However, there is some debate over whether or not Japan's effort can be categorized as quantitative easing at all.

Economic efforts in the United States and the United Kingdom during 2009-10 also met with disagreement over definitions and effectiveness. European Union countries are not permitted to engage in quantitative easing on a country-by-country basis, as each country shares a common currency and must defer to the European Central Bank.

There is also an argument that QE has psychological value. When interest rates are near zero but the economy remains stalled, the public expects the government to take action. Quantitative easing shows action and concern on the part of policymakers. Even if they cannot fix the situation, they can at least demonstrate activity, which can provide a psychological boost to investors.

Of course, by purchasing assets, the central bank is spending the money it has created, and this introduces risk. For example, the purchase of mortgage-backed securities runs the risk that those securities may default. It also raises questions about what will happen when the central bank sells the assets, which will take cash out of circulation and tighten the money supply.

The Bottom Line

The controversy surrounding QE brings to mind Winston Churchill's famous quip about "a riddle wrapped in a mystery inside an enigma." Of course, some experts will almost certainly disagree with this characterization.