Recession or depression? | 19
pressures to contract balance sheets - possibly by 15-20 per cent,
due to greater caution in a post bubble world together with the
impact of recession on non-performing loans � one can see the
incentive to introduce radical quantitative easing.
Limited quantitative easing is potentially demand (consumers
and companies many not be willing to borrow even if, in the
extreme, the Government nationalised the banks and tried to
force them to lend) and supply constrained (banks could
theoretically sit on their piles of reserves).
More aggressive quantitative easing could be effective � the
potential size of quantitative easing is unlimited. The Bank of
England could flood the markets with money and print money to
finance an unlimited fiscal expansion � but there are big risks.
What is quantitative easing (QE)?
BOX 1
QE does not mean that the Bank of England is considering `printing money' in the same manner as the
hyperinflations experienced during the French Revolution, Weimar Republic or present day Zimbabwe.
Instead, quantitative easing draws on the experiment undertaken by Japan over the 2001-06 period
and to some extent the US Federal Reserve over recent months.
Short-term interest rates are falling towards zero. Clearly the Bank of England will then run out of bullets
with regard to generating a monetary stimulus through base rate reductions. However, whilst this weapon
will have been exhausted, the Bank of England will still retain other significant weapons at its disposal.
As interest rates move towards zero the MPC could announce that it intends to keep base rates at say a
quarter-point for the next 24 months. This would help pull down other interest rates of a longer maturity. In
addition it could help reduce deflationary expectations and increase consumer and corporate confidence.
However, this stimulus may not be enough and so the Bank of England could then attempt to flatten
the yield curve and push down yields at the far end of the curve - by purchasing long-term securities
such as gilts or corporate bonds. This would have 2 effects.
Firstly, higher demand should raise demand and gilt prices. Given the inverse relationship between
bond prices and yields, bond yields (long-term interest rates) would then be pushed down.
Secondly, by purchasing gilts from the banks, the Bank of England would expand the money supply.
Banks would be sitting on a lot more cash (excess reserves) and this would provide an incentive for
them to increase lending.
In theory the QE process should be very effective. In practice it may be much less effective, for a number of
reasons. Firstly, bond markets are deep and very large purchases might be required to push down yields.
Secondly, even if the banks acquire much higher reserves there is still no guarantee they will increase
lending. In the wake of the financial crash they may decide to operate with a much thicker cushion of
reserves. Finally, consumers and companies may be unwilling to borrow even at zero interest rates.
In a financial crisis induced recession QE is more likely to be effective if bank balance sheets have
been re-built. Of course this also means that interest rate reductions should then be more effective as
well, even in the absence of QE.
The UK is moving in the direction of introducing QE with the announcement that the Bank of England
has a new �50bn facility to purchase assets. QE could then help reduce interest rates at the far end of
the yield curve and also put downward pressure on sterling.
QE is probably a necessary but by no means sufficient condition for stabilising the downturn.

Page 1Page 2Page 3Page 4Page 5Page 6Page 7Page 8Page 9Page 10Page 11Page 12Page 13Page 14Page 15Page 16Page 17Page 18Page 19Page 20Page 21Page 22Page 23Page 24Page 25Page 26Page 27Page 28Page 29Page 30Page 31Page 32Page 33Page 34Page 35Page 36Page 37Page 38Page 39Page 40Page 41Page 42Page 43Page 44Page 45Page 46Page 47Page 48Page 49Page 50Page 51Page 52Page 53Page 54Page 55Page 56Page 57Page 58Page 59Page 60Page 61Page 62Page 63Page 64Page 65Page 66Page 67Page 68Page 69Page 70Page 71Page 72Page 73Page 74Page 75Page 76Page 77Page 78Page 79Page 80 Produced by PageSuite