The financial crisis of 2008 plunged the world economy into an era of unprecedented economic turmoil, bringing to a halt one of the most prolonged periods of growth in recent memory. The collapse of Lehman Brothers – resulting largely from exposure to increasingly worthless mortgage-backed securities – caused a complete loss of confidence in banks, freezing interbank lending and bringing the flow of money around the world to a halt. Bank after bank had to be bailed out, with the collapse of Lehman paling into insignificance compared to the impending carnage of major bank failures across the globe.
While the immediate response of governments, including in the United States, was to bail out financial institutions that were “too big to fail,” the effect of this was merely to prevent a total economic meltdown – it did not address the catastrophic impact that the banking crisis had on the broader global economy. Central banks quickly moved to lower interest rates, in order to stimulate borrowing and economic activity, but that strategy quickly ran out of steam as interest rates approached 0%. There was no scope for further reduction, since this would make it more attractive to hold onto cash.
Quantitative easing was in fact a last-ditch attempt by central banks to stem the downward spiral of the global economy. While many equate this to “printing money,” it is in fact a way of injecting money into the economy which in theory avoids the disastrous consequences that printing money has had in the past. For example, the hyperinflation seen in the German Weimar Republic in the 1920s was largely a result of the government literally printing money and using this to finance its own debt. This in turn made government debt worthless, since a theoretically infinite amount could be financed using this mechanism.
Quantitative easing involves a government – for example the Federal Reserve in the US – purchasing large amounts of assets such as bonds from non-governmental institutions, including major banks. It does this by creating new money – hence the comparison to printing money – but it avoids the trap of making purchases from government institutions such as the U.S. Treasury. The money then goes on to the balance sheets of the banks, which in effect recapitalizes them. In the case of the financial crisis of 2008, this was critical since banks had suffered major losses and also were in the middle of a liquidity crisis because other banks would not lend to them.
Aside from improving the stability of the banks, the primary goal of quantitative easing during and after the financial crisis was to get the banks to start lending again, using the additional capital on their balance sheets. This in turn was supposed to stimulate the economy by making more money available to both consumers and businesses.
However, there has been a lot of criticism of quantitative easing since that time. A number of influential investors and economists have stated that it is both ineffective and dangerous – for an example of this, see Ken Fisher’s Forbes article, “Betting Against Bernanke”.
One of the major criticisms is that the banks did not actually start to lend more, but instead used the money in other ways, such as making new acquisitions – which actually led to further job losses as organizations merged and eliminated redundant positions. The reason put forward for the banks not lending is that quantitative easing involves purchasing long-term bonds, which reduces long-term interest rates since bond issuers do not have to offer high rates to attract buyers. Since banks take short-term deposits and issue long-term loans, they make profits based on the difference between the two rates. Lower long-term rates therefore make lending less attractive compared to using capital inflows from quantitative easing to make strategic acquisitions.
The question, of course, is whether or not quantitative easing has actually done its job. There are those who say it hasn’t, including Alan Greenspan, the former Chairman of the Federal Reserve. On the other hand, others such as Joe Gagnon, Senior Fellow at the Peterson Institute for International Economics, argue that it has, but that the central banks have not been aggressive enough. There are also conflicting messages coming from global financial institutions such as the International Monetary Fund. For instance, the IMF has warned that the Bank of England could see losses amounting to nearly 5.5% of the UK GDP when it finally unwinds quantitative easing in that country – an illustration of the damaging long-term effects. On the other hand, the IMF has warned against the US withdrawing quantitative easing – citing a concern that it could disrupt delicate financial markets.Comments Off
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