First of all the Bank of England 'prints' money. Not literally, but essentially it increases the size of its own cash deposits out of thin air. Then the Bank uses this new cash to buy back government securities from financial institutions like banks. The commercial banks' balance sheets therefore become more liquid since they have replaced government securities with straight cash. This is important because banks are limited in the amount that they can lend to businesses and individuals by the amount of cash they hold in reserve (the 'reserve requirement') so by increasing the cash assets of a commercial bank, the Bank of England makes additional lending to industry and individuals possible, thereby stimulating the economy.
An additional impact is that because the central Bank is buying lots of gilts, the price of those gilts in the market goes up - they are more expensive. That means they are less attractive to investors and financial institutions, who find something else to invest in - perhaps company bonds or equities, again helping companies raise cash and therefore stimulating the economy. Even better, because those financial institutions now find it more attractive to lend to companies (by buying company bonds), the interest rate that companies have to pay on those bonds goes down - again making it easier for companies to raise cash and therefore stimulating the economy.
At some point in the future, the Bank of England is able to sell the government securities it bought and theoretically it would destroy the cash, so the long term effect of quantitative easing could be balanced out. Of course, the Bank could choose not to do this.
Now while all this is going on, the government still has a budget deficit to finance (actually a thumping great budget deficit). You might think that if the government is 'printing money' anyway, it could print some more to pay for all those vital and 'vital' public sector costs. Actually, 'printing' money to pay for a budget deficit (as opposed to printing money to ease credit) is very often disastrously inflationary (think Weimar Germany or Zimbabwe) and largely because of this it is expressly forbidden to EU member states (even those outside of the Eurozone) by the Treaty of Maastricht.
So to finance public sector expenditure, the government has to issue gilts to the market regardless of the quantitative easing taking place at the same time. There is a benefit to the exchequer of doing this while interest rates are low in that the new government debt issued can be at lower interest rates than the old government debt being bought back through quantitaive easing. The government has replaced debt on which it pays a higher rate of interest with new debt on which it pays a lower rate of interest. However, were the government's AAA credit rating reduced by the credit rating agencies, the new debt would be less attractive to investors and would have to be issued at higher interest rates.
So what could go wrong?
1. Regardless of their extra liquidity, the commercial banks fail to increase their lending to industry and individuals. There is some evidence that they are still reluctant, and you will hear politicians from different parties complaining about this from time to time.
2. It works too well and over-stimulates the economy, leading to inflation. A risk yes, but a manageable one in the current climate.
3. The UK loses its AAA credit rating. Still a risk - and this would be bad. This is ultimately the reason for the emergency budget we had recently. If you just look at the numbers (deficit to GDP ratios etc), we probably should have been downgraded under the last government, and it was probably the election of a government more committed to reducing the budget deficit that saved us.
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Date: 2010-07-22 09:49 am (UTC)First of all the Bank of England 'prints' money. Not literally, but essentially it increases the size of its own cash deposits out of thin air. Then the Bank uses this new cash to buy back government securities from financial institutions like banks. The commercial banks' balance sheets therefore become more liquid since they have replaced government securities with straight cash. This is important because banks are limited in the amount that they can lend to businesses and individuals by the amount of cash they hold in reserve (the 'reserve requirement') so by increasing the cash assets of a commercial bank, the Bank of England makes additional lending to industry and individuals possible, thereby stimulating the economy.
An additional impact is that because the central Bank is buying lots of gilts, the price of those gilts in the market goes up - they are more expensive. That means they are less attractive to investors and financial institutions, who find something else to invest in - perhaps company bonds or equities, again helping companies raise cash and therefore stimulating the economy. Even better, because those financial institutions now find it more attractive to lend to companies (by buying company bonds), the interest rate that companies have to pay on those bonds goes down - again making it easier for companies to raise cash and therefore stimulating the economy.
At some point in the future, the Bank of England is able to sell the government securities it bought and theoretically it would destroy the cash, so the long term effect of quantitative easing could be balanced out. Of course, the Bank could choose not to do this.
Now while all this is going on, the government still has a budget deficit to finance (actually a thumping great budget deficit). You might think that if the government is 'printing money' anyway, it could print some more to pay for all those vital and 'vital' public sector costs. Actually, 'printing' money to pay for a budget deficit (as opposed to printing money to ease credit) is very often disastrously inflationary (think Weimar Germany or Zimbabwe) and largely because of this it is expressly forbidden to EU member states (even those outside of the Eurozone) by the Treaty of Maastricht.
So to finance public sector expenditure, the government has to issue gilts to the market regardless of the quantitative easing taking place at the same time. There is a benefit to the exchequer of doing this while interest rates are low in that the new government debt issued can be at lower interest rates than the old government debt being bought back through quantitaive easing. The government has replaced debt on which it pays a higher rate of interest with new debt on which it pays a lower rate of interest. However, were the government's AAA credit rating reduced by the credit rating agencies, the new debt would be less attractive to investors and would have to be issued at higher interest rates.
So what could go wrong?
1. Regardless of their extra liquidity, the commercial banks fail to increase their lending to industry and individuals. There is some evidence that they are still reluctant, and you will hear politicians from different parties complaining about this from time to time.
2. It works too well and over-stimulates the economy, leading to inflation. A risk yes, but a manageable one in the current climate.
3. The UK loses its AAA credit rating. Still a risk - and this would be bad. This is ultimately the reason for the emergency budget we had recently. If you just look at the numbers (deficit to GDP ratios etc), we probably should have been downgraded under the last government, and it was probably the election of a government more committed to reducing the budget deficit that saved us.