April 2009

During the first quarter, economic data has continued to confirm a deepening recession. Growth and industrial production have slumped in the major economies, global trade has effectively come to a standstill and unemployment is rising rapidly. Monetary and fiscal stimulus packages have yet to have any impact on economic activity and it may be several months before they do.

Against this backdrop, central bank efforts to restore stability appear almost desperate. Interest rates in the major economies are effectively at, or heading towards, zero. As monetary easing has so far been ineffective, however, policymakers have increasingly turned to the idea of “quantitative easing”.

In practice, quantitative easing involves central banks buying securities, such as government bonds, from commercial banks in exchange for increasing the reserves that these banks are obliged to hold in their accounts with the central bank. This effectively swells the central bank’s balance sheet, while the commercial banks’ balance sheets correspondingly shrink. In order to expand their balance sheets anew, so the theory goes, commercial banks will increase their lending and so channel much-needed liquidity into the economy.

Having been seriously attempted only once in recent history, namely in Japan during the “lost decade” of the 1990s as a way of tackling deflation, there is little evidence to suggest that quantitative easing can actually bolster economic activity. As it was implemented without much conviction, economists are divided as to whether or not the Japanese experience was successful; although domestic growth did not contract while quantitative easing was implemented, it also failed to expand after the policy was abandoned. In any case, Japan, characterised as it is by a culture that embraces the concept of savings, is hardly a proxy for the profligate, credit-addicted Anglo-Saxon economies. And it is far from certain whether, in the current environment, banks would be particularly keen to expand their balance sheets.

Quantitative easing remains a controversial concept. While its proponents defend it as a feasible means of encouraging banks to lend again, antagonists worry about a monetary bubble and warn of the potentially enormous inflationary impact that this could have further out, citing historical instances of “printing money” that ended in catastrophe, such as the economic collapse of Germany’s Weimar Republic in the 1920s.

There is general agreement that the stability of the banking system is a prerequisite for economic recovery. However, central banks are rapidly running out of policy options to aid this development. If quantitative easing fails to prompt lenders into lending again, other measures might become necessary, including greater involvement by governments in the way banks are run.