A Licence To Print Money

The Bank of England has warned it may soon be necessary to 'print money'. Will this rescue our economy - or simply make matters worse?

You may have heard the term "quantitative easing" in recent weeks and wondered what on earth it means and why our glorious leaders are considering it. My economics is a little rusty these days, as it's a long time since I studied it at university, but here is how this term fits into the current mess we find ourselves in.

One way the government can influence the economy is through monetary policy. This is where it adjusts the amount or cost of money in order to push the economy in one direction or another. If the economy is getting overheated then interest rates, i.e. the price of money, can be raised. This makes borrowing more expensive and should act as a brake on the economy. At the moment of course, we're doing the reverse of this and lowering interest rates in order to boost the economy.

Adjusting interest rates is the main method of monetary policy that major economies use at the moment. For example, the Bank of England is set an inflation target by the government and it then uses interest rates to try and keep inflation between 1% and 3% a year.

Quantitative easing is another method that can be used for monetary policy. However, rather than targeting the price of money, it aims to address the supply of money. The theory is that if you increase the supply of money, the price of it comes down and this should act as a boost for the economy.

As interest rates moves towards zero, the government's ability to cut interest rates (and boost the economy) diminishes. So this is why the Bank of England is looking at these so-called unconventional forms of monetary policy. It believes the economic situation may become so dire that it will need these additional tools to do its job.

Are we printing money?

Quantitative easing is often referred to as printing money. It would be nice to think that the Governor of the Bank of England pops down to the basement and shrieks "start the presses!" but in today's electronic world the way it works is slightly different.

Essentially the Bank of England buys assets such as government or corporate bonds. The increased demand for these assets should lower their rate of interest and the cheaper level of borrowing should then boost the economy.

How this fits into the bailout

If you read about the banking bailout on Monday then you may recognise that the government's plan to allow the Bank of England to buy up to £50bn of assets is a form of quantitative easing. Mervyn King, the Governor of the Bank of England, added some more detail to this in a speech on Tuesday night.

The money for these purchases will be created by issuing more government debt. In terms of timescale it will happen in weeks rather than in days or months. King said that the Bank would choose assets very carefully and only buy them where there is "genuine private demand for an asset in normal conditions". He added that corporate bonds and commercial paper, i.e. debt issued by large companies, are the assets being most closely examined. When some normality returns, the assets can be sold and the debt used to buy it can be paid off.

King also said that the bailout was "not designed to protect the banks as such". It was "designed to protect the economy from the banks. In particular, the Asset Protection Scheme (aka the insurance policy) aims to remove a degree of uncertainty about the future losses banks will make.... the insurance policy will be most cost-effective for taxpayers if all the major lenders sign up to lending targets."

So far only Royal Bank of Scotland and Northern Rock have signed up to lending targets (although the latter's is yet to be specified). It looks like there will now be pressure on the other banks to follow suit, although in December HSBC did say it was planning to lend £15bn to UK homeowners in 2009, a 20% increase over the amount it lent in 2008.

How will it help?

As I said on Monday this whole process is about smoothing the transition from our over-indebted world to one that's slightly more sensible. It's not designed to solve the problem but to ease the pain a little by making the recession shorter and shallower than it otherwise would be.

We can't make any accurate predictions about how this recession will play out but this shouldn't worry anyone. The fact is, we've never been able to make accurate predictions about stuff like this. The only difference is that now many more people are aware of this.

What we can say is it's going to take a few months before any of this has any impact. That's the nature of monetary policy unfortunately. It's a blunt instrument. So for the time being the dreadful economic data will continue to come.

This Friday will see the estimate of Gross Domestic Product (the output of the economy) for the last quarter of 2008. This is the first period that's included the latest phase of credit crunch and this number is going to be truly horrible. Perhaps one thing to watch out for is signs that quoted companies are finding it easier to refinance their debts. That could be the elusive `green shoot' everyone is so keen to spot.

In a recent podcast, David Kuo signed off with a quote from Winston Churchill which sums up the best approach to take at times like this - if you're going through hell, keep going!