"Quantitative Easing" - A way forward?

About roughly a month ago, I asked Mr Walton that perhaps, with the threat of deflation looming, the best thing for the Bank of England to do would be to print more money. My thinking was that by printing more money, the government would be literally shoving more money into the economy, which would in turn stem off deflation and potentially help to self-right the economy.

Sadly, as it was the end of period 3, Mr Walton gave me one of those looks which said "I really want to go and have a cup of tea", quickly mumbled "Yes" and made a sharpish exit from the room.

Now, without wishing to sound like I am the new prophet of the credit crunch or anything, looking at the papers now, my prediction seems to have come true.

Only 4 days ago the Open Market Committee of the US Federal Reserve (the American equivalent to the Monetary Policy Committee) announced its intention to start buying mortgage-backed securities (the supposed 'dodgy debt' that caused the credit crunch in the first place). Where would the money for this come from? The short answer: nowhere. The Federal Reserve will simply create money, electronically or through printing, to use to buy this 'toxic debt'.

Now, the upside for this is obvious: by putting money straight into the economy through such purchases, there are strong cash injections into the economy. Best of all, the government gets to do this for free. This will improve liquidity, allowing banks to start lending and business thus to start investing. It will reduce the cost of borrowing, allowing consumers and business alike more breathing space, reducing any potential falls in GDP and increases in unemployment.

You might start to wonder, however - since this is all so good, why don't we do it all the time? Well, as the saying goes, there's no such thing as a free lunch. The main danger with printing more money is that it has a strong inflationary pressure upon the economy. Milton Friedman won the Nobel Prize for Economics in 1976 for, amongst other things, the simple equation:

MV=PQ

Where M is the Money Supply, V is the speed at which money circulates through the economy, P is the price level (ie the level of inflation) and Q is the real economic output. Increasing the supply of money, by printing more of it, will increase inflation and/or GDP growth.

This effect can be so extraordinary that in Zimbabwe, where the government has been printing money for years, the economy suffers Hyperinflation. This is the rather comical situation where inflation reaches levels that devalue the currency so much that the economy cannot function properly. The official inflation level in Zimbabwe is 231,000,000%, meaning that when the $100 billion dollar note was introduced last October, it was only worth 8p.

However, inflation is not our main concern. We are currently experiencing a demand side slump in the world economy. Demand side slumps, or falls in the Aggregate Demand of the economy lead to higher unemployment, lower inflation (or possibly deflation) and falling economic output. The threat is actually from the pessimistic and demoralised economic situation that deflation can cause, and the economic depression that may result from the declines in consumer spending and reductions in employment levels of recent times.

Overall then, printing more money is potentially the only way forward. We are nearing the end of the usefulness of interest rates as a means of controlling the economy. In fact, low interest rates, as seen in Japan in the 1990s, may prove counter-productive (though something called "The Liquidity Trap" - where returns are so low that investment in anything is severely discouraged and people simply hoard money). In the short run, printing money may prove to be the most useful tool available to the government. But even in the medium term, it must avoid using it as a "magic bullet", a fix-all cure, and must know when to stop.

Otherwise we could leave the recession to find ourselves waking up to a inflationary crisis in 5 years time.

Further Info:

Forget Hard Choices. We need pampering - Anatole Kaletsky, The Times.
Press Release of 16th December - The Board of Governors of the Federal Reserve
Federal Reserve slashes Interest Rates to zero - Larry Elliot and Ashley Seager, The Guardian
Deflation: Making sure it doesn't happen here - Ben Bernanke, Governor, US Federal Reserve