Quantitative easing or money printing?

Money printing is one of the most controversial topics in economics. Recent media discourse though, suggests that this is the new normal. After all, it has been observed for the past few years in America, Europe and Japan. Central banks have recently changed the name to Quantitative Easing (or QE for short). This has prompted some in in finance field to speculate the demise of the dollar and more disturbingly, the return of hyperinflation. This notion though, is not reflected empirically. Central banks have been doing this for some years now and no significant rise in inflation has been noticed. It is hence logical to refute the simplistic view that QE is the same as money printing. However, to do so, one must understand the difference between ‘quantitative easing’ and ‘money printing.’

To pinpoint exactly how quantitative easing and money printing are different, one needs to know what each is. Quantitative easing refers to a policy where the central bank starts buying financial assets on a large scale from the private sector. These assets are typically government bonds, and sometimes bonds from big corporations that are very unlikely to go out of business. What differentiates QE from a normal transaction is that large scale asset purchases by the central bank are financed by ‘newly created’ money. In this case, central bank reserves, where reserves are digital accounts that private banks have at the central bank and can use to pay each other.

With QE, central bank reserves are created. But, with traditional money printing notes and coins are created. This is important because notes and coins end up in the hands of the consumer. Whereas reserves end up in the hands of financial institutions. This is again important because where money ends up first, is likely where one sees the biggest impact on prices. This explains why we have seen massively increased asset prices in countries where there has been QE, but not so much inflation.

While the central bank creates reserves. It also takes something out of the economy, namely ‘bonds.’ This is important because bonds are actually used as money in large parts of the financial sector. With money printing, the government spends more money into the economy. But, with QE this doesn’t have to be the case. If the government doesn’t simultaneously increase its spending, the central bank merely inserts one money like instrument while taking out another.

The monetary system consists of a monetary core of central bank money. First, notes and coins, and on top of that bank reserves. Then, there is a layer of money created by private banks. And then, finally, there is a layer that consists of financial instruments often used as money, but only used in some parts of the economy. So, when QE happens, reserves are added to the economy while, at the same time bonds in the financial crusts are taken out of the economy. However, the effective money supply remains the same.

This begs the question, if the effective money supply is not changed, then why bother with Quantitative Easing at all?

First, it is important to realise that reserves are more liquid than bonds and can be directly exchanged for cash with the central bank. So, when there’s crisis, reserves are safe while government bonds cannot always be relied upon for payment.

Second, the interest rate on reserves is typically lower than the interest rate on government bonds. So, what is happening here is that government bonds are getting scarcer in the monetary financial system. And what happens to things that are getting scarcer? Well, their price goes up, of course. And, confusingly, with bonds, if their price goes up, this means their interest rate goes down. And since central bankers already control interest rates on short term debt by setting the interest rate on reserves, they can now also control interest rates on longer term government bonds through quantitative easing.

Also, there is a third effect that central banks rely on, that is that by increasing the quantity of available reserves, private banks can more easily expand their lending and therefore the quantity of private bank money. This however, is not guaranteed to happen since bank lending also depends on people being willing to borrow.

Finally, by performing QE, central bankers have made government borrowing cheaper by lowering interest rates. This enables governments to spend more. Although, governments don’t always use this opportunity. If the central bank and government work in tandem, then QE becomes more like money printing because money is added to the economy and nothing was extracted from it.

Hence, quantitative easing concerns itself with buying assets with newly created reserves which makes the system safer. And since it is safer, this could in theory make banks more confident to increase their lending. At the same time, because it takes bonds out of the economy, QE will lower long term interest rates. Finally, by making interest rates lower, it could encourage governments to spend more.

There are two main reasons why QE is not money printing. The first is that QE means more bank reserves in the economy. This is important because this type of money is much more likely to get stuck in the financial sector rather than ending up with consumers. Hence, it is more likely to increase the price of assets and reduce the long term interest rates on bonds than it is to cause any significant inflation. The second key difference is that, while money printing only adds monetary instruments to the economy, QE adds core money as well as extracts financial instruments. This is another reason why we have not seen massive inflation as a result of QE.