Back in September 2012, Jens Weidmann, President of the German Bundesbank, quoted Johann Wolfgang von Goethe. That’s the German author who wrote ‘Faust’, and about his pact with the devil. In one of the stories from ‘Faust’, the devil disguised himself as a fool, and persuaded the emperor, who was suffering from too much debt, to solve his problem by printing more money. The result, of course, was runaway inflation. Mr Weidmann was drawing a parallel between Faust and Quantitative Easing or QE. He has, in effect, described QE as the work of the devil.

There is a snag, however with the view that QE will inevitably lead to hyperinflation, which is that the view is wrong.

QE is not money printing at all. When a central bank engages in what it calls unconventional asset purchases, otherwise called QE, it is not quite the radical policy that critics say it is. Under normal circumstances the central bank controls the short term rate of interest by buying and selling short term bonds. This often gets overlooked. In the days when economic conditions were what one might call normal, and the Bank of England occasionally increased or decreased interest rates, it didn’t send out a decree to all banks saying “by the power vested in me I command that from this day forward all banks will lend money at the following rate”, neither did the Bank pluck out a level and change interest rates as if by magic. Instead, the bank bought and sold short term bonds to affect the rate of interest.

When interest rates headed to zero, or, in the case of the UK (where the role played by Building societies made a zero interest rate impractical) when rates hit half a per cent, central banks found the conventional way of influencing borrowing was ineffective. So they engaged in buying long term bonds from the public instead.

The Bank of England explains it like this: “The policy of asset purchases is often known as 'Quantitative Easing'. It does not involve printing more banknotes. Furthermore, the asset purchase programme is not about giving money to banks. Rather, the policy is designed to circumvent the banking system. The Bank of England electronically creates new money and uses it to purchase gilts from private investors such as pension funds and insurance companies. These investors typically do not want to hold on to this money, because it yields a low return. So they tend to use it to purchase other assets, such as corporate bonds and shares. That lowers longer-term borrowing costs and encourages the issuance of new equities and bonds.” See: Quantitative Easing

What is overlooked by those who think QE will lead to hyperinflation is that these days bank lending is crucial in determining what is called the broad money supply.

Consider the equation PT = MV. It means average price multiplied by the number of transactions equals the amount of money in circulation multiplied by the velocity of circulation.

Inflation increases with a rise in the money supply providing the other two variables are unchanged.

But at a time when banks are still reluctant to borrow, and at a time when – thanks to falling asset prices – households feel poorer; at a time when overpriced asset prices make households feel insecure; at a time when household indebtedness has increased consumer’s desire to save, and at a time when a demographic bulge – otherwise known as the baby boomers – approaches retirement thus leading to a rise in savings, there is pressure on the velocity of money to fall.

It happened in Japan 20 years ago. Asset prices crashed at a time when a high proportion of the population was approaching retirement, and deflation was the result. In 2006/07/08 US house prices crashed, denting US consumer confidence. In the UK in 2000 stock prices crashed and, even today, have not fully recovered. The resulting fall in confidence was delayed by the onset of a housing bubble that more than made up for loss of wealth caused by poor equity performance. For all these reasons there is downward pressure on the velocity of money.

Without attempts to boost the money supply, the devil we call deflation may eventually rampage across the land, like one of the four horseman of the apocalypse.

On the other hand, by employing QE, central banks hope to force the price of government bonds upwards, making other assets look cheap, which in turn they hope will lead to them rising. To an extent this has happened and QE may be associated with higher equity and gold prices.

Less positively, it may also be associated with higher oil prices.

QE may also have stopped house prices in the UK from crashing, but whether this was a good thing, considering many believe UK house prices are too high, is a moot point.

© Investment & Business News 2013