The Bank's £200bn gamble

The Bank of England will this week announce its intention to flood the economy with 'helicopter money', its latest attempt to tackle the recession. Sean O'Grady reports

What is "quantitative easing"?

It is economists' jargon for what is more colloquially termed "printing money" – increasing the quantity of money. Nowadays that does not literally mean speeding up the printing presses at the Bank of England's works at Debden in Essex; it means an electronic transfer of money between the Bank of England and the commercial banks, and thence, so the idea runs, to companies and households.

How does it work?

The Bank of England uses "open market operations" – financial transactions in the markets. It buys the banks' assets, such as government securities and commercial bonds and maybe even their devalued mortgage-backed securities. Importantly, it does so without funding that purchase by borrowing money itself; in effect the Bank just creates the money and transfers it to the banks.

What is the difference between "credit easing" and "quantitative easing"?

Subtle, but important. Credit easing, as its name suggests, is specifically aimed at aiding the supply of bank credit in the economy, and tends to mean purchases of corporate paper and mortgage-backed and other asset-backed securities. The Bank of England's £50bn asset purchase facility (APF) provides both a framework and a start to that policy: initially it provides for the Bank of England to buy corporate bonds, commercial paper, and securities issued by the banks under the credit guarantee scheme. This is all financed by the issue of Treasury bills (and thus is not "printing money"). About £820m of the fund had been disbursed thus far (in its first fortnight).

However, the APF could be expanded and/or supplemented to include purchases of other assets – such as gilts – and for those purchases, and for the purchases of commercial paper, to be "unfunded". That would be classified as "quantitative easing" rather than credit easing.

What else could the Bank buy?

In one sense, it doesn't matter. To demystify matters, imagine if the Bank of England offered to buy, say, every MoT failure in the land for £1,000. Or if it offered to buy every unwanted pet for a generous £5,000 a pop. Threadneedle Street might be chocker with rusty old cars or stray dogs and cats, but it would, it has to be hoped, start to move the economy forwards again. Ben Bernanke, the chair of the US Fed, famously quoting Milton Friedman, talked a few years ago about "helicopter money" – dropping banknotes from the sky. In other words, it is all about getting money – spending power – into a demoralised economy. That is the end; the means can be many and varied.

Who decides?

Technically the Governor of the Bank of England, on behalf of the Monetary Policy Committee, asks permission of the Chancellor via an exchange of letters to try the new policy in pursuance of the Bank's 2 per cent inflation target. The letters will probably be published, along with the MPC's latest decision on interest rates, on Thursday at noon.

What happens next?

Despite the potential for turf battles, the Bank and the Treasury seem agreed at least on the need for quantitative easing, though perhaps less so on the scale and pace of the interventions.

Observers are more interested in how – and when – the policy will eventually be wound down, and whether the politicians will determine that, rather than the Bank of England.

How large will the easing be?

This is really anyone's guess, and the chances are that the Bank will feel its way along at first. The Chancellor may determine a global sum available to the Bank to use at its discretion over an indeterminate period, or he may decide to authorise a smaller amount now and more, possibly, later – less flexible for the MPC. Guesstimates of the total involved vary from £50bn to £200bn.

Will it work?

As with all of the authorities' previous schemes, sadly there is no guarantee that it will. The banks could simply "hoard" the extra liquidity, and are under no obligation to lend it on: except, that is, those that are nationalised or majority-owned by the Government and will have pressure put on them to do so.

Most economists think that the policy will have some effect, provided it is implemented rapidly. However, the example of Japan, where the authorities began the policy a little late in their long deflation, is not encouraging, and her economy remains in the doldrums. In all events, it will be many months before the benefits of the policy show through.

Will interest rates go to zero?

It seems unlikely. The consensus of opinion is that the Bank can begin to print money before rates hit zero. Zero rates also tend to have perverse effects on savers and on bank margins. The markets expect another cut this week. A half percentage point reduction to 0.5 per cent would not be a surprise.

Won't quantitative easing cause inflation?

Yes – and that is the general idea. But Warren Buffett, the world's most successful investor, has warned of "an onslaught of inflation" as a result of current policies.

Short-term, the danger at the moment is deflation – falling prices – rather than runaway inflation. If deflation takes hold, as it did in the UK and US in the early 1930s, and in Japan since 1990, then the chances of pulling the economy out of its tailspin will be small. Inflation will no longer erode the value of debt, exacerbating the credit crunch for some families and companies – who then sell assets and make the crisis worse. So that is why the Bank of England is, unusually, trying to induce inflation.

But what about longer-term inflation?

Quantitative easing has never been tried in these conditions before. It is perfectly possible that, with the best will in the world, the Bank could overdo things, and see the inflation target busted once again, possibly with an unprecedented run on sterling. This would especially be the case if economic growth in markets such as China revives, and with it commodity prices. Then interest rates may have to rise and quantitative easing may be thrown into reverse before the UK economy is fully recovered. We are, as the cliché goes, in uncharted waters – and they are likely to become more treacherous still.