A Licence To… Print Money

According to the ancient and fundamental text of Chinese philosophy, Tao Te Ching, “you govern a kingdom by normal moves; you fight a war by exceptional moves“.

Taoism is not normally associated with the Bank of England, but it has decided that exceptional moves are in order, with its decision to use quantitative easing (also read printing money) in a bid to revive the UK economy.

The Bank has run out of road for interest rate cuts, as the official interest rate is now down to 0.5%, but quantitative easing is arguably the most significant step taken so far in the credit crisis.

It is far more radical than taking large stakes in the several banks or slashing interest rates to an all-time low.

It is unknown territory, with only the warnings of economists and the lessons of history to guide policymakers.

By buying up £75bn in gilts, more if necessary, it is hoped that that the UK’s commercial banks will lend out more.

If lending is the lubricant needed to getting Britain’s stalled economy working again, quantitative easing is pouring oil into an engine by jerrycan.

Without such a bold move, the fear is that deflation will take hold in the UK, as prices fall due to a lack of demand.

One economist told CoreData that if deflation happens and wages are cut, then consumers could decide they will never be able to pay off their debts and will throw in the towel.

If this happens, the already weakened banks will suffer more defaults.

If the banks see more loans turn bad and their asset bases decline, then they will withdraw even more credit from fundamentally sound enterprises, accelerating a disastrous downward spiral.

But quantitative easing is, by its every nature, a hit and miss affair. Hit it, or overdo the easing, and inflation could take off, as money flows the market. Miss it, as Japan did in the 1990s, and the economy stagnates.

Apparently when it has been used before the precise balance has never been found, so there is no guide on how to do this successfully.

The Bank of England is acting boldly; it intends to increase the monetary base of the UK economy by 80% in three months.

In contrast, Japan increased the monetary base by 74% over five years.

Plenty of other questions arise with quantitative easing.

How much will the public debt increase by with quantitative easing?

How much can the public increase by and what will it mean for taxpayers and public spending in the future?

What happens if the money goes to foreign banks?

And what does it mean for pension funds, as lower interest rates will raise their liabilities?

The world is watching.