How Quantitative Easing Works

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Most of the money in our economy is created by banks when they make loans. But in the aftermath of the financial crisis, banks stopped lending, and so stopped creating new money. 

At the same time, people were still repaying their loans, meaning money was being ‘destroyed‘ and the total amount of money in the economy was shrinking. To counter this and to ‘replace’ the money that banks were destroying, the Bank of England created £375 billion of new money through a scheme called Quantitative Easing (QE). As the Governor of the Bank of England said at the time:

“[A] damaged banking system means that today banks aren’t creating enough money. We have to do it for them.”

- Sir Mervyn King, then-Governor of the Bank of England, speaking in 2012

How does Quantitative Easing work? 

In the press, QE was generally presented as “The Bank of England prints money and lends this to banks so that they can increase their lending into the economy”, but this is completely inaccurate.

In reality, through QE the Bank of England purchased financial assets – almost exclusively government bonds – from pension funds and insurance companies. It paid for these bonds by creating new central bank reserves – the type of money that bank use to pay each other. The pension funds would sell the bonds to the Bank of England and in exchange, they would receive deposits (money) in an account at one of the major banks, say RBS. RBS would end up with the new deposit (a liability from it to the pension fund), and a new asset – central bank reserves at the Bank of England.

Quantitative Easing therefore simultaneously increased a) the amount of central bank money, which is used in the system that banks use to pay each other, and b) the amount of commercial bank money (deposits in the bank accounts of people and companies). Only the deposits can actually be spent in the real economy, as central bank reserves are just for internal use between banks and the Bank of England.

(See the further reading section below for a more in-depth explanation of the process).

Why was Quantitative Easing ineffective in boosting GDP?

The problem was that the money created through QE was used to buy government bonds from the financial markets (pension funds and insurance companies). The newly created money therefore went directly into the financial markets, boosting bond and stock markets nearly to their highest level in history. The Bank of England itself estimates that QE boosted bond and share prices by around 20% (Source). In theory, this should make people feel wealthier so that they spend more. However, 40% of the stock market is owned by the wealthiest 5% of the population, so while most families saw no benefit from Quantitative Easing, the richest 5% of households would have each been up to £128,000 better off (according to Strategic Quantitative Easing, p28, by the New Economics Foundation).

Very little of the money created through QE boosted the real (non-financial) economy. The Bank of England estimates that the £375 billion of QE led to 1.5-2% growth in GDP. In other words, through QE it takes £375 billion of new money just to create £23-28bn billion of extra spending in the real economy. It’s incredibly ineffective, because it relies on boosting the wealth of the already-wealthy and hoping that they increase their spending. In other words, it relies on a ‘trickle down’ theory of wealth.

A far more effective way to boost the economy would have been for the Bank of England to create money, grant it directly to the government, and allow the government to spend it directly into the real economy. This is the approach we have advocated in our paper “Sovereign Money: Paving the Way for a Sustainable Recovery“, and pound for pound of stimulus, it would be many times more effective than Quantitative Easing.

Further Reading

 

Bank of England: Quantitative Easing

Cover - Quarterly Bulletin 2009 Q2 This 8 page paper from the Bank of England is extremely clear on the mechanics of QE and how the Bank of England expected it to have an effect on spending in the real economy.


New Economics Foundation: Strategic Quantitative Easing

NEF Strategic QE Cover
This recent paper from the New Economics Foundation gives more technical detail on how QE was implemented, and assesses how effective it really was. It then proposes a way to redirect the QE money into the real economy. Download here

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  • Richard

    i get the desired future state… A democratic body that controls the creation of money for the benefit of the majority. BUT how do we transform the current process. What steps are to be taken and how painful will it be?

  • JeffMowatt


    So, we invented three trillion dollars, lent it to ourselves, and are
    trying to salvage a broken system so far by reestablishing the broken
    system with imaginary money.” http://www.p-ced.com/1/projects/ukraine/sumy/iscs2009/

  • Peterm

    Yes I agree that it would be better to spend money into the economy. But QE, in the sense of swapping money in the form of bonds for money in the form of cash, contrary to popular opinion, is not spending money at all.

    Its just moving money at the Fed or BoE from one account to another. It makes stuff all difference to the economy, or the lending practices of banks.

    If its about swapping bad securites for cash, that’s different. That’s like giving the banks money for old rope. Or rotten useless rope!

    I do suspect that’s what’s really behind it all.

    • ianb

      I’ve heard it said that the Fed is buying bonds AND ‘toxic’ CDOs but as far as I know the BofE is sticking to bonds only. It struck me at the time as significant – an admission as you say that the Fed is doling out money for old rope – or worse, hugely rewarding potentially criminal activity, textbook moral hazard. Sadly I couldn’t find confirmation but perhaps someone here could help with that?.

    • Bob

      Thank you, this was my thinking but I was getting confused by the fed purchasing toxic assets.

  • Dylan

    So, when the Bank of England purchases government bonds via QE from let`s say pension funds and insurance companies, new money is created.
    Here`s the rub though, those private institutions had to originally purchase those bonds from the Government. The BOE is merely reimbursing them, though making their assets liquid. The real money creation is still being passed onto the government.
    There must be some incentive for these private institutions to purchase these bonds and then get reimbursed, perhaps they sell the bonds at a tidy profit. What`s to stop this process going on indefinitely? Is this not effectively the same as the original open market operations, just gone covert?

    • Dylan

      The situation is further compounded when you have, let`s say, a commercial bank such as Barclays, purchasing a bond from these pension funds and insurance companies and then the BOE purchases the same bond through QE from Barclays. Because commercial banks can also create money when they purchase assets in addition to the BOE, the money for the bond has been created twice!

  • Jake Stevens

    Quantitative Easing is like the Democratic Party of economic policies. It’s not anywhere close to the ideal, but it’s a lot better than the only politically feasible alternative – doing nothing.

  • george

    QE is feed the rich. This creation of money has funded the rise of stock prices. Share price inflation. Share prices do not reflect their underlying real value. And most stock is in the hands of the wealthiest 5%. It has also found its way into the property market but only to the wealthiest 5%. This has also created house price inflation. House prices are now even more unaffordable than ever before. This QE would have been better spent on either boosting the average persons income or on reducing the deficit.

  • Gordon Stewart

    if you drop all the doublespeak you are left with this……Q E is counterfeiting plain and simple and if its bad for me to do it, it cannot be good for others to.

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