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Qualitative Easing and the Crisis - Iceland Cometh?

12/09/2009

Drastic times call for drastic measures. The current crisis has brought global central banks to their knees. Interest rates have been lowered to zero, or nearly so, in a concerted attempt to stimulate investment and consumption spending. The effect has been minimal.

While quantitative easing - the method central bankers employ to lower interest rates - has received much press coverage there remains a more salient, if latent, monetary policy going overlooked. As Philipp Bagus and I have outlined in a recent Economic Affairs article, the current crisis response has seen a high degree of qualitative easing to mitigate liquidity pressures. Central banks, especially the ECB and the Fed, have purchased low quality, typically subprime, debt from the private banking sector. The result has been a marginally improved situation for private banks as the average quality of their assets, and hence their value and liquidity, has been improved. As there is no such thing as a free lunch, it should come as no surprise that the central banks' balance sheets have commensurately deteriorated.

Central bank leverage - the use of debt to finance its operations - has increased significantly. The ECB's equity ratio, the amount of equity available to cushion any losses suffered on asset prices, has varied throughout the year between 11 and 14 percent. Effectively, a 14 percent loss on its assets would bring the ECB to insolvency.

The Fed is not much better off. Over 43 percent of its assets are now loans to Freddie Mac and Fannie Mae, or loans secured by them. How would you feel if your personal bank shouldered such an over-weighted, and risky, loan portfolio?

When central banks ran out of high quality assets to exchange with the banking sector the period of quantitative easing commenced. We now find banks awash in liquidity and reserves, with the contingent possibility of excessive inflation should these stop being held and loaned to the business community. The quantitative and qualitative easing policies were easy to enact. We have much less faith that these same central bankers will be able to unwind them in a timely manner when the time arises.

Central bankers have pursued extreme policies during the current crisis, with little positive effects. More worrisome is the fact that they are now placed in precarious financial positions, with relatively small loses exposing them as insolvent. If you thought a reckless central bank was difficult enough to live with, wait until you see one go bust (as Iceland recently did).

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Contact David Howden

David Howden is Chair of the Department of Business and Economics and professor of economics at St. Louis University's Madrid Campus.

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