By Parush Arora
Crisis drives innovation and creativity. The Great Depression, unarguably one of the biggest crises in economic history, lead to the emergence of Keynes and his conventional monetary tools. Post recession, there was an increase in money supply and decrease in interest rates so as to increase lending, spending and investment.
Quantitative easing: Healing the unconventional way
The housing bubble in the US burst in 2008, freezing the credit market worldwide. This lead to major changes in the developed economies. The banks were reluctant to spend and limited their lending in wake of the poor performance of the economy.
After 2008, the conventional tools turned out to be ineffective owing to the nature of the crisis.
This lead to the emergence of unconventional tools like ‘quantitative easing’. In quantitative easing, the central bank purchases securities and bonds from the public in exchange of newly generated currency.
This includes government bonds. Through this, nominal interest rates, which do not take into account inflation, can be pushed to zero, or even negative. Thus, quantitative easing makes it cheap for the people to borrow money.
Post crisis, the interest rates in the US were as low as 0.25%. Low interest rates incentivised the banks and the hedge funds to invest in riskier assets that offered higher returns. The cost of borrowing was low and the standard monetary policies was ineffective. This made it profitable for the firms to borrow more and use the extra cash to amplify their investments. The Fed implemented quantitative easing by buying financial assets, raising the bond prices and decreasing their yields. These steps ensured that these assets are available to the public at cheaper interest rates.
Greece and the Union: Revival too unrealistic, damage control important
As recession hit the financial markets, the world economy faced a distorted flow of credit. Countries like Greece got stuck in the debt trap. Hence, they could not honor their loans. Its lenders could not tackle their own expenditures and defaulted as well . This ignited a chain reaction leading to the Euro crisis. The European Central Bank(ECB) reacted decisively by staying consistent with its mandate of maintaining price stability over the medium term. In view of rapidly receding inflationary pressures, the policy rate was cut by 325 basis points and stood at 1% through quantitative easing.
Though a complete revival remains distant, these measures will prevent the European economies from falling into another crisis.
Weighing the demerits: Quantitative easing skewed?
Decreasing the interest rates through quantitative easing increases exchange rates. This depreciates the domestic currency and initiates growth through increased exports. If all the countries start following the same procedure, this might become a game of stealing growth from each other in order to stabilise their own economy.
[su_pullquote]The biggest criticism of this policy is that it penalises the savers.[/su_pullquote]
This could be one reason why quantitative easing is recently becoming popular among the developed nations. The biggest criticism of this policy is that it penalises the savers. This is because the incentive to save disappears with a massive reduction in the interest rates.
This further dents investment. The economy risks ending up in a vicious circle. Given the lack of benchmarks to effectively judge low interest rate policies, it is difficult to predict the future of the developed nations and the stability in the world economy.
Featured Image Courtesy: 1350 KMAN
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