Quantitative easing

So the results of the Comprehensive Spending Review (CSR) have now been announced and they are -in the my view – very depressing. I was listening to George Osborne on Radio 4 this morning and essentially his argument is that this has to be done (some – myself included – disagree) and that he doesn’t even need to have a plan B as his plan A is what we need to do. What is available, according to Osborne, is the ability of the Bank of England to use monetary stimulus if growth should suffer as a result of the spending cuts.

Essentially – as far as I’m aware – this refers to the process of Quantitative Easing. I’m not an economist and I have to admit that I don’t fully understand this, but what I gather is that this involves the Bank of England essentially creating money (crediting its account) and then using this money to buy various financial products. The idea then is that there is more liquidity in the markets, things can be bought and sold, and money can make its way out into businesses who can then pay salaries and carry on operating.

One consequence of quantitative easing is that it is likely to result in inflation. At first glance this seems fairly obvious as money has simply been added into the economy, without actually increasing the net value of the economy. What £1 can buy should therefore decrease. It’s probably not as simple as that since it presumably depends on the actual values of the products that the Bank of England has bought in order to get the money out into the marketplace. If they are able, reasonably quickly, to resell these products for a value consistent with what they paid for them, they could then remove this money from the marketplace and everything cancels. Presumably the amount of inflation must depend – to a certain extent – on the difference between the actual realisable value of the products bought by the Bank of England and the amount that they paid for these products.

The net effect of quantitative easing is presumably then that there is more money in the marketplace and so products can be bought and sold and salaries can be paid. However, it will probably result in some amount of inflation, so everyone would presumably effectively be taking a pay cut of – possibly – a few percent. The alternative would be to make a few percent of the working population redundant, so quantitative easing does something reasonably positive, since it could be preventing some unemployment. However, it is clearly not progressive in that everyone sees their salary devalued by the same percentage. Since low income workers probably spend almost all of their disposable income, they are probably more affected by this inflation than high earners who can save some fraction of their income and earn interest.

Presumably an alternative to quantitative easing would be simply to increase tax for a few years. It could amount to the same thing since it would be reducing people’s salary by a few percent, and the money raised would make it into the marketplace through public sector projects or by paying public sector workers. It’s presumably a little safer in that the consequences of quantitative easing could be quite unpredictable, and it could be more progressive in that it could be aimed at the higher earners (of course being progressive doesn’t appear to be high on the current government’s agenda). Essentially, the government has chosen to make massive public sectors cuts – rather than raising money through taxation – and the only mechanism they have for stimulating growth (if it is required) could have the same effect as taxation would have had. Still not obvious that the government’s approach is the only one that makes sense, or maybe I’m completely wrong and don’t understand anything.

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