Show Me the Money!
Liquidity, Quantitative Easing and Whereabouts
Where is all the liquidity that Central Banks (CBs) in the world pumped into the economy since the Great Financial Crisis?
It is an issue that both non-specialists and economists have raised some years ago and that sees a revival, in particular after the Covid-19 crisis has started. Experts tried to give a possible explanation to this problem and it seems that they managed to find a plausible explanation.
After the 2007/2009 crisis, the Federal Reserve, the European Central Bank and many other central banks started the so-called “Quantitative Easing” (QE) programmes.
Quantitative Easing
QE is defined as a non-conventional monetary policy tool, because it is an alternative strategy to the standard control of short-term interest rates as policy instrument. To put it simply, CBs buy assets in the economy such as bonds, corporate bonds, asset-backed securities, etc. and these purchases enable CBs to keep long-term interest rates low for an extended period of time. This practise signals to the private sector — namely, investors — what it is likely to happen in the future and, therefore, it reduces the uncertainty about future costs that an investor might face due to unexpected increases in interest rates. Hence, the ultimate aim of CBs is to incentivise investments by making borrowing less costly and by alleviating insecurity about future costs of funding. As a result of these QE programmes, a huge amount of liquidity entered into the economy.
The mainstream view is that such measures have helped to tackle the effects of the Great Financial Crisis and the European Sovereign Debt Crisis in 2012. However, the programmes seem not to be as successful as they should have. In fact, an increase in the inflation rate was expected as an increase in lending by part of commercial banks. Neither of the two happened. Firstly because commercial banks absorbed almost all the new liquidity provided by CBs as reserves and therefore it basically never entered into the real economy, as shown by the difference in growth of the monetary base M0 — which is the money printed by CBs — and M2 — which is the money that circulates in the economy (data are for the U.S. but the picture is similar in many countries).
A second cause is the (almost) zero inflation rate: people know that a dollar today will have (almost) the same purchasing power of a dollar next year and as a consequence, private agents are willing to hold more money for the same level of interest rate — a situation known as “liquidity trap”.
Thus, commercial banks do not lend to people and people do not spend their money. These are, apparently, the main reasons why we do not observe inflation and why money circulating in the economy does not increase as CBs want. The Covid-19 crisis has worsened this process.
Conclusion
To sum things up, an enormous amount of liquidity is provided by Central Banks that however is stored in banks’ reserves and that is held by people in banking accounts. As a consequence, this money does not enter into the real economy and the effect is that economic activity had a hard time in advancing, remaining in a situation of stagnation.
A way out? What about the NextGenerationEu…
