A leading economist and writer for the London Daily News George Hatjoulis explains the reasons for "Quantitative easing"  and the severity of the economic crisis on our economy

By George Hatjoullis

The government has responded to the crisis with some very large numbers. The central bank has cut interest rates to very low levels and there is now talk of something called ‘quantitative easing’. What does it all mean and how will it help?

Irrespective of how the crisis started the problem now is a collapse in confidence and high uncertainty. Firms and households respond as prudent individuals. Spending is cut, debt is paid off and savings increased. However, individual prudence spells collective disaster as the prudent behaviour spreads the gloom and precipitates more belt-tightening. A vicious circle ensues which could take us into a protracted depression unless the circle is broken. That is where the government action comes in.

The government is borrowing money which prudent individuals save and is spending it on our behalf. Quantitative easing takes this process one step further as the government, in effect, borrows money from the Bank of England. The BoE is the ultimate creator of money so such a process is often referred to as printing money. In normal circumstances this process is potentially inflationary but right now the risk of deflation is deemed much greater. Either way government spending replaces private spending allowing individual prudence whilst at the same time protecting jobs. Such is the essential logic behind the present government response to the economic crisis.

What about the money given to banks? Well nothing has really been ‘given’ to banks. Bank shares have been bought by the government with some of the money borrowed from us. Money has also been lent to the banks secured on, admittedly questionable, assets (loans made by the banks). The government may also buy some questionable assets directly. Whether the banks have been given anything depends on how you value these assets.

Why have banks been the given so much attention? The banking system constitutes the arterial system of a market economy and credit is the blood it carries. The prospect of banks failing affected everyone. Savers were fearful of losing their savings whilst borrowers simply could not roll over maturing loans. Business thrives on credit and deprived of it jeopardises jobs.

Has the bank crisis been resolved? No, not yet. Bank capital ratios need to be restored to allow more lending. Banks must have a certain amount of capital (essentially shareholder money) for each loan. This can be done in one of two ways. Either more capital is contributed or the bad loans that existing capital is supporting are sold. The bank capital ratios have been reduced because the value of existing loans had to be written down.

 Unfortunately the process of write downs is not over it would appear. As prudent firms and individuals cut back spending and jobs are lost, loan quality deteriorates further requiring more write downs! The length and depth of this recession/depression will depend on how effective all this government and central bank activity proves. Time is also a healer and in the long run things will get better. But as J. M. Keynes, the originator of the ideas behind many of the policy responses, noted, in the long run we are all dead.