Past banking crises tell us that for a decent recovery to take place, bad debts must be removed from the balance sheets of banks. The US bank plan is not risk-free, but US authorities seem to be pulling out all the stops to make it work.
The move to 'quantitative easing' and US efforts to remove toxic debt from banks add to confidence of a global economic recovery from later this year and through 2010. These are positive moves for shares.
Past banking crises tell us bad debts must be removed from banks' balance sheets to get a decent recovery. The US bank plan is not risk free, but US authorities seem to be pulling out all the stops to make it work.
As the global financial crisis and associated recession have gone from bad to worse, the worldwide policy response has become more extreme. This has been highlighted with several central banks embarking on 'quantitative easing' and the US authorities at last moving to remove bad or 'toxic' debt from US banks. These moves beg a number of questions: What is quantitative easing? Will it work? What about inflation? Why is it so important to remove bad debt from banks' balance sheets? Will the US Government's latest bank plan work? Will New Zealand need to follow?
What is quantitative easing?
Quantitative easing is a way of increasing money supply. Central banks do this to try and get money pumping around the economy when cutting interest rates isn't working. Most obviously when interest rates are so low they can't be cut any more. It effectively involves printing money and injecting this directly into the economy by buying public and private sector debt. Before he became the Federal Reserve's chairman, Ben Bernanke described the impact of quantitative easing as not very different from dropping dollar bills from a helicopter.
Why use quantitative easing?
Normally a central bank buys and sells government bonds to maintain a target level for its key interest rate. Over time the amount of cash in the economy normally grows in line with nominal GDP. And as the cash circulates it supports measures of broader money supply and credit even though these are multiples of actual cash in the system.
However, the 1930s depression tells us that the combination of falling consumer prices and prices for assets such as shares and property, along with high debt levels can create a downwards spiral where the supply of and demand for credit falls regardless of the level of interest rates. This is called a 'liquidity trap'. The only way for a central bank to fight it is to print money and pump it into the economy.
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