QE2: life raft or sinking ship?

Can quantitative easing kick-start the economy? Lucy Mair takes a closer look at the Bank of England's controversial money-printing policy

Earlier this month, the Bank of England's (the Bank) monetary policy committee (MPC) voted unanimously to inject £75 billion of new money into the economy in a second round of quantitative easing (QE). The decision came in response to global economic slowdown, the deepening crisis in the eurozone, and fears that the UK could lapse back into another recession. The programme, known as QE2, is intended to stimulate the domestic economy by increasing the amount of money in the banking system, and thereby easing the flow of credit and boosting spending. It follows a dose of £200 billion of QE pumped into the economy between March 2009 and January 2010, which lifted output by 1.5 - 2 per cent.

When the Governor of the Bank, Sir Mervyn King, announced QE2 on October 6, the markets responded positively and the FTSE 100 gained 3.9 per cent, yet the value of the pound fell to a 14-month low and inflation threatened to surge to an all-time high, leaving many people questioning whether QE2 will be able to buoy the economy.

QE is the practice of supplying the economy with extra money to stimulate demand. The Bank creates new money electronically, which is used to purchase government bonds from private financial institutions, including high street banks, insurance companies and pension funds. This step encourages the sellers of government bonds to invest the money they receive from the Bank in riskier financial assets, such as corporate shares and bonds. They can also finance new loans to customers against the increased funding, which boosts cash and credit flow in the economy. The increased demand for bonds from the Bank also pushes interest rates down for business and consumer borrowers. As a result, money flows more easily and cheaply throughout all levels of the economy, which increases confidence and stimulates economic growth.

Mo money mo problems

QE is employed only as an emergency measure because the increase of cash in the economy causes inflation to rise, which devalues savings and pension funds in real terms, and therefore depletes people's spending power. But, according to the Bank, QE2 is justified because there's a shortage of money in the system. And although annual inflation rose to 5.2 per cent in September, the MPC predicts it will fall sharply in the new year, and could even dip below the Bank's two per cent target.

Even though QE has helped the British economy in the past, printing money weakens the value of sterling, which can upset the market by making British exports cheaper, and imports more expensive. There's also a risk that the money injected into the banking system through QE will be channelled into emerging markets, where returns tend to be higher, rather than being invested in domestic assets and lending to British companies. To bridge the gap, Chancellor George Osborne has proposed a policy of "credit easing", in which the Treasury will purchase small companies' corporate bonds to inject funding into struggling businesses.

Three strikes and you're out?

At the most, QE2 is predicted to boost the economy by 0.75 per cent, which the British Chamber of Commerce warns is unlikely to be enough to prevent a double-dip recession. This thought was echoed by Sir Mervyn King, when he commented that the present situation could be the worst financial crisis in history, and by the Centre for Economics and Business Research, which estimates that GDP will remain at a virtual standstill throughout 2012. With the interest rate already set at a historic low of 0.5 per cent, the Bank is reportedly already looking ahead to the possibility of launching QE3 in early 2012, and subsequent rounds of money printing that could push their total injections of cash to keep the British economy afloat up to £400 billion.