Investment special: The zero era

The Bank of England’s latest announcement of quantitative easing, widely referred to as QE2, prompts as many questions as it does answers — particularly for investors and pension-holders. Under a QE regime, money printed out of thin air is used to purchase government bonds from banks and other private sector investors. The theory then has it that long-term interest rates will fall, and banks will have more money to lend to eager borrowers.

There’s just one problem with this cunning plan: it doesn’t work. It did not work in Japan, the first country to flirt with QE. Richard Koo, chief economist of the Nomura Research Institute, calls QE ‘the 21st century’s greatest monetary non-event’. The reason for his scepticism is that we are not in a normal business-cycle recession, in which the central bank reacts to a disorderly economic boom by hiking interest rates to suppress inflation. Businesses retrench, and as inflationary pressure subsides, interest rates are gradually reduced. Instead, we are in what Koo calls a ‘balance-sheet recession’: amid the economic uncertainty of the continuing financial crisis, businesses and households are more keen to pay down debt than to take on more, so it doesn’t really matter how low you make interest rates, because people aren’t really interested in borrowing.

The reason for reintroducing QE is that the Bank of England, like other central banks, is desperate to create economic stimulus, and to support ailing private-sector banks. Policy rates (i.e. the Bank’s base rate, which has been at 0.5 per cent since March 2009) cannot realistically go any lower, so QE is pretty much the last bullet in the monetary arsenal.

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But in Koo’s words, QE with interest rates at zero is like a shopkeeper who cannot sell his store of 100 apples at 100 yen each, so he tries stocking his shelves with 1,000 apples, and when that has no effect, adds another thousand.