Why does the Bank of England keep printing more money?

Over the last three years an extra £375billion has been pumped into the economy, but things keep getting worse.

Our economy is on its knees. We are in the first double dip recession since the 1970s and it looks like growth is going to remain fairly lacklustre for the rest of the year, so will the Bank of England’s (BOE) latest bout of quantitative easing (QE) be enough to stimulate the economy?

The signs don’t look good. Since the BOE first embarked on QE in March 2009 the economy has barely grown and the number of people claiming unemployment has actually risen. So why did the Bank of England bother with pumping another £50billion into the UK’s financial system, when it seems like the return on the £325billion of QE they had done before this didn’t lead to much to bang for the Bank’s buck?

So what are they trying to do?

To answer this question we need to find out what QE is. The way some of the politicians describe QE you would think that the Bank prints more money, which then goes directly into the average Joe’s pocket. This is NOT what QE is.

QE essentially gives money to banks. “Don’t banks get enough money already?” I hear people cry. Banker bashing is turning into a bit of a national past-time in the UK, especially with the Barclay’s Libor-fixing furore; so does more QE add fuel to the fire?

Yes and no. Although the Bank of England is considered the “captain” of the economy, tasked with steering the UK economy through the good times and the bad times, its tools to do this are limited. If we stretch the shipping analogy a little further, then the UK economy is the middle of the perfect storm.

First there was the financial crisis and the implosion of the US housing market in 2007/08, then there was the sovereign debt crisis in Europe that continues to rage. Added to that the myth of an end to “boom and bust” economics in the UK that was perpetuated by former PM Gordon Brown, meant that we saved nothing in the good times and instead spent like crazy and now have to embark on a harsh austerity programme that is denting our own growth. The UK economy is up the creek without a paddle, and there is only so much the Bank of England can do.

It has already cut interest rates to a record low of 0.5%, which still hasn’t helped us out of this mess. The other way it can try and boost the economy is to try and get banks’ lending again.

The basis for more “stimulative” monetary policy is that people will invest in upgrading their businesses or starting new ones if credit is: 1) cheap and 2) plentiful.

This creates wealth, jobs and hopefully consumer spending that can boost growth down the road – in theory. These are the conditions that the Bank of England is trying to create with more QE. However, something funny is going on: Ever more money is being pumped to the banks so it trickles down to the “real” economy, not just the virtual economy of the financial markets. But this is not happening.

The latest Bank of England data on credit conditions in the UK paints a bleak picture. The total number of loans extended by banks to UK businesses in May fell by 1.7%. Other ways to raise finance, like offering bonds in the capital markets, have picked up slightly since the start of this year, but not by enough to negate the consequences of tight bank lending conditions. Consumer credit is slightly better, its annual growth rate in May was 2.4%, but this is still much lower than the 6.4% annual growth rate back in 2008.

Why isn’t it working?

So why isn’t the money flowing down to the businesses that need it? This is where it is easy to blame bankers, but to do so would not be entirely fair. Banks like lending – especially if they can borrow at cheap rates and lend at higher rates.

However, in this environment demand for lending is also weak. When confidence is low and people are worried about losing their jobs or not getting enough orders in to keep their business afloat for the next six months, they are unlikely to want to expand or borrow money if they don’t think they can pay it back.

So part of the reason that QE doesn’t work is because people don’t actually want to borrow.

The other reason is that banks have been faced with a wave of new regulation in recent years and being urged to hold large amounts of cash - called capital buffers - to protect them in case the economy gets even worse or the eurozone sovereign debt crisis deteriorates further.

While the Government is urging banks to lend, the regulators are telling them to be cautious and build up a tsunami-resistant rainy-day fund. Thus, banks are only going to lend to the highest quality borrowers in this environment, and when lending standards are tightened and bank managers’ risk aversion levels are high, this doesn’t help the economy.

What’s QE actually doing then?

If these extra billions aren’t flowing into the real economy they must be stuck in the “virtual financial economy” I mentioned above.

This economy is the world of stocks, bonds and commodities. Cash from QE is thought to seep into these markets propping up oil, stocks and bond prices rather than benefitting the “real” economy.

Since reaching a low in March 2009, the S&P 500 stock index in the US has more than doubled in value. The FTSE 100 is also 60% higher and UK Gilts – Government bonds – have seen their price rise by a third. Commodities have also benefited, with oil, gold and agricultural prices tending to rise when more QE is pumped into the economy.

If you are a stock or bond investor and you have your money in these markets then QE has been great for you. For everyone else they have seen QE erode their income even more by pushing up commodity prices.

With or without the latest injection of QE from the Bank, it’s unlikely to help the UK economy any time soon.