How Does It Work?

9th January 2009 - How does it work?

The diary entry of two days ago "Stopping the recession" was about putting more money into the economy by way of the central bank. How actually does this work? The central bank increases the size of individual banks’ accounts at the central bank. These accounts are called "reserves". The mechanic of quantitative easing is that the banks build up excess reserves. If banks swap their securities for part of these reserves, the size of their own balance sheet shrinks and as a counterparty, the balance sheet of the central bank increases. With an improved balance sheet, individual banks will then start lending to end borrowers and so put liquidity into the system. In theory at a later date when things have improved (and cynics might say when rampant inflation has set in), reverse quantitative easing is possible by the central bank selling the excess assets which sucks money out of the economy. In theory.

Germany is beginning to recant. The central government is taking a 25% stake in Commerzbank, the second largest bank in Germany, in return for injecting 18bn euros. In practice this is more than a part-nationalisation of one bank because Commerzbank has itself just taken over its hitherto rival Dresdner. Martin Blessing of Commerzbank said "We are weatherproofing our bank for an economically stormy environment". So that’s ok then.

Meantime, back over the pond, the President-elect is seeking approval from Congress for a stimulus package worth (wait for it) up to $1.2 trillion. This is the first time the word "trillion" has appeared in this diary which must indicate something!