Qualitative Easing

While quantitative easing has received much press, qualitative easing has been neglected. Qualitative easing consists in central bank policies that deteriorate the average quality of the assets that it holds. This can occur both with and without quantitative easing. By selling high quality assets (i.e., foreign exchange, government bonds, or gold) to buy low quality assets (i.e., asset backed securities, or granting loans to a tumbling banking system), there may be qualitative easing without an increase of the central banks´ balance sheet (i.e., without quantitative easing). This was the strategy of the FED before the Lehman Brothers collapse in September 2008. When the purchase of low quality assets is not sterilized, there is quantitative and qualitative easing at the same time. This has been the strategy of the ECB during the financial crisis and the FED after Lehman.

Why is the average quality of the assets of a central bank important? It gains importance as it relates to the quality of money represented by the central bank´s balance sheet. This occurs for four main reasons.

First, qualitative easing can be used to stabilize a tumbling financial system, by buying its troubled assets and injecting high quality assets. Of course, the sterilization strategy is limited by the amount of high quality of the assets on the balance sheet. Qualitative easing waters down the average quality of these existing assets. When the high quality assets are exhausted, quantitative easing becomes necessary if the banking system is to be supported further.

Second, besides supporting the banking system internally, central bank assets may be used to defend the currency on the foreign exchange markets. Qualitative easing reduces the average quality of the assets that may be used for this defence in relation to its liabilities, i.e., mainly the monetary base.

Third, in case of a monetary reform or a break down of the financial system, the quality of the assets of a central bank in relation to its liabilities restrains the value of a new currency.

Fourth, low quality assets may lead to losses for a central bank and finally to balance sheet insolvency. In this case, a recapitalization of the central bank involving higher public debt and, eventually, debt monetization becomes likely.

Out of these four main reasons a deterioration of the average quality of the assets of a central bank may lead to, at time sudden, losses of confidence and purchasing power.

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