Imagine a bank that looks like this (simplified for my benefit as much as anything else!):

It has £100,000 of money on deposit. According to banking rules, each bank is allowed to loan out 90% of the money it holds on deposit. Or to put it another way it must keep 10% of the money it holds as customer deposits in cash reserves. Most people don’t need their money as cold hard cash but banks keep this amount for those that do. The rest can be given out to loan customers (at an interest rate of course).

The bank also may own other assets such as Government bonds or property. It cannot loan a percentage of these assets though they make up the accounts of the bank.

Quantitative easing to my knowledge purchases these assets from the banks for cash. The Bank of England twists a few dials in its big Computer Cash machine creating for itself, say £50,000 extra cash. It passes this £50,000 to Bank A in exchange for £50,000 worth of its assets.

The Bank of England now own the assets and Bank A now has £50,000 more of cash reserves. This means if it wants, under the 90% cash reserves rule – it only needs to hold 10% of this (£5,000), the rest it can loan out to you and I for car loans, mortgages or a wee wad of cash to get that Llama farm started you always thought of. The amount of cash in the economy should then increase by £45,000 through the purchases made by those taking out the loans. But better than that, imagine if this £45,000 goes directly to you when someone purchases that 1 bedroom flat you have just sold.

Assuming you are already living somewhere else and decide not to pay off the mortgage that money will probably end up in Bank B or Bank C (as an independent financial adviser I go for Bank B). This new bank on receipt of your deposits can now do what Bank A has done with its extra cash… it can loan out 90% of the £45,000 you just gave it as a deposit. 90% x £45,000 = £40,500 money available to be loaned out from this new bank deposit to some other friend of yours to purchase their first gold laminated dustbin or to set up an ethical business in the developing world. (Money is just the opportunity, it has no taste or ethics of its own). Can you see how the picture develops ? The money supply “expands”

However.

The banks may not decide to loan out the cash. It remains only a potential increase in the amount of cash swilling around. The bank could just hold it in its reserves. This is the risk, this is the experiment.

Vox O’Malley – also a Financial Adviser HERE and developing an ethical investment site HERE

So, here is what seems to be happening in my best layman’s terms. The businesses in our economy are not selling enough stuff because we are not buying enough stuff.

The businesses are not making enough profits and some are even making a loss therefore they decide to cut their costs which in some cases results in making people redundant. Those businesses then cut costs and increase their profit but the income normally received by the people made redundant is no longer out there being spent on other businesses.

The economy as a whole shrinks – businesses don’t want to take on new staff, develop new things for us to buy or take risks with new ventures. Ordinary people are nervous about their jobs and future income and so keep their money rather than spend it, further reducing the likelihood of stuff being made and sold.

Banks, who normally create more money by lending money to us at various interest rates through mortgages or personal loans, are nervous about the level of “bad debt” they own. To counteract this bad debt they want to keep as much good money on their accounts (in the form of our savings and deposits) and are extra nervous about creating any more bad debt by lending to people like you and me.

But the economy and the businesses which support our income and fill the government vaults with taxes need us to purchase their goods and services. So the Bank of England has dropped their interest rate consistently to help pump more cash into our hands. Anyone with a mortgage linked to this rate will have seen some extra cash in their bank account over the last period. Perhaps we have used this to buy more iPods, food or holidays but equally we might have just put it back in the banks as savings or paid off more of our mortgage debt. So, some of the rate drop “works” by increasing the purchasing of stuff but in other cases it just stays in bank accounts or reduces our personal mortgage debt. If these rate drops don’t do enough then the Bank needs to come up with additional options to get cash swilling around in the economy – getting more money to us in such a way as to make us feel “flush” enough to spend on the goods & services our businesses want to sell.

So the latest trick is “Quantitative Easing”… dealt with in part 2