While quantitative easing has received much press, qualitative easing has been neglected. Qualitative easing consists of policies that deteriorate the average quality of the assets that a central bank 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 bank´s balance sheet (i.e., without quantitative easing). This was the strategy of the Fed before Lehman Brothers collapsed in September 2008. When the purchase of low quality assets is not sterilised, 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? There are four main reasons.
First, qualitative easing can be used to stabilise a tumbling financial system, by buying its troubled assets and injecting high quality assets. Of course, the sterilisation strategy is limited by the amount of high quality assets on the balance sheet. Qualitative easing waters down the average quality of these existing assets. When 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 central bank liabilities – mainly the monetary base.
Third, in the 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 constrains the value of a newly issued currency.
Fourth, low quality assets may lead to losses for a central bank and finally to balance sheet insolvency. In this case, a recapitalisation of the central bank involving higher public debt and, eventually, debt monetisation becomes likely.
The authors analyse the qualitative easing of the European Central Bank and its possible consequences in the December 2009 edition of Economic Affairs.