An Idiot’s Guide to Quantitative Easing: What is Quantitative Easing (QE3)?
A funny thing happened on the way to Wall Street. News about the economy was as dark as the ink it was printed with, and yet stock markets vaulted upward. The Federal Reserve had been teasing the stock markets with round three of quantitative easing (QE3), and the noses of the market bulls now flared at the scent of new money.
Bad news was good news because surely it meant that somewhere in the unseen regions of the Federal Reserve’s office building some clerk would soon be getting the go-ahead to start typing numbers into the balance sheets of Federal Reserve banks. With those simple clicks, new money would be created out of nothing — hundreds and hundreds of billions of dollars of new money that would never see a printing press and never look green.
Quantitative easing and stock market bubbles
The economy and the stock markets have been working like a teeter-totter ever since Federal Reserve Chairman, Ben Bernanke, started printing money as a way to save the economy. For the bulls of the stock market, the worst of times (for the first time in U.S. history — maybe world history) has become the best of times because a major fall in the economy means Ben Burn-the-Banky will start pumping money out of nowhere into banks. Those banks will invest the money — much of in the stock markets — so stocks will go up.
Believing banks will become buyers after each round of quantitative easing, smaller investors jump in and buy ahead of the new money. They hope to get ahold of good deals on stocks just before the big investment banks buy large enough quantities to drive the prices up. So, they speculate on whether or not the Fed will engage in quantitative easing in order jump in just ahead of that action and buy before the money drives the price. In so doing, they drive the price up themselves.
Many don’t wish to play in this high-stakes casino, so a small volume of trades by banks that are far too big to fail along with the speculators that run with them like pilot fish on a shark, drive the market upward. But a small volume or narrow base also means the market is a house of cards. When there are not many major players, it only takes trouble with a few to bring the house down.
As a result, the 2012 stock market, which many consider a bullishly good sign of economic recovery, is really nothing more than the worst bubble the world has ever seen — funded far higher by quantitative easing than the housing market that created the dot-com bubble (and subsequent crash in 2000-2001) or the housing market crisis of 2007-2008:
Money was too cheap and too plentiful. [The Fed chairman] caused the stock market bubble and that led to the real estate bubble and the consumer debt bubble. Now those bubbles have burst and what is Ben Bernanke — the current Fed chairman — doing? He’s printing more money. Bernanke couldn’t get a job as a banker. He’s just a printer. That’s all he knows how to do. Print money. There isn’t enough trees to print all of the money Bernanke wants. (Jim Rogers, who saw the economic collapse of 2008 coming in 2006 and made a well-known fortune because of it.)
Quantitative easing is a rocket ride into the unknown
If you don’t understand what quantitative easing is, there are three reasons you should not feel bad. First, you have found “An Idiot’s Guide to Quantitative Easing”
Second, those who are inflicting QE upon us, don’t understand it either. So, you stand in the company of the world’s most elite bankers. What I mean is that you are on the starship Economic Enterprise. Piloting the ship, where Sulu would usually have sat, is Ben Burnthebanky. Our captain Obama has given full control of the ship over to him while he takes to the campaign trail. Ben has ordered Scotty to run the engines at 110% capacity from this point forward, and has assured everyone on board the engines will not blow.
Uncle Ben is taking us to explore strange new worlds of finance by going where no central banker has gone before. Well, Japan tried flying this bizarre route when their economy crashed in 2001, but they never returned. Even without the devastation of a tsunami, it’s questionable whether Japan would have recovered from their earlier economic crash as their path out via QE buried them in debt equal to about 240% of their GDP, which has never done anything but get worse.
Nevertheless, our intrepid Uncle Ben has the quantitative mechanics that drive our “warp engines,” and believes in QE so much he’s announced (repeatedly) a third likely stimulus round (the 110% throttle), even though the first two (unsurprisingly known as QE1 and QE2) have not delivered as much as he promised in the past. But, where there is a one-uh and a two-uh, there must be a three-uh. Quantitative Easing 3 (QE3) was first thought to be on its way in February 2012, then again in early summer and now ready in time for September 2012. The market is chasing a phantom, deeper and deeper into outer space. It is almost like Gentle Ben offers hints of QE to tease the markets upward, offers hints again to tease it upward some more and will only finally deliver when teasing gets to the point of wearing off.
Third, do not feel bad for not understanding what “quantitative easing” is because it is a form of money creation, and even economists speak of monetary “theories” or “theories of money creation,” which indicates perhaps they don’t understand, themselves, how money is created … or, at least, can’t agree on how it should be created. So, they have different theories of how the creation of money actually happens.
I suppose that is why we are on this voyage of discovery — to test some extravagant theories of money creation. And in what better year? 2012, as you know, is a good year for an apocalypse. So, our journey is bound to be interesting from here on out.
The quantum mechanics of quantitative easing
Quantitative easing works by telepathy. The Federal Reserve telegraphs its intent to buy treasuries from the narrow selection of banks that are allowed to buy federal bonds at wholesale. This assures the banks will be willing to buy the treasuries the government wants to sell at low interest because the banks all know the Fed will “repurchase” them at a slight premium if they cannot resell them for more elsewhere. That means the banks cannot lose by buying these bonds once the Fed has said it will buy them from the banks. This telegraphing also tells the stock markets that banks will soon have ship loads of new money to invest when they resell the bonds to the Fed and, so, stimulates the stock markets.
By law, the Federal Reserve cannot do what is call “monetizing the debt.” It cannot buy treasuries directly from the U.S. Treasury. That’s too much like the government buying its own debt by issuing bonds and then printing money to pay them off when they mature. The Fed avoids this on a technicality by enticing banks to buy them first. By becoming the ultimate buyer of those bonds, the Fed enables the U.S. government to keep down the cost of its debt (as issued in treasury bills, notes and bonds) when the bonds are auctioned by the Treasury.
Quantitative easing is working fantastically at keeping a supply of cheap credit available to the government, but that’s not the Fed’s mandate from congress. The Fed’s mandate is to keep the job market healthy while holding down inflation. Obviously quantitative easing is a failure in terms of the Fed’s mandate because jobs did not improve subsequent to QE1 and QE2. The money the Fed created in the banks’ own reserve accounts did not get invested into new U.S. factories or trickle down into jobs.
So, the simple mechanics of how quantitative easing works is this:
- A nation’s central bank announces that it will engage in QE — that it will buy X billions of dollars (euros or whatever the currency of the nation is) from banks.
- The government’s treasury issues long-term bonds to finance the government debt.
- The banks, now knowing the central bank is a ready buyer for those bonds, buy the bonds directly from the government treasury.
- The banks either sell the bonds on the market to individual and corporate investors or sell them to the central bank (Federal Reserve in the case of the United States) at a small premium.
- The central bank then creates a deposit in the reserve accounts of those banks for the amount of bonds it is buying from the banks plus the small premium. The money deposited never existed before. It does not come out of some other account. It is just a batch of very large numbers suddenly created as deposits in the reserve accounts of those banks. (Reserve accounts being money that national banks must by law keep in reserve at the federal Reserve Bank of their region in order to be considered “national” banks.) Instantly, each of those banks are billions of dollars richer. (For more detail on how the Federal Reserve System creates “fiat money,” see “The U.S. Federal Reserve for Dummies.”)
- The central bank then takes possession of the bonds and becomes the government’s bond holder.
In the end, of course, the Fed is still the primary buyer of U.S. debt because the banks would not be buying the bonds in such number if they did not know the Fed was willing to buy any that they were not able to resell to private investors at an attractive profit.
So, you can see that quantitative easing is somewhat of a circus in which the Fed pretends not to be financing U.S. debt directly by putting one step between itself and the government’s issuance of those debt instruments. Because, however, the Fed telegraphs its intentions, it can really be said to be the prime mover here and the primary purchaser of government debt in that everything else happens only because of the Fed’s announcement that it will buy the debt in the end.
“Quantitative easing” is a term coined by Ben Bernanke. What it means is that the Federal Reserve System injects an enormous quantity of new money into the nation’s monetary system in order to ease the flow of credit on the principle that banks with lots of liquid cash are more willing to loan it out.
Quantitative easing, therefore, is another kind of supply-side economics. It puts money into the economy at the top through the biggest banks in the belief that this money will trickle down through the economy and create jobs. The principle belief — which has not panned out too well — is that banks will loan money if they have it to people who need it at lower interest rates. Loans stimulate purchases, which create market, which result in more hired laborers to manufacture goods, etc.
The reason it has not been all that successful in increasing the number of loans is that a populus that was already top-heavy with debt hasn’t taken the bait. (If people had better jobs because stimulus was given in the form of government projects that create actual work, they might have more confidence that they could pay new loans and be more willing to take those loans out. Without a solid employment picture, people are going to be reluctant to buy on credit.)
The high risks of quantitative easing and money printing
Ben Bernanke is the first to use quantitative easing in the United States, but it has been used a great deal elsewhere under different names … and has failed miserably everywhere it has been used. Many economists consider “quantitative easing” a euphemism for a practice that used to be more simply called “printing money” whenever so-called “third-world nations” have used it. So, you ill often hear people saying that Beneficent Ben is printing money.
When said with a bit of a curled lip, it means creating money by decreeing it ito existence, whether it is printed the conventional way on press or simply created as data in bank accounts. “printing money” does not simply mean normal money minting operations (running a press); it means running the presses as fast as you needed to (110% for example). It refers to the attempt by governments to get out of financial difficulty by just printing as much money as they need to pay their obligations. It has NEVER worked for third-world countries in great debt, but we are told it is supposed to work well for large, successful nations like the U.S. and U.K..
Don’t ask why it should work with better results for these once prosperousnations … because you’ll never hear an answer that doesn’t make you feel twice as lost.
The Fed — Bernanke in particular — argues that QE ala Ben is different than old-fashioned “money printing” because the goal is different. Those runty third-world nations tried to do what is called “monetizing debt” or “debt monetization.” They had huge national debts and simply said, “We own the money printing presses. So, let’s create enough money this week to pay off our entire debt.”
To the ignorant, that makes sense because they forget about the “perception” of value that “money” relies on in order to keep working. (See “The Moron’s Guide to Money: What gives money its value?“) Once nations start running the presses at full throttle, the perception of value explodes into a million pieces, and their money becomes worthless in everyone’s eyes because it is no longer regulated by trusted principles, and it takes so much of it to pay off a national debt that its practically blowing around for free in the wind.
The price nations have paid for printing as much money as they wanted has always been self-destruction. Their money was quickly regarded as worthless by the entire world. If such policy were legitimate, all governments should try to create the highest budgets they possible can in order to do everything they want to do and then simply create, right from the beginning, as much money as they need to pay everyone in accomplishing those projects. They should be able to build bridges to the moon. This is also sometimes called “fiat money,” in that the government just decrees that it has as much money as it needs.
Bountiful Ben feels we’re safe from the hyperinflation that money printing causes. After QE1 and QE2, consumer inflation is still at the desired target of about 2%. (But what if the gauge is stuck as I maintain below that it is?)
QE is different than old-fashioned, nutty, third-world money printing, says Ben Bernanke, because the goal is different! The government is not trying to monetize its debt. Apparently it is only inadvertently monetizing its debt. In Ben’s view, the goal is not to provide low interest buyers of government bonds for the U.S. government, but is to keep housing prices from falling and to stimulate job creation in the housing market. (Nevermind that the Fed’s mandate is to keep INFLATION in check, not to prevent DEFLATION.)
The Fed argues that creating jobs by stimulating the housing market fits the job side its dual mandate, so the principle is still intact. How is it true, though, that the Fed is not monetizing the national debt when all the money created by QE is used directly to buy U.S. Treasury bonds that fund long-term government debt? Does creating the money 0ut of thin air for additional reasons, such as stabilizing housing prices, in any way diminish the fact that the Fed has been buying long-term government debt?
So far, the world is accepting this argument because other governments feel they need to do the same thing … and because inflation has not budged. But the notion that inflation has not budged is not entirely true either. Rather, the particular items the Fed is watching have not seen their rate of inflation grow, but many other things have inflated tremendously during this time. The Fed, for example, pretends that you don’t need to heat your house with oil or drive your car with oil. While oil has inflated, the Fed discounts it from its inflation equation because the price of oil is driven so much by speculation that it can’t be trusted as an index to inflation.
But what if the price of oil right now has less to do with speculation than with Fed practices? Oil, after all, is priced all over the world in dollars. So, if dollars are being seen as worth less throughout the world, then the price of oil will certainly inflate.
Who opposes quantitative easing?
Besides me and a few other crusty people, there is Richard Fisher, president of the Federal Reserve Bank of Dallas, who respects Bernanke in tone, but comes right out and says the United States is running ”the risk of being perceived as embarking on the slippery slope of debt monetization.”
Just perceived as monetizing the debt? Are we not actually doing it? And, even if we’re not, remember “perception is everything” when it comes to the value of money that has no intrinsic value. If your money becomes perceived as worthless because of how you’re managing it, then it is worthless.) Fisher goes on to say,
“We know that once a central bank is perceived as targeting government debt yields at a time of persistent budget deficits, concern about debt monetization quickly arises.”
Yes, we know this, AND we are doing it. The U.S., may in part be enjoying exceptionally low interest on its debt because Europe is in worse condition, so money is fleeing to the U.S., but it is also enjoying low interest because banks don’t insist on making a lot of interest from the government if they know that within a day of buying as many bonds as they can, they will be able to resell all of them to the Fed for half a point more than what they put out. It’s free-money press for them.
In the very same speech, Fisher goes on to say,
“The math of this new exercise is readily transparent [yes, like the air from which the money is created!]: The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt. This is risky business. We know that history is littered with the economic carcasses of nations that incorporated this as a regular central bank practice. So how can the decision made last Wednesday be justified?” (“A Bridge to Fiscal Sanity,” a rare Federal Reserve speech by Richard Fisher. The second half, in particular, is well worth reading as a thoughtful expression of the downside risks of Fed QE policy.)
At least, one central banker sees the game for what it is. I’m not just a lone conspiracy theorist for thinking the Fed is primarily assuring the U.S. government of low yields (essentially low interest) on the bonds it issues. Fisher, a Fed board member in the minority, sees quantitative easing the same way I do: the Fed is essentially “printing money” based on nothing in order to buy up the nation’s debt in the form of bonds.
Regardless of its objective, the debt IS what The Fed has been buying with the money. With the Fed now as its ready buyer for long-term bonds, the U.S. government is assured of auctioning all its bonds at very low interest rates. Apparently the Federal Reserve as a whole has decided this is only a bad game if you keep playing it, but what is the end game so that you can stop playing it?
Clearly, this process has created and sustained stock markets that have become addicted to the mega money involved in quantitative easing just as we created* with the housing bubble. That’s why the market now goes up when economic news is bad. It’s the sign of an addict who needs his next hit so badly that he doesn’t mind knocking off his grandmother to assure that he gets his narcotics. The market is almost yearning each day to hear that the country is dying financially so that Benedryl Ben will mainline some cash into the economy.
Stock markets have become obsessed with cash candy, and they cry if the Fed stops giving it. Every day, you hear stock analysts yearning for it and speculating on when it will come. That’s why, to me, the long rally of the Dow-Jones Industrial Average and the Standar and Poor’s 500, which have just about reattained their pre-recession highs, is worse than meaningless. It’s a promise of disaster. Just as the highly inflated housing market could only be sustained by looser and cheaper credit all the time, so today’s stock market is only sustained by accounts of cash created via more and more QE, which like any drug produces less spectacular results with each new hit. So the rallying market is just the biggest of all pyramid schemes.
How will quantitative easing be different this time so that it is not debt monetization?
First of all, with the next round (QE3), the Fed sounds like its going to make a clearer delineation by not using the “new money” to buy bonds, but using it to pay off underwater mortgages. That would certainly be closer to the Fed’s stated goal of making certain housing prices do not deflate. So, I would suspect the next round of quantitative easing won’t be tied directly to national debt, lest the rest of the world wake up to the fact, once and for all, that the U.S. is just monetizing its debt.
The Federal Reserve is likely to step in with $1 trillion worth of easing that could be announced as soon as this month, according to a growing consensus of economists who see the recent uptick in economic growth as unsustainable.
With the Fed’s Open Market Committee set to meet next week, expectations are rising that the languishing housing market will drive the central bank to buy up mortgage-backed securities.
The goal of the purchases will be to drive down interest rates even further from current record-low levels, and, less obviously, to spur confidence that more monetary tools remain to stimulate the economy. (CNBC)
That was in January just before the Fed’s Open Market Committee met, and it didn’t happen. Here we are again at the same juncture. All along, economists and market analysts have speculated that the Fed will do QE3 soon, and that hope alone has kept propping up this low volume rally in the market. (It’s low volume because a lot of the usual players are staying out of this oddly rigged game, suspecting that it’s going to end like the housing bubble did.)
Just a few months ago, market observers speculated that another round of quantitative easing — QE3, in this case — would be politically infeasible and probably unnecessary given hopes for better growth in 2012. But with housing stuck in neutral and a European recession on the horizon, economists believe QE3 is all but certain. (CNBC)
The so-called recovery has been founded on quantitative easing and is dependent on it. Oddly, even the hope of QE3, which has been talked about since January as if it were just around the corner, is sufficient to drive the market up through speculation that it will happen. Maybe this is what Ben had in mind when he said at the beginning of his first term as Fed Chair that he wanted to see more openness in communication. By merely communicating hints of QE, Bernanke has single-handedly driven the market up again and again, so ready are his speculating minions to take their cue.
So, isn’t quantitative easing just a government Ponzi scheme?
What is the justification for continuing to think quantitative easing is creating a recovery that will eventually be self-sustaining, when each round of QE gets bigger because the returns are diminishing and the results are never lasting? Does that not clearly indicate this is just a government Ponzi scheme where the next big round of phony money pays off the investors of the previous round? Clearly, it only props up the old economy up as long as we keep doing it.
Apparently, there is no limit to our efforts to avoid the pain of economic correction. The only appropriate correction under true capitalism would be to let houses fall back to values that can be sustained with solid credit regulations — the kind of credit regulations we had before we started this long ride up the housing roller coaster of sloppy bank deregulation in the Reagan era.
The truth that regular readers The Great Recession Blog know is that we’ve printed money to keep U.S. debt interest down by buying our own bonds as soon as the Chinese and others moved away from our money. The new money hasn’t created hyper-inflation because banks have not been making more loans until just recently and people have not been wanting to take out loans. So, much of the money had not gone into general circulation. It is re-inflating bank balance sheets and being pumped into stocks. Thus, the only inflation we’re seeing from all this new money is the inflation of the stock market, which doesn’t affect prices.
In other words, yes, the usual inflation gauge is simply stuck. Money does not create inflation in the prices of consumer goods if it stagnates or, for other reasons, never makes it into the hands of consumers. What will happens when it finally begins to move into consumer hands now that its already out there? So far, it just seems to be moving around the stock market, bidding up prices of stocks. We still have 10% of all mortgages in the U.S. underwater. We still have millions of foreclosures suppressing the price of homes. We still have the same high unemployment numbers. After two massive rounds of QE, almost none of that mess has been cleared up. The only thing that has happened is the stock market has gone up, and oil has gone up.
The short of all this is that the Federal Reserve cannot bring itself to back away from the Greenspan policies of cheap and easy credit that created this huge bubble in housing prices. We’re addicted to that kind of economy and are not willing to bear the pain of its correction. So, the Fed keeps trying to sustain those higher home prices. Not knowing how to solve the conundrum it is creating, the Fed will start buying up all the bad mortgages for the next round of QE
Is QE3 a “looming fiscal apocalypse?”
At end of this speech quoted above, the president of the Dallas Fed says,
Monetary accommodation, by itself, is not the answer to our current woes. The Fed, as I see it, has taken a leap of faith that our political leaders will forge a sensible budgetary and regulatory path that incentivizes businesses to put to work the money the Fed is printing to invest in creating jobs for American workers while averting what the Stanford historian David Kennedy described in yesterday’s New York Times as “a looming fiscal apocalypse.” …Otherwise, the effect of quantitative easing will, in my view, simply result in financial speculation, further investment in more welcoming quarters abroad and, ultimately, in “super ordinary” inflation.
Yes, it has resulted in further investment in the welcoming quarters of stock exchanges. The best result this particular Federal Reserve president could see was that the second round of quantitative easing would buy congress time to find a better solution. That might have been a worthy reason for engaging in QE, but clearly congress has done nothing with the time. Congress could not agree on anything and defaulted to an automatic series of cuts. The effects of QE2 have long worn off, and now QE3 is continually spoken of in order to buy more time, yet never enacted, lest we all see how poorly this final round actually performs and all the speculation in the stock market pours out, deflating the market. Poor results would cause many to realize that QE has finally run its course. At that point, everyone starts to see the charade for what it is, and everyone runs.
It is hard to see how this is going to fly apart and who will be hurt in the end, just as it was hard to see eactly how the housing bubble would fly part, but it seems certain the present stock bubble will fly apart. The first two rounds QE did nothing to solve our underlying problems. If they were intended to buy the government time, the government failed to note the intent and act upon it. Time is up.
Even this one Fed president quoted above says the best he could hope the rounds of QE would do is buy congress time to find a solution. What will make QE3 any different in that respect? Does congress sound any more ready to work together in the year ahead than it has been?
For further reading about quantitative easing:
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