What is Quantitative Easing?

Quantitative Easing allows central banks, such as the U.S. Federal Reserve, to pull the levers of the financial system like never before. Is this strategy effective? Fair? Smart? One thing is certain: it is powerful.

What is Quantitative Easing?

Quantitative Easing (QE) is one of the processes by which the Federal Reserve, and other central banks, create money. The strategy is intended to boost economic growth by injecting credit into the banking system and letting flow through the economy.

First, the Fed buys government bonds, such as Treasurys and mortgage-backed securities, from a “primary dealer.” Primary dealers are big banks such as Wells Fargo, Bank of America, Morgan Stanley, Deutsche Bank.

To pay for these assets, the Fed creates money out of thin air. No physical money printing is required; the majority of modern money only exists on a computer screen anyway. The Fed electronically credits reserves to the primary dealer’s account with the click of a button.

Free Money

If you’re thinking, “wait a minute, it sounds like the government is just funneling free money into the pockets of big banks!” You’re exactly right. The Fed trusts these banks to distribute the money efficiently among consumers and businesses. Moral concerns aside, let’s look at the monetary effects of QE:

Increasing the Money Supply

The banks now have extra cash reserves, which they can use to make purchases or lend to consumers and businesses. Because the economy functions on a fractional reserve banking system, banks can lend out much more cash than they hold in reserves.

For example, if the Fed sets the marginal reserve requirement to 10%, banks can lend out $10 for every $1 they hold in reserves. When the Fed credits $1 billion in reserves to Morgan Stanley, Morgan Stanley can turn around and pump $10 billion into the economy.

When the Fed floods the system with money, consumers and businesses tend to spend more, which boosts economic growth.

Lowering Interest Rates

When engaging in QE, the Fed generates artificial demand for government bonds, which raises bond prices. This forces bond yields to fall (bond prices and bond yields are inversely correlated). Treasury yields function as a benchmark for interest rates across the economy, including the rates consumers pay on credit cards and mortgages.

The Fed wants to decrease yields because interest rates are essentially the price of money. When interest rates fall, it encourages consumers and businesses to take out loans for big-ticket items. This pumps money into the economy, increases consumer spending, and spurs economic activity.

The Downsides of QE

If QE creates so much economic growth, why doesn’t the Fed just continually pump the market with free money?

Unfortunately, free money has serious consequences. History is full of examples of central banks trying to engineer artificial economic growth through money printing. They inevitably run into some combination of the same three problems:

  1. Inflation
  2. Credit Bubbles
  3. Wealth Inequality

Inflation

When a central bank pumps liquidity into the system, every dollar already in circulation decreases in value. People and businesses may feel richer, but ultimately the deteriorating currency eats away their extra purchasing power.

It goes back to the basic principle of scarcity: the more money floating around the system, the less valuable it is. Less valuable money translates to higher costs of goods and services.

Credit Bubbles

An asset bubble occurs when the money funneling into an asset surpasses the economic value that the asset provides. Asset bubbles can occur in any asset class. The most infamous asset bubbles in recent history are the dot-com bubble of the late 1990s (technology stocks) and the Great Financial Crisis of 2008-09 (real estate).

Credit can severely exacerbate the devastation of an asset bubble. In economics, credit refers to the money a debtor borrows from a creditor. Credit allows consumers, businesses, and investors to get their hands on a lot of money in short order, which is great if everyone allocates their money appropriately. However, if all the new credit gets funneled into the wrong asset class, a credit bubble emerges.

For example, in the years leading up to the Great Financial Crisis, consumers took out massive loans to purchase real estate. Investors also took on debt to speculate on housing. Housing prices went through the roof. When borrowers started defaulting on their debt obligations, everything fell apart.

When a central bank injects credit into the system via quantitative easing, the money often ends up allocated to unproductive assets and companies. Economists call this the “malinvestment problem.” Malinvestments burden the economy and create asset bubbles.

Wealth Inequality

Central banks can increase the money supply all they want, but they cannot direct where that money will end up. Unfortunately, the free money often ends up in the pockets of the “haves” rather than the “have nots.”

QE tends to boost asset prices, especially stocks, bonds, and real estate. People typically take this as a sign of economic growth, but rising asset prices do not always contribute to aggregate human flourishing. Large asset owners, such as large corporations and investors, benefit greatly while the lower and middle classes are left in the dust. In this way, QE may contribute to a rising gap between the rich and the poor.

In a free-market economy, businesses should only be rewarded if they provide a useful service to the economy. Central banks skew this system by generating artificial reward through money printing. It may promote growth in the short term, but only at the expense of economic stability over the long term.

Finding a Hedge

Economists will never reach a full consensus on quantitative easing. Without it, we may have experienced more severe recessions, slower growth, and higher unemployment. On the other hand, we may have avoided massive asset bubbles, stabilized our economy, and cultivated human flourishing across every income bracket.

One thing is certain: central banks will never stop meddling in the markets. Wise investors look for a way to hedge against excessive money printing and other central bank catastrophes, just in case the monetary experiments fail. For that, many rely on the world’s oldest and most trusted form of physical money: gold.

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As always, thank you so much for reading – and happy investing!

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