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 money into the banking system and letting flow through the economy.
Prior to the ’08-’09 Global Financial Crisis, the Federal Reserve’s monetary policy centered around interest rates. To stimulate economic growth, the Fed just had to lower interest rates.
In December of 2008, interest rates basically hit zero. The Fed could not lower rates any further, and had to resort to more extreme strategies.
Their solution? Quantitative easing.
How Quantitative Works
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, and 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.
Increasing the Money Supply
The banks now have extra cash reserves, which they can use to create even more money. A bank “creates money” by making loans to consumers and businesses.
The lending process simultaneously creates a loan and a deposit. Deposits are the numbers you see on your computer screen when you view your bank account balance. They are backed by someone else’s debt, not physical currency. 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 reserve requirement to 10%, banks can hold $10 of deposits for every dollar they hold in reserves. When the Fed sends $1 million of reserves to Morgan Stanley, Morgan Stanley can turn around and create $10 million of new deposits.
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 four problems:
- Asset Bubbles
- Debt Crises
- Wealth Inequality
When banks pump money 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.
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 Global Financial Crisis of 2008-09 (housing).
The central bank and commercial banks can essentially create as much money as they want. Quantitative easing 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 money gets funneled into the wrong asset class, a asset bubble emerges.
In the years leading up to the GFC, 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 money into the system, it often ends up allocated to unproductive assets and companies. Economists call this the “malinvestment problem.” Malinvestments burden the economy and pave the way to recessions.
It is important to understand the nature of credit. Credit refers to the money a debtor borrows from a lender. Credit feels a lot like currency. You can spend it like currency. When your bank account increases by $10, it feels the same as holding a new $10 bill.
But credit is not currency. When credit is created through the lending process, it is backed by debt. The borrower is endowed with new purchasing power, but this purchasing power comes at a cost. The borrower now carries a debt burden equal to his increase in purchasing power. New purchasing power was not created; it was shifted from the future to the present. The borrower must sacrifice future consumption to pay back the full value of his loan, plus an additional payment every year (the interest rate).
Credit creation means debt creation.
The more credit is created, the more purchasing power is pulled from the future into the present. When the future finally arrives, there might not be any purchasing power left. To stay solvent, consumers, businesses, and governments must acquire more and more debt, pulling more and more purchasing power from even further in the future.
This dynamic explains the massive increase in both public and private debt in recent decades.
At some point, public and private borrowers will fail to find lenders willing to support their unquenchable thirst for credit. When the lending stops, borrowers can no longer pay back their loans. Borrowers suddenly default on their debt obligations, and credit starts evaporating from the economy.
Central banks can increase the money supply all they want, but they cannot control where that money goes. 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 with wealth if they solve problems for other economic participants. 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!