Blog

Peak Prosperity

Quantitative Easing - Crash Course Chapter 10

What exactly is this process that the world is betting on?
Friday, August 22, 2014, 8:34 PM

Chapter 10 of the Crash Course is now publicly available and ready for watching below.

Here in 2014, the developed world is currently in the middle of the largest monetary experiment in all of history, one that spans the globe.

This is very important because when you strip away a lot of economic gobbled-gook, money is really a social contract.  We agree that it has value, but otherwise it is backed by nothing more substantial than that; our mutual agreement.

Given this context, we should view money printing as really more of a social experiment than a sophisticated monetary practice.

And so we're going to study it here as such because, when a nation’s money system breaks down, society as a whole is impacted. Commerce is heavily disrupted, shelves are cleared, careers are ruined, and the future is badly diminished.

At the exponential pace at which the Fed is increasing the money supply, and knowing the huge challenges the Fed – and most other world central banks  - face in trying to stop or even slow down their money printing, the potential for a disruptive global inflationary period is very real.

So what exactly is quantitative easing

For the best viewing experience, watch the above video in hi-definition (HD) and in expanded screen mode

Coming next Friday: Chapter 11: Inflation

For those who simply don't want to wait until the end of the year to view the entire new series, you can indulge your binge-watching craving by enrolling to PeakProsperity.com. The entire full new series, all 27 chapters of it, is available -- now-- to our enrolled users.

The full suite of chapters in this new Crash Course series can be found at www.peakprosperity.com/crashcourse

And for those who have yet to view it, be sure to watch the 'Accelerated' Crash Course -- the under-1-hour condensation of the new 4.5-hour series. It's a great vehicle for introducing new eyes to this material.

Transcript: 

Welcome to this chapter on Quantitative Easing, or “QE”.

Here in 2014, the developed world is currently in the middle of the largest monetary experiment in all of history, one that spans the globe.

This is very important because when you strip away a lot of economic gobbled-gook, money is really a social contract.  We agree that it has value, but otherwise it is backed by nothing more substantial than that; our mutual agreement.

Given this context, we should view money printing as really more of a social experiment than a sophisticated monetary practice.

And so we're going to study it here as such because, when a nation’s money system breaks down, society as a whole is impacted. Commerce is heavily disrupted, shelves are cleared, careers are ruined, and the future is badly diminished.

So what exactly is quantitative easing?  It's money printing, simple as that. 

However, today we don't actually print all that much physical cash. So when I say ‘money’ being printed, don't think of big stacks of one hundred dollar bills; think instead of digital ones and zeros - mainly a lot of zeros - showing up on electronic ledgers.

We discussed QE briefly in the chapter on the Fed, but here we’ll go into it in more detail.

Again, the way the Fed creates money is simply by creating an accounting entry that says the money exists.  Imagine if one day you woke up, checked your bank account, and found a billion dollars in it.

Looking into it, you discovered that the Fed had deposited that money there last night.

This money would be very real to you and would completely change your financial circumstances.  You could spend it just the same as if you had earned it over sixty-six thousand three hundred and thirteen years working at the current minimum wage of $7.25 per hour and saving every dime.

But where did the Fed get that billion dollars?  What did it do to earn that money?

This quote tells the tale.

Let me highlight that last line...

"When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn.  When the Federal Reserve writes a check, it is creating money."

In our example, the Fed simply created money when it sent it to you.  Tap - tap - tap...a few keys were clicked on a keyboard and - voila! – your billion dollars was created and deposited in your account.

At the end of 2013, this process was being used to the tune of $85 billion dollars per month, only that money was not going into your account, not unless you were a very large financial institution.

The Fed creates that money when it buys either Treasury bonds or mortgage-backed securities, which is what “MBS” stands for.

The mechanism is easy to explain.  Say the Fed wants to buy $40 billion of Treasury notes.  First, it will under the Fed, announce to the market, which means the big banks who play in this game, that it wants to buy $40 billion of Treasury bonds and the price range it is willing to pay.

A variety of banks will then offer up the specific bonds at specific prices and the Fed chooses which among them to actually buy and then buys them.

These bonds are now assets on the Fed’s books. So if we were to take a look at the Fed balance sheet we should see it growing by leaps and bounds over the past few years.

Indeed that's exactly what we see.

The Fed’s balance sheet is now nearly $ 4 trillion in size, and every single one of the dollars represented by that $4 trillion number was literally printed, or mouse clicked into existence, out of thin air.

Now to really make the point that these are extraordinary and unusual times, I shall point out that the Fed’s balance sheet was only some $880 billion before the economic crisis struck in 2008.

That is, to grease every economic transaction throughout the nation's entire history up until 2008 required the cumulative injection of $880 billion of circulating base money that the banks could use to lend out via fractional reserve banking.

But since 2008, an additional $3 trillion has been created by the Federal Reserve and injected into the system.

So where did all that newly created money go?  Well, we should be able to detect it if we look at a chart of circulating money in our system known as 'base money.' 

And, yep, that's exactly what we see. 

This additional $3 trillion has found its way into various corners and crevices of the financial universe, but the majority of it, around $2.3 trillion is parked right back at the Fed in the form of something called excess reserves.

Recall, banks keep some money in reserve when they make a loan out of deposits and if they keep more than is required that money is called an excess reserve.

So this chart tells us that the Fed has been pumping money into the financial system but the majority of that money has not been made available to Main Street in the form of new loans.  Instead it has been idly parked at the Fed earning 0.25% interest.

But this still leaves us with some $700 to $800 billion that has not been parked in the form of excess reserves

Which is out there bidding up stocks, bonds and real estate, mainly due to large institutions buying up vast quantities of all three asset classes using money the Fed printed out of thin air.

This chart showing the relationship between the S&P 500 and Fed printing tells the tale.  It's a safe prediction to make that the US stock market will fall, and fall a lot, if the Fed suddenly stopped printing up money.  The stock market is now hooked on this artificial stimulus.

So, how long can this money printing continue? At some point, it needs to stop, right? I mean, we’ll destroy the value of the dollar if we print too many of them. Right?

The answer to this is “yes”. But it’s a lot easier to say than to do.

A huge and poorly understood concern is that this freshly-printed money, once created, is going to be very very difficult to retrieve should that be necessary.

You see, quantitative easing works really well when the money is going out the Fed's front door, but it's not going to work very well in reverse.

In fact it may be impossible without crashing the stock and bond markets -- creating all sorts of difficulties for both the Fed and our leaders in Washington DC.

Here's why.

When the Fed is out there buying a huge proportion of something, say Treasury bonds, the price of that asset class is driven up in the marketplace by the demand being artificially created by the Fed.

That's just Economics 101.

Because the Fed pre-announces its asset purchases, the folks it buys these assets from have a huge advantage. Here’s why.

When the Fed announces it plans to buy a bunch of Treasury bonds, the banks rush out and buy them first. This is called “front running”, Then the banks turn around and sell these very same Treasury bonds to the Fed at a higher price than they bought them for, allowing them to pocket fat profits. Pretty sweet deal, huh?

Everyone is happy playing this game. Show US government enjoys a strong market for its debt, plus gets ultra low interest rates as part of the deal. The banks make big money with no risk. And the Fed gets lots of freshly printed money out into the system further driving down interest rates – which boosts the bond market, the stock market and housing prices.

That's a win, win, win situation right there. In this scenario, everyone loves the Fed and its magic checkbook, which makes all these popular results possible.  Well, at least everyone in power that can skim easy profits from the system.

But now let's try running that process in reverse. What happens when the Fed decides it’s time to stop flooding the world with free money, and instead attempts to reduce the money supply?

Where the Fed was buying Treasury bonds from the banks at a profit to the banks, when the Fed turns around to sell these same assets back to them, the reverse will, by definition, be true – meaning the banks will be buying Treasury bonds that are falling price, not rising.

The Fed will be demanding money from the banks and  in return, will be giving them bonds that it is flooding the market with. Prices in a flooded market only head one direction: downwards.

And at the same time, the US government will still be selling plenty of new bonds into the market. Only now, the Fed won't be there buying them. 

What does this mean? It means that the new bonds from the government, plus the new ones being sold by the Fed will be competing for a dwindling supply of money. And mathematically, that also means that interest rates will be rising.

And as interest rates go up, the bond markets will suffer losses, as will stocks and home prices.

That is, everything the Fed has worked so hard to engineer since the 2008 will be undone. And likely within a very short time period – perhaps just a few months.

If you’ve been wondering why the Fed spent most of 2013 hemming and hawing about whether or not to decrease – or “taper” – its ongoing $85 billion in monthly asset purchases, , this is the main reason.  It feared undoing all the years of hard work it spent getting the stock, bond and housing markets to inflate.

But if the Fed cannot easily undo its quantitative easing efforts, then what are the risks we all face?

Well, here's where history is really quite clear.  You can get away with printing for a while, but when it catches up with you, it does so with a vengeance. 

The reason is not terribly hard to understand. You cannot print true prosperity.  Real wealth does not come from printed money.  Real wealth only comes from real people performing actions that create real value. 

If it were possible to print up prosperity, every central bank should simply cook up enough new money to hand it out to its citizens and eliminate poverty.

But, of course, that cannot work.  Money is not real wealth, it is merely a claim on wealth.  You can make as many claims as you wish, but the amount of real stuff remains the same and will shrink in relation to all that printed money.

Quantitative easing and the other central bank shenanigans of the past several years are not ordinary.  They aren’t normal and they haven't been tried before.  They signal a huge and abnormal departure from everything we know about what works and doesn't work economically.

We'll each need more to our wealth strategies besides complacency and hope.

Perhaps this time is different. But if not (and it almost never is), then we should all be crystal clear on the risks.

At the exponential pace at which the Fed is increasing the money supply, and knowing the huge challenges the Fed – and most other world central banks  - face in trying to stop or even slow down their money printing, the potential for a disruptive global inflationary period is very real.

Which brings us to the next Chapter on Inflation.

Thank you for listening.

Endorsed Financial Adviser Endorsed Financial Adviser

Looking for a financial adviser who sees the world through a similar lens as we do? Free consultation available.

Learn More »
Read Our New Book "Prosper!"Read Our New Book

Prosper! is a "how to" guide for living well no matter what the future brings.

Learn More »

 

Related content

11 Comments

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Offline)
Joined: Feb 4 2010
Posts: 3936
Playing the Game.

This whole setup is a three card monty, as far as I can tell. Jokers everywhere, no aces.

Way out of my depth. Let me lower the conversation to one I can grasp. Lets play Monopoly.

New rules. (Lock the door Fat Albert) I will be banker. I get to print as many dollars as I want. I can buy up all the houses and hotels with money I have printed. If you argue I will send in Fat Albert to explain the rules again. Fat Albert can make things very clear, losers.

What can be the trigger for the end of QE? That is when I have all the pieces and I can drop the pretense that we are playing a game.

The real game is more nuanced. "I" am a loose collection of ego challenged psychopaths. Once "I" have all the pieces then the real action starts. Evil defeats itself violently.

The winner may be Fat Albert, but it is probably the skinny kid who understood what was going on and slipped out before Fats locked the door.

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Offline)
Joined: Feb 4 2010
Posts: 3936
Follw up.

My Bad sorry.

But I had to follow up with a blast from the past.(1969) The Games People Play.

While they while away the hours
In their Ivory Towers
Till they are covered up with flowers
In the back of a black Limousine.

 

Merle2's picture
Merle2
Status: Bronze Member (Offline)
Joined: May 4 2014
Posts: 34
What we should do

This is scary stuff, indeed!

What should we do? In my opinion, the Fed should phase out QE3 until it is down to zero. We would end up with a fixed base money supply (M1). Then we should limit the fractional reserve rates so there will be no increase in lending, and hence the overall money supply (M3, MZM) will stay fixed. This policy change would cause a huge correction in the stock market, but eventually we would recover and end up with a fixed money supply with an economy that was nearly steady state. Oh, and the money they print while winding down QE should not go to the Fed. It should go as tax credits distributed equally to everybody.What do you think? Would that work?

What will we do? Probably the Fed will continue to print money until either there is a sharp increase in borrowing or foreigners bail out on the dollar. Either way, it leaves the economy flooded with dollars, sharply driving up inflation and interest rates. After that, it is anybody's guess what will happen, but it would not be pretty.

 

 

 

Leslie Davis's picture
Leslie Davis
Status: Member (Offline)
Joined: Aug 23 2014
Posts: 1
'Money Plan"

The 'Money Plan' is described here. Basically it allows for money to come into circulation as wealth instead of debt.
http://www.lesliedavis.org/news

As a candidate for Minnesota that is my proposal for money. I have lots of great issues that you can see at www.LeslieDavis.org

P.S. Forcing us to borrow money at interest to have a medium of exchange is economic servitude. Slavery.

There's no time to lose. Call me at 612-529-5253

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Offline)
Joined: Feb 4 2010
Posts: 3936
Pornograph for the Nomenclature

These problems are all symptoms Merle. There are two causes that are all being seen through the lens of Money. (To paraphrase Chris).

Overpopulation based upon cheap energy. We convert 10 units of oil energy into 1 unit of food energy. This has enabled us to grow from 2.7 billion when I was born to neigh on 8 billion now. I hope to see my second doubling-sort of.

Overconsumption per capita.

In my view, we are going through an uncomfortable evolutionary bottleneck right now. There is a mad scramble for resources. Here is an example of Prime Real Estate. The Agents of the Elite had their meeting there. It was a pornfest for the nomenclature.

Forget what they were saying at Jackson Hole- look at the scenery. That was the whole point of the gathering. It was to remind everyone important about the Prize. See the Water-see the Land- the fish in the stream, the clean air. All unspoiled, yours for the taking. But only if you play The Game.

Hint: See where nubile young women gather. They have a strongly developed instinct for real wealth. The instinct is honed by the necessity to raise healthy children.

 

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Offline)
Joined: Feb 4 2010
Posts: 3936
Flashback

Iceland. Remember?

nigel's picture
nigel
Status: Silver Member (Offline)
Joined: Apr 15 2009
Posts: 129
Arthur Robey wrote: Hint: See
Arthur Robey wrote:

 

Hint: See where nubile young women gather. They have a strongly developed instinct for real wealth. The instinct is honed by the necessity to raise healthy children.

 

 

Ignoring the nature nurture debate, putting people into categories based on simple differences such as gender is flawed thinking. You can do better.

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Offline)
Joined: Feb 4 2010
Posts: 3936
Nigel

I am not, and have never been a citizen of the USA.

I hold it to be a self evident truth no two people are, or could ever be equal. They are not born equal, do not have equal rights and are definitely not of equal value. The only rights that they have are the rights they give themselves.

I am not even my own equal. The quality of my thinking varies depending on a myriad factors.

From this axiom we can say that women are not the equal of men. They have a different perspective, one that is shaped by both their environment and their function.

It is a self evident cruelty to impose inappropriate standards on any other creature. Am I to beat my dog because he cannot write his name?

Women are not my equal. I cannot give birth.

It is for this reason that I am opposed to women being cajoled into the armed forces. Violent death is Mens business. It is for this reason that I protest the secondment of womenfolk into the workforce as a result of the compounding growth of the economy.

Equality is a mirage offered to us by Satan himself. It is an ideal that can never be met and should never be attempted, as it will end in cruel failure.

herewego's picture
herewego
Status: Silver Member (Offline)
Joined: Aug 11 2010
Posts: 142
With respect, Arthur

... because I DO enjoy and benefit from your contributions here, a few random responses:

The only rights that they have are the rights they give themselves.

Let's not forget the rights most people have, which are those, fair or grossly unfair, that they happen to be born with.

Sameness and equal rights are not at all identical concepts. 

Most civilizations have been based on people most definitely NOT having equal rights.  They sound pretty hellish.  In this one we have a history of, in part, experimenting with the idea that all people have the same rights before the law.  It has not been proposed that all people are the same!  Rather, we have been wondering if we might build safer, happier, more sane cultures if we face the challenge of learning to treat all people fairly in relation to each other.  There have been some pretty good minds on the job over the past centuries.  I'm certainly happier for their work.  It has opened the vision of a far more soul-satisfying human culture if we can rise to the inner work required to get better at negotiation and problem solving rather than acting out another round of might is right.

Part of my rights that are currently equal to yours before the law is that I make my own decisions about children and money.  This is good, because we are past the time by far when the most important function of a woman was her reproduction.  When I was 14 I listened hard to the world and heard it tell me that my intelligence, love and energy were needed by those already on the planet, and by the planet itself.  I chose not to have children and to love what's here because NOT reproducing is what my species and biosphere needed of me.  Better for everyone, in my case.

Another part of my rights that are equal to yours is that I can conduct a sexual relationship with a man without my financial survival depending on his good will.  I am allowed to make my own living and I do.  We can base our connection on mutual benefit.  It can actually be consensual.  Nice.

Though I am not at all the same as you, I can and do have equal rights.  I claim that.  I have sometimes had to fight for the social space to exercise them.  Here's hoping I will be able to stand for them when it gets physical as so many must.

Susan

Merle2's picture
Merle2
Status: Bronze Member (Offline)
Joined: May 4 2014
Posts: 34
If QE went viral
Leslie Davis wrote:

The 'Money Plan' is described here. Basically it allows for money to come into circulation as wealth instead of debt.
http://www.lesliedavis.org/news

Interesting link, Leslie. So you would like to become governor of Minnesota and finance a huge infrastructure renewal by creating your own dollars out of thin air? Perhaps you haven't got the memo, but only the Fed can do that. If you tried it, they would call it counterfeiting.

You say this would not be inflationary, and perhaps it would not be inflationary if Minnesota did it in small amounts, but what if every state did it? What if every county and municipal government did it?

Sorry but I don't think democratizing the money printing effort is going to solve our problems.

Twodogs-and-Sanchez's picture
Twodogs-and-Sanchez
Status: Member (Offline)
Joined: Aug 27 2014
Posts: 3
Treasury Bonds

Great explanation of QE, but doesn't go quite far enough.  

Following up on three aspects of it:

1) Treasury bonds-  How are they created?  

2) Tracing all of the Trillions of dollars to their 'landing place' in Global banking?  Is that a FED not disclosable  secret?  If so, Why?

3) How much of the billions that, say, Lord Blankfein at Goldman Sucks got during the past 6 yrs went to legitimate uses, as opposed to his compensation and that of his accomplices?

Banking "profits"  have reached historic, record levels, and the revenues and profits are used to determine how much bonus money is going to a precious few highly connected executives in the top 12 Banks.  How much is that?

Why? Why do they get to pay themselves billions in bonuses for doing nothing and why and how is that not made public??

 

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Login or Register to post comments