Crash Course Chapter 10: Quantitative Easing

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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.

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