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Everything You Ever Wanted To Know About QE But Were Afraid To Ask

Everything You Ever Wanted To Know About QE But Were Afraid To Ask

It’s been said that we have information in the information age.  To be sure we do know a heck of a lot more than we ever did before.  With the touch of a button our cell phones can deliver to us the entire record of human knowledge to this point.  Not bad.

It all started some 4,000 years ago, the first time that hairy little guy decided to dip his hand in that inky substance and record a thought on the wall of a cave or to chisle some bartered transaction into a rock so as not to forget.  The culmination of the practice of recording our every thought since that first one has had an ironic effect.  We tend to believe that all information given by those we revere is set in stone.  We’ve taken for granted that even if we don’t know something, as long as it’s official sounding, someone else knows it and can produce verification for the practice from a hard bound leather book written two hundred years ago.  While political and economic speak is always rife with examples of this, “QE” is a particularly egregious example.

Every time I turn on a news source, someone is discussing QE2 (or QE1 for that matter) and whether or not the Fed should pursue QE3.  The terms are bandied about as though they were covered in ninth grade economics and we should all be up to speed.  Bernanke and the talking heads sound so confident.  It’s as if they’re talking about the application of tried and true remedies right up there with chicken soup and penicillin.  None of us could afford the risk of slipping up our hand and asking, “hey, what the heck is QE2 anyway?”.  Surely this would invite snickers, looks of disdain, perhaps even an unfortunate wedgie out back by the dumpster.  Better just to smile and nod in agreement assuming that those in the know have it all under control.

It is in service to all of the cautious but curious, wedgie avoiders that I offer this addition to the tome of economics.  I hope to clarify and in clarifying I hope to arm you so that you’ll never fear seeing the band of your underwear as it’s pulled over your head.

“QE1, QE2 and potentially now QE3 all refer to the term “Quantitative Easing”.  The number refers to the fact that it is done in blocks of time and money.  The first block ended late last year and we’re currently in the second block.  Quantitative Easing is a term (only recently minted by the way) which just describes the process of pumping new money into the economy when interest rates are already at or around zero percent as they are today.  Normally, central banks (like our Federal Reserve) would use their influence over interest rates to indirectly cause more or less money to enter the monetary system.  When you get to zero percent, rate setting is not really an effective way to bring in more dollars.  That is where Quantitative Easing comes in.

It may seem a little “Alice in Wonderland”, but the FED (Federal Reserve Bank) actually has the power to create money ‘ex nihilo’ which literally means “out of nothing”.  “Ex Nihilo” by the way, IS one of those terms that has been around for hundreds of years.  The Fed employs this power vigorously in service to Quantitative Easing.  Here’s how it works.

Basically, the Fed pushes a button and adds money to their account.  As I mentioned, the money is just made up.  With those funds, they then go out and purchase assets.  Sometimes the assets are purely financial in nature, like all of the mortgage backed securities they’ve been buying, but sometimes they are hard assets like hotels and commercial centers.  The Fed doesn’t like to talk much about the hard assets, but if you do a little research, you’ll find they’re becoming quite the property owner.  More on that another time….

The effect of buying all of these assets is (to simplify a bit) that the banks benefit by either being the seller of those assets and no longer having to show them as liabilities (T.A.R.P.), or by seeing an increase in their deposits (directly or indirectly) both of which allow them to make more loans and earn more profit.  The idea is that if the banks lend more, borrowers, like you and me will go out and buy more goods or invest in our businesses to increase productivity.  All of this combined activity is supposed to stimulate our economy and cause it to grow.

The term ‘Quantitative Easing’, though it is presented as a long establish concept is actually quite new.  The only historical precedent for QE is the use of a very similar approach in Japan starting in the 90’s.  If you wonder how effective QE has been in that country, google the lost decade sometime.  It hasn’t been pretty.

At any rate, a discussion of the whether or not QE is a good or bad thing in our situation is outside the scope of this entry, but it’s worth having another time.  At least next time I, or someone else, brings up the term QE, you’ll know what the heck they’re talking about.  Even if they don’t.

As always, I wish you Better Banking…

Adam

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