Saturday, February 18, 2012

What is Quantitative Easing?

What is Quantitative Easing and why would you care?

The short answer:  It's ultimately very inflationary and shields Congress from the discipline of balancing their budget.  One part of the government is essentially subsidizes another part of the government and the public ultimately gets ruined.   Prices could eventually rise 50% based on the QE done to date and there are promises of even more QE.  The Fed pretends that it knows how to avoid such a general price rise, but they will be in a severe political conflict when it comes time to reverse what they've done.  I'll explain below.

Definition of QE
Quantitative easing is where the Federal Reserve creates money out of nothing and buys government bonds to fund some or all of the Federal Government deficits.  Yes, that's right, from nothing.   They buy outstanding government bonds and make an accounting entry on their balance sheet with the agreement of the US Treasury.  Congressmen can just spend and spend and spend.  Why not eliminate all taxes??  No need for taxes!

When the Fed buy bonds, the seller of the bonds receives money in their checking account.  In a fractional reserve banking system, banks can then lend money against those new deposits as long as they keep, say, 10% of their outstanding loans in cash or near-cash.  Thus, if a bank sees a $1 million in new deposits, they could lend another $9 million.

Money Multiplier and Credit Expansion due to New Reserves
Because of this "multiplier effect", when the Fed (Federal Reserve) buys bonds and adds deposits to the banking system (does Quantitative Easing), these new reserves are called "high powered money" because it can support up to 10 times the amount of money in the system.

Quantitative easing so far has added 50% to bank reserves that COULD be lent out and lead to a 50% surge in outstanding credit.   Have a look below (all blog images can be enlarged if you click on them).   See the jump from about $1300 to over $2100 or about a 50% jump in M1 (defined as cash and checking deposits) in 2008?   At a 10 to 1 multiplier, lending and money outstanding could jump $8000 billion on a $800 million increase in banking system deposits.  (The real multiplier is somewhat less than 10:1,  something more like 4:1)

A 50% surge in money in the banking system COULD mean a 50% increase in general prices if there is not a corresponding increase in goods and services ( ie., too much money chasing too few goods).   In reality it's not happening YET.

I could happen.

Reversal of Quantitative Easing
The problem is that the Fed Reserve should sell those bonds, ie.,take that money out of the banking system (reverse the QE) when excess reserves (become lent out) cause prices and business activity to rise.  Some of this is what is intended.  But if you have too much "tinder" in the fire, there's a risk of loss of control.   The Fed should be removing excess reserves now not later--but they're not.  They are considering more QE not less despite that the country is no longer in crisis!   Even today, there's no reason to have a $1 Trillion in excess reserves sitting in the banking system causing people to worry about it's ultimate effect (and I'm not the only one).   Sadly the Fed Reserve is now in the business of subsidizing runaway government spending and keeping interest rates near zero. Also sadly, they are making sure that risk-averse savers are punished with losses of up to 3% per annum.  Thanks alot Ben.  Who elected you?

To make a long story short, the Fed may be forced to reverse the Quantitative Easing just when it's the most inconvenient time to do so.   They could easily be forcing interest rates upward just when inflation and market is forcing market interest rates up.  Higher interest rates will cause government deficits will explode (see The Case For Gold)!   If they can't do it, they won't and price inflation will be inevitable.  They're already in a box and the public and savers will be scr*wed.  What a horrible state of affairs!  

Another question is:  who's going to limit the banks from doing other things with the available credit (money)?  Banks have shown that they can cause mischief and the government has proven itself to be a clueless regulator.  Ben Bernanke is known to approve of some of this new money inflating assets such as the stock market!  So, we'll have new asset bubbles.  The whole thing stinks!    There is a whole range of unexpected outcomes and un-intended consequences. 

This is another powerful reason to hold gold instead of US dollar currency.  The 50% rise (or more) of prices due to rapid money creation (out of nothing) will probably happen at some point.   Watch for more QE in the near future (it's happening all over the world in the past few weeks) which will raise the danger even further.  

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