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A PeakProsperity.com reader recently lamented:
I have been trying to get my head around the mechanism of QE. Not
being an economist or experienced investor I don't really understand a lot of
the jargon. The usual simple definition of QE as "thin air money
printing" does not satisfy my need for understanding either. Have hunted
for a description of QE for dummies that leaves me feeling like I get it, but
with no luck. My difficulty is in understanding how thin air money gets into
circulation.
So I'm going to do my best to answer this plea in as intuitive and
straightforward a manner as I can. I, too, share the need to understand the
mechanism of a process in order to feel like I have a grasp of it. And I
think it's critically important to understand QE (also known by its full
name, "quantitative easing") and what it really represents. Because
it is, without a doubt, one of the largest market-shaping forces of our
times.
Further, it presents extraordinary risks and may well turn out to be a
decisive shaping process for the future, as well. And not in a good way.
Despite its sophisticated-sounding name, QE is nothing more
complicated than the Fed buying "assets" from commercial banks and
other private financial institutions. I put assets in quotes because the Fed
does not buy things like land, Stradivarius violins, diamonds, gold, or
silver from these institutions, but rather various forms of debt.
The main forms of debt purchased are Treasury bills/notes/bonds and
Mortgage Backed Security (MBS) paper.
There could well be other forms, too, but we currently have no
visibility into the composition of the sizable portion of the Fed's balance
sheet that comprises the "other assets" line. I'll get into that in
more detail in a minute.
QE Explained
First, here's the an explanation of QE:
Quantitative easing (QE) is an
unconventional monetary policy used by central banks to stimulate the
national economy when conventional monetary policy has become ineffective.
A central bank implements quantitative easing by buying financial assets from commercial
banks and other private institutions, thus creating money and
injecting a pre-determined quantity of money into the economy.
Quantitative easing increases the excess reserves of the banks, and raises the prices of the financial
assets bought, which lowers their yield.
(Source - Wikipedia)
The reason that QE differs from normal monetary policy is that, in the
normal case, the purchase of various bond types by the Fed does two things:
It lowers interest rates, and it increases the amount of money in the system.
QE, on the other hand, cannot lower interbank interest rates any
further than they already are, because they are at 0%. So a different name is
used for the process in which the only thing being eased is the quantity of money. Hence
Quantitative Easing (QE).
This is just a fancy way of saying that the central bank, via prior
errors and miscalculations, has found itself stuck in a trap where it has
lost one of its most potent tools: the price
of money. And now it can only fiddle with the quantity of money.
Here's a simple picture that I drew to illustrate just how simple this
fancy-sounding process really is:
When the Fed performs this trick, what happens is that the assets end
up on its balance sheet as well, assets of course. Luckily
the Fed provides reasonable clarity in a timely manner on the expansion of
its balance sheet. So we can see pretty well what's going on here as it happens.
In graph form, we can see that the Fed's asset balance had been
holding steady at around $2.75 trillion for a bit over a year. But then the
latest round of QE (QE4) began, which has swelled the Fed balance sheet above
than $3 trillion and it's way to (at least) $4
trillion by year end (2013).
Here's a nice short description of the process of QE:
A central bank [performs QE] by first crediting its own account with
money it has created ex
nihilo ("out
of nothing"). It
then purchases financial assets, including government bonds
and corporate bonds, from banks and other financial institutions in a process
referred to as open market operations.
The purchases, by way of account deposits, give banks the excess reserves required
for them to create new money by the process of deposit multiplication from increased lending in the
fractional reserve banking system.
The increase in the money supply thus stimulates the economy.
Risks include the policy being more effective than intended, spurring
hyperinflation, or the risk of not being effective enough, if banks opt
simply to pocket the additional cash in order to increase their capital
reserves in a climate of increasing defaults in their present loan portfolio.
(Source -
Business Insider)
The Price of Thin Air Money
At this point you might be thinking, where did the Fed get the money to buy these assets?
The answer to that is simple: It
was created out of thin air. Or ex nihilo, if you want to use Latin to make it
sound more official.
In these modern times, no actual paper money was created and
exchanged, of course; just a few clicks on a computer keyboard. And voila!
billions and billions of dollars
are created.
There are several critical risks to flooding the world with invented
money. Once we understand them, it becomes clearer how the Fed's decision to
pursue QE has put it in a box, where its available options are becoming fewer
and fewer. And it explains why the Fed is continuing and
will continue until it simply can't with its aggressive money
printing.
In Part II: Why
You Really, Really Need to Care about the Implications of QE, we
lay out these risks and identify the markers you can follow to track them. We
then detail how the QE process is destined to devolve and the implications
this will have for your wealth and well-being.
To make our situation clear, we are living through the largest and
most outlandish monetary experiment ever conducted by humans upon themselves.
These are extraordinary times, and no matter how many times the mainstream
press tries to convince you that a rising stock market or a rebounding
housing market implies that we are returning to healthy economic balance,
don't fall for it.
The Fed is in uncharted territory, having created a monster it can no
longer control. In the process, it is blowing new asset bubbles that are
benefitting those with first access to the newly-printed money (banks and
corporations) at the expense of savers, pensioners, and anyone exercising
fiscal prudence. This, of course, is creating a vast and growing inequality
between the top 1% and everyone else.
When this misadventure in monetary policy ends, as both math and
history says it must, it will be messy, uncontrolled, and very painful for
holders of just about every sort of finanical instrument out there (stocks,
bonds, derivatives, etc). That's why understanding the root causes and risks
of QE is so important, in order to identify the best shelters for protecting
the purchasing power of your wealth through this transition.
Click here
to read Part II of this report (free
executive summary; enrollment
required for full access).
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