Thursday, July 26, 2012

Quantitative Easing

What isn’t easy is to remember what the Federal Reserve’s latest monetary whip, to energize a sluggish economy, means. Here I teach myself again.

Put in the simplest words, quantitative easing is another way of saying “printing more money.” And the name applied here is “quantitative” because the Fed determines in advance what quantity of money it will print. The “easing” part is trickier.

The Fed buys, from the banks, long term financial instruments that they are holding. An example is mortgage-backed securities. The Fed pays for this with money it creates out of thin air. The consequences? The banks have more cash. When instruments are purchased, their value goes up. When dividend-yielding financial instruments are purchased, their value goes up too—but their dividend yields go down. QE therefore reduces “yields” as well. Another name for yield is interest rate.

Now the “easing” part is tricky because what the Fed wants the banks to do is to lend the extra money to businesses and industry. Business and industry spend the money on structures and capital goods. This causes demand to increase. Demand in turn causes companies to produce. And in order to produce, they hire people. Simple, but very indirect.

The current situation is that banks don’t want to lend to people who need money; they want to lend to the wealthy only—who don’t need money. Banks behave like this because the risks of lending into a sluggish economy are high. But the banks love quantitative easing because they don’t mind selling long-term financial securities. It increases their flexibility without imposing a cost or forcing them  to do anything.

The very fact that the Fed must print money to begin this attempt to stimulate the economy, very indirectly, increases the money supply at a time when there is already too much money in circulation. This means that quantitative easing is inflationary. Inflation hurts people who save and those on fixed incomes; it helps people who borrow; they pay back loans with money that is worth less than the money they borrowed.

Now the straightforward way to stimulate the economy is denied to the Fed—but at least theoretically available to the Executive branch. That way is to launch programs to hire people directly—as Federal employees. If the programs are well designed, thus if the people hired actually believe that the job will still be around in a couple of years, they will start consuming. That causes demand to increase—and the “easing” then follows.

I feel for the Fed. It wants to do what the Executive branch might wish to do but hell will freeze over before the Legislative branch will let it do it.

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