Monday, September 23, 2013

Capitain Imperio Explains It All: QE

One of the bond gurus whose CNBC blather WB sent me to claimed that only 23% of Americans understand QE. I think he meant that only 23 basis points of Americans understood QE. In any case, the Capitain, as undeterred by the lack of any actual military or nautical rank as he his by his lack of relevant expertise ventures to clarify.

QE, or quantitative easing, consists of the Fed buying up a whole lot longer term government bonds. Recall that a bond is a sort of a contract whereby those with money agree to lend it to the government and the government agrees to pay it back with interest. The buyer of the bond is giving up his money for a promise of repayment, with interest. The key point to note here is that the price of the bond is inversely proportional to the interest rate. If people are really eager to buy bonds, the government gets its money for a low interest rate.

With that bit of basics out of the way, note that when the Fed buys bonds, what is actually doing is trading cash (which it, being the Fed, can manufacture) for the government promises to pay. It would be a mistake to call this "just printing money" though, since it's really trading one sort of store of value (cash) for another (government bonds). But it does make that store of value more liquid, and cash, unlike a government body, pays no interest. Of course, if the lunatics in the Republican House decide to default, those bonds lose their value and the whole scheme collapses.

Buying the bonds has two important economic effects - it drives down long term interest rates (since bonds become more expensive), and it pumps loose cash into the economy. Lower interest rates are stimulative, because it's cheaper to borrow to buy a house, car, or factory. Loose cash, not earning interest, is or ought to be a an incentive to spend or invest in the real economy.

The flaw in this notion is that if inflation is really low, it really doesn't cost one much to just keep your cash in barrels, Walter White style - and in fact there are a couple or three trillion bucks in actual currency, mostly dollars and Euros, floating around, not to mention much more in some kind of checking or similar account.

Add in a bit of inflation, and this suddenly become highly unprofitable. Now, inflation is eating away at what you don't spend or invest. if you accept the obvious Keynesian point that recession is caused by inadequate demand, you can see that the stijmulative effect can be powerful.

In any case, all that cash looking for a safe home is potentially hazardous. No sooner did the Fed announce no taper (decrease) in the QE and big amounts of capital sloshed into India, Indonesia, and elsewhere.

Which is one good reason to prefer fiscal stimulus.