You may have heard lately that the Federal Reserve will potentially undertake additional measures to assist in our attempted economic recovery.  Regular readers here may recall I wrote on this subject several weeks back.  The buzzwords for this anticipated round of action by the Fed are "quantitative easing."  I wanted to use this article to explain this concept and how it affects you.

To back up for a moment, if you don't know much about the Fed, it's at least important to understand their role in the economy and the government's operations.  Essentially, one of the Fed's primary responsibilities is to act as a lender of last resort to the US Treasury, and by extension, the government.  When the government does not have the funds to pay for something, and it cannot or will not borrow the money (for whatever reasons), it can turn to the Fed to "monetize" its debt.  What this boils down to is the Treasury auctions off government debt (Treasury bonds), and the Fed purchases them.  When this transaction occurs, the Treasury receives capital from the Fed, and the Fed puts the bonds on its balance sheet as an asset it can lend against and thereby collect interest.

The end result of this arrangement is that money is created from nothing (by the Fed) to pay the Treasury, which in turn places the money into circulation.  This adds to the total money supply and thus dilutes the value of all other dollars already in circulation.  In short, you receive less for your money when making purchases since its value is diminished (i.e., the more dollars there are the less each one of them is worth).  This effectively serves as a tax on you that you cannot see, and that most people won't understand to begin with since it is never explained in this manner to them.  What I've just described in this paragraph is the definition of inflation.

So to summarize: quantitative easing = inflation = your dollar will eventually buy less.

All that said, what are the distinct advantages and disadvantages of quantitative easing for you?

Advantages:

-- Inflation raises the paper value of assets, such as real estate, stocks, etc.  An argument could be made that the current rally in the stock market we've been witnessing is at least partially fueled by the Fed's inflation of the money supply. 

-- Adding new money into circulation could potentially provide a short term boost to the economy, thus providing a generally positive lift to economic activity as a whole, and hence benefitting you indirectly.

Disadvantages:

-- Increases the money supply, diluting the value of all dollars over the mid- to long-term.  This reduces your individual purchasing power.  Over extended periods of time wage levels have fallen behind inflation levels, thus resulting in a declining standard of living for the citizenry.

-- Increased Treasury bond purchasing by the Fed drives down interest rates, thus punishing savers and rewarding spenders.  An argument exists that we need more saving and less consumption in order to restore economic fundamentals, but this quantitative easing policy works against that premise.

-- Rising value of paper assets creates an incorrect perception amongst investors that they're wealthier than they really are, and can distort spending and savings habits.  (See the 2007-09 real estate meltdown for evidence of this wealth perception gone awry.)

-- Continued quantitative easing degrades confidence in our currency, since it becomes weaker over time.  Consumers of our debt (particularly foreign countries like China) become less willing to purchase that debt, thus denying financing to our government (i.e., the government has less money to spend).

One of my favorite investment professionals, Peter Schiff, has likened this quantitative easing to giving a drug addict another shot of drugs to make him feel better while he's in withdrawal.  While it's true in the short term the extra hit will alleviate the addict's withdrawal pains, in the long run he's only harmed by the continual supply of drugs into his system.  I think this is a perfect analogy for the relationship between quantitative easing and our economic predicament.

Incidentally, you may also have heard that gold is making new record highs.  There are two reasons for this in my opinion, which are directly and indirectly connected to quantitative easing:
 
1) Gold moves higher as the dollar weakens and goes lower.  Since the dollar is the world's reserve currency, investors counter its weakness by moving into assets considered to have tangible worth, such as precious metals, commodities, etc.  Gold is still considered chief amongst these defensive hedges against dollar weakness.

2) More subtly, I believe gold is rising because large investors (countries, institutional investors like banks) are accumulating it not only for defensive purposes as outlined in #1 above, but also due to the possibility that gold will again be used as backing for money.  Until 1971, the dollar was backed by gold.  A return to this gold standard may materialize as confidence in the dollar (and the paper money ["fiat"] system as a whole) erodes.

I want to conclude this post by pointing out that the Fed is now the second highest single purchaser of Treasury debt (ahead of Japan and right behind China).  China has begun buying less of our debt in favor of Greek debt.  (While this may sound good on the surface since we'll owe China less money, we're simply trading that situation for the inflationary one described above).  I believe that the Fed's purchasing has ramped up to compensate for China's reduced purchasing.  In the long run this hails the eventual loss of confidence in our debt/currency by foreign investors, and the fix for that will have to be rising interest rates to entice them back to the table.  These rising interest rates will bring numerous implications, such as higher mortgage rates, car loans, credit card rates, and generally speaking, less access to debt by the average consumer.  Decreased access to debt for Americans means a further decline in standard of living.  We'll explore this more in a future post, but I think for the time being it's enough to know that quantitative easing will contribute to this eventual decline.
 


Comments

PSP
10/14/2010 20:04

Hey, great article. It does a great job of explaining QE.

Gold is a very intersting item. It seems like its value is much higher than its usefulness - which makes it a very volatile investment. I don't think central bankers will give up their powere by switching back to gold though.

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