Gold and quantitative easing: Inflation all over again?

Perhaps you have heard that the Fed is printing money to get out of the crisis and that such actions cannot possibly end other than in even more money being printed and in the dollar losing its ability to buy you tangible assets. In our essay on gold and the dollar collapse we pointed out that since 1970 the debt numbers have gone up more than 40-fold (!). In 2002, future Fed chairman Ben Bernanke noted that “the U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.” In keeping with these words, Bernanke has played an important role in the introduction of three rounds of what is known today as quantitative easing (QE) — programs expanding the money supply beyond the usual. The bill for QEs is $2.25 trillion and counting. As of Jan. 17, 2013, U.S. debt totaled $16.4 trillion. These extraordinary numbers call for a deeper analysis and today we focus on what QE actually is.

The beginning of the economic crisis is usually linked with the date of Sept. 15, 2008 when the U.S.-based investment bank Lehman Brother filled in for bankruptcy. Lehman Brothers went down with a bang, sending shockwaves through the financial markets and effectively beginning the global banking crisis. Lehman went bankrupt because of its bets on U.S. mortgages that had gone bad. When it became apparent that Lehman would not meet its obligations, everybody in the markets began to fear that everybody else could have excessive exposure to the housing market by holding assets linked to the performance of that market on their balance sheets. The market “dried up” — the lending between financial institutions effectively came to a halt and there was no liquidity in the market. In such an environment the financial markets ceased to channel funds to businesses and the credit market froze. Without credit, companies were not able to operate in a regular way. Such a disruption added to the problems stemming from the declining house prices. So, the lack of liquidity in the financial markets translated into a recession.

Facing the possibility of the further havoc, the U.S. government set the Troubled Asset Relief Program (TARP) into motion under which the U.S. Treasury was buying assets linked to the mortgage market to pump money and, therefore, liquidity into the banking system. TARP was a prelude to QE.

Under usual conditions, when the economy is struggling and there is not enough credit available, the central bank can lower the interest rate in order to make credit cheaper and more accessible. A lower central bank interest rate translates into lower interest paid by companies to commercial banks. It has also an adverse effect on savings — it becomes less profitable to keep your money in the bank because the interest you get is also lower. So, central banks tend to lower interest rates in hope of making credit cheaper, stimulating consumers to spend more and companies to invest more. Following the events of September 2008, the Fed brought its federal funds rate close to 0%. However, even combined with TARP, this did not bring the expected liquidity to the market.

Even though bailouts may have prevented the economy from slipping into chaos, the economic environment appeared to be deflationary. This means that with inflation close to 0%, the Fed feared a scenario in which the economy would actually experience deflation. Deflation results in falling prices. At first sight it may be hard to recognize why this would be harmful for the economy. To understand that, we need to consider that falling prices put off people from spending their money. After all, if goods are getting cheaper and cheaper, why buy a car now and not in several months when it costs less than today? Such thinking limits spending and the economy starts to wobble because the producers cannot find enough buyers for their goods. This limits output, which, in turn, limits growth. Such an extremely simplified picture shows you why deflation is an unfavorable scenario. Generally, in the long run the market would be expected to fix itself — when prices get low enough, somebody would finally buy and prices would start to rise thus fueling growth of prices and economic activity. However, this is not in tune with what the Powers That Be are concerned with — they don’t want to have to tell voters that they have to wait a bit before things get better — they want to show that they can make things better right away.

If you consider that the interest rate can go only as low as 0%, you will come to the conclusion that in late 2008 the Fed practically lost its ability to stimulate the credit market and avoid deflation by lowering interest rates. At that time the Fed wanted to achieve a number of goals, including delivering liquidity and increasing spending to boost up the economy. Since the interest rates were already close to 0%, it adopted an unconventional policy. Namely, it started buying mortgage backed securities (MBS, assets linked to the performance of the real estate market) and Treasury securities. The gist of this approach was that the purchases were covered with newly created money.

Technically, the Fed did not print any new dollars. It took in MBSs and bonds from commercial institutions (e.g. banks) in return for acknowledging a claim against it. The commercial banks and other institutions could use that claim to lend out additional amounts of money. The Fed’s idea was that buying assets would drive their prices up and simultaneously drive bond yields down (bond yields fall when bond prices rise and vice versa). Lower bond yields would be accompanied by lower interest rates and would make it easier for companies to find access to credit. Low bond yields would also make bond investments unprofitable for those willing to gain stream of income from them and force investors to switch to other assets, mainly to the stock market. This would, in turn, help to channel funds to U.S. companies and give the economy an impulse to grow. All of this would result in higher prices (inflation) and in increased economic activity.

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