What Is Quantitative Easing?
Quantitative Easing (QE) is often termed an unconventional monetary policy tool, but it has actually been used since the early 2000s in Japan, as I will discuss later. It is employed when interest rates are effectively zero and additional stimulus is deemed necessary by a central bank; to understand why interest rates cannot be negative imagine what you would do if the bank actively reduced your savings. Yes, a bank run would occur because under your bed, at least the value of your money is the same. Thus QE works by jacking inflation up quietly, though it is analogous to the fundamental basis for monetary policy: in a bearish market you had to force people to invest and consume rather than save money in the bank or under the bed (inflation reduces the value of money wherever it may be and stashing it under your bed no longer makes it safe). In theory this is necessary to prevent or reduce the impact of a recession, wherein a cycle of unemployment, leads on to less consumption, leads on to less profit for businesses which leads on to less ability and desire to keep employees hired and to invest in more infrastructure, which means even higher unemployment etc etc. It does this by increasing demand for goods and services artificially, allowing a central bank to theoretically reduce the length of a recession or nip it in the bud by preventing the stages above from taking place.
How Does It Work?
Assuming the above premise was true and stimulus was a universally effective solution, QE is a particularly effective tool and is extremely efficient at stimulating the economy; although it has not been restricted to any one asset, let us look at its largest holdings: US treasuries. Demand for treasuries are particularly high during recessions because people are afraid and wish to lock in a modest interest rate, where saving rates are already zero and the economy looks to be in such bad shape that any other investment would be very risky. This demand for treasuries allows the US government to pay a low premium to borrow money which allows it to spend more; if lots of people want to lend you money, you could choose to borrow from the people who are willing to lend it to you the cheapest. The FED now steps in and purchases even more treasuries; this would reduce treasury yields further and keep them at near-zero, allowing the US government to borrow more cheaply and spend even more.
The FED buys the treasuries as a loan; money was created in an accounting entry to buy the treasuries. This creates money virtually and thus theoretically creates inflation (more money chases the same goods, raising the price of these goods; this is inflation). As yields on treasuries are suppressed to near zero by the FED's artificial demand, investors realise that the inflation created by the virtual money would shrink their savings faster than investing in treasuries. Thus they move into riskier asset classes or start spending more.
Has It Worked?
This theory is correct only to a point, because in an inflationary environment where everyone is moving into riskier assets, consumers who are very poor at making good investment decisions will move into the stock market, buy investment houses or be persuaded into buying the most fashionable of financial assets. They also spend on cars and consume goods that they would if they were not in a recession. Interest rates in mortgages, car loans, student loans, savings rates and treasuries are all linked by a monetary spectre called arbitrage; as rates rise in treasuries for example, bankers would rush to buy treasuries, reducing money available for lending to mortgages and student loans. This drives rates up in these areas. As rates are low in treasuries, money rushes out and depresses other rates. Investors and consumers may borrow at low rates, falsely assuming that rates would stay low.
Therein lies the crux of the problem: rates are by no means static, as the demand created by the FED must be sustained in order to keep rates low; if the FED stops buying treasuries, rates would rise. If the FED was buying only a small proportion of treasuries, this rise would be small; at current standing however the rate rise could be very high, which would cause many cash-strapped borrowers who had made plans at the low rates to default on their loans. As demand crashes so too will the price assets where leverage had been prevalent. However, this is not the main problem. If all the spending and investments were able to grow the economy fast enough, it could overtake even a high interest rate environment which would allow everyone to pay off their debt. The main problem is that although said spending is growing, the economy is growing slower than expected at 1.8%.
Those who believe that QE is preventing recovery often maintain that recessions occur when there is a mismatch of skills and products with that which is really in demand; stimulus is compared to the effect of giving a drug addict more of the same, removing the symptoms of withdrawal but increasing his dependence on the drug. Stimulus in this way incentivises people to carry on doing the same things that had led to the theoretical recession, deepening the roots of the problem.
Although QE has 'prevented' a recession, there is little evidence suggesting that this solution is permanent. Historically, Japan first used QE from 2001 to 2007 by increasing its current account balance from 5 to 35 trillion yen and also tried to suppress the value of the yen in order to boost exports; these attempts were however unsuccessful (Glen Allen, 2010). Employment in the US is also shifting from full-time to low-wage part-time, though and the average American is $15488 in credit card debt, down from a high of 19000 due to defaults and write-offs (Tim, 2013). Arguments that QE will work assume that the Japanese had not gone far enough, as for whether this is true I cannot say.
Hey I'd love to hear if you agree, disagree or want my head on a pike, feel free to ask me anything.
Article Source: http://EzineArticles.com/?expert=Han_Jun_Low
Article Source: http://EzineArticles.com/7872989
Quantitative Easing (QE) is often termed an unconventional monetary policy tool, but it has actually been used since the early 2000s in Japan, as I will discuss later. It is employed when interest rates are effectively zero and additional stimulus is deemed necessary by a central bank; to understand why interest rates cannot be negative imagine what you would do if the bank actively reduced your savings. Yes, a bank run would occur because under your bed, at least the value of your money is the same. Thus QE works by jacking inflation up quietly, though it is analogous to the fundamental basis for monetary policy: in a bearish market you had to force people to invest and consume rather than save money in the bank or under the bed (inflation reduces the value of money wherever it may be and stashing it under your bed no longer makes it safe). In theory this is necessary to prevent or reduce the impact of a recession, wherein a cycle of unemployment, leads on to less consumption, leads on to less profit for businesses which leads on to less ability and desire to keep employees hired and to invest in more infrastructure, which means even higher unemployment etc etc. It does this by increasing demand for goods and services artificially, allowing a central bank to theoretically reduce the length of a recession or nip it in the bud by preventing the stages above from taking place.
How Does It Work?
Assuming the above premise was true and stimulus was a universally effective solution, QE is a particularly effective tool and is extremely efficient at stimulating the economy; although it has not been restricted to any one asset, let us look at its largest holdings: US treasuries. Demand for treasuries are particularly high during recessions because people are afraid and wish to lock in a modest interest rate, where saving rates are already zero and the economy looks to be in such bad shape that any other investment would be very risky. This demand for treasuries allows the US government to pay a low premium to borrow money which allows it to spend more; if lots of people want to lend you money, you could choose to borrow from the people who are willing to lend it to you the cheapest. The FED now steps in and purchases even more treasuries; this would reduce treasury yields further and keep them at near-zero, allowing the US government to borrow more cheaply and spend even more.
The FED buys the treasuries as a loan; money was created in an accounting entry to buy the treasuries. This creates money virtually and thus theoretically creates inflation (more money chases the same goods, raising the price of these goods; this is inflation). As yields on treasuries are suppressed to near zero by the FED's artificial demand, investors realise that the inflation created by the virtual money would shrink their savings faster than investing in treasuries. Thus they move into riskier asset classes or start spending more.
Has It Worked?
This theory is correct only to a point, because in an inflationary environment where everyone is moving into riskier assets, consumers who are very poor at making good investment decisions will move into the stock market, buy investment houses or be persuaded into buying the most fashionable of financial assets. They also spend on cars and consume goods that they would if they were not in a recession. Interest rates in mortgages, car loans, student loans, savings rates and treasuries are all linked by a monetary spectre called arbitrage; as rates rise in treasuries for example, bankers would rush to buy treasuries, reducing money available for lending to mortgages and student loans. This drives rates up in these areas. As rates are low in treasuries, money rushes out and depresses other rates. Investors and consumers may borrow at low rates, falsely assuming that rates would stay low.
Therein lies the crux of the problem: rates are by no means static, as the demand created by the FED must be sustained in order to keep rates low; if the FED stops buying treasuries, rates would rise. If the FED was buying only a small proportion of treasuries, this rise would be small; at current standing however the rate rise could be very high, which would cause many cash-strapped borrowers who had made plans at the low rates to default on their loans. As demand crashes so too will the price assets where leverage had been prevalent. However, this is not the main problem. If all the spending and investments were able to grow the economy fast enough, it could overtake even a high interest rate environment which would allow everyone to pay off their debt. The main problem is that although said spending is growing, the economy is growing slower than expected at 1.8%.
Those who believe that QE is preventing recovery often maintain that recessions occur when there is a mismatch of skills and products with that which is really in demand; stimulus is compared to the effect of giving a drug addict more of the same, removing the symptoms of withdrawal but increasing his dependence on the drug. Stimulus in this way incentivises people to carry on doing the same things that had led to the theoretical recession, deepening the roots of the problem.
Although QE has 'prevented' a recession, there is little evidence suggesting that this solution is permanent. Historically, Japan first used QE from 2001 to 2007 by increasing its current account balance from 5 to 35 trillion yen and also tried to suppress the value of the yen in order to boost exports; these attempts were however unsuccessful (Glen Allen, 2010). Employment in the US is also shifting from full-time to low-wage part-time, though and the average American is $15488 in credit card debt, down from a high of 19000 due to defaults and write-offs (Tim, 2013). Arguments that QE will work assume that the Japanese had not gone far enough, as for whether this is true I cannot say.
Hey I'd love to hear if you agree, disagree or want my head on a pike, feel free to ask me anything.
Article Source: http://EzineArticles.com/?expert=Han_Jun_Low
Article Source: http://EzineArticles.com/7872989
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