Why 'Quantitative Easing' Isn't Money Printing

Last update on July 1, 2013.

A couple of years ago, you couldn't read financial news without reading someone say

'Buy Gold! The U.S. is printing Money! Hyperinflation, here we come!'

2 years later, here we are. Gold has gone back down from a high of about $1,900 an ounce, to about $1,200 an ounce where it sits today.

On the inflation front, hyperinflation hasn't materialized at all. Just take a look at this graph. In fact, the Federal Reserve (i.e. the entity that is supposedly 'printing money'), is doing everything it can to fight deflation, which is the opposite of hyperinflation. 

It's easy to understand why some people thought hyperinflation was imminent. They thought that the Federal Reserve (the 'Fed', for short)  was printing billions of dollars of money. They thought that the Fed was doing something similar to Germany in the 1920s, and Zimbabwe in currenty day, where in both cases the government printed ridiculous amounts of money to finance their government, and caused hyperinflation.

If in fact, the Fed was printing billions of dollars, I would have agreed. I would have said, 'go buy gold'. Run from bonds. Run from stocks. Go buy gold.

The truth is, while the Fed is technically printing money, but it's not really printing money. Confusing, isn't it? To understand what I mean, we need to define 'money'.

What is money?

Sounds like an stupid question, doesn't it? You know money when you see it. But reality isn't that simple.

Let's take an example. Let's suppose you have $1,000. With the $1,000, you buy a long term government bond. Now, you have $0 in cash, but $1,000 in government bond. Are you any richer or poorer? No. Your wealth remains the same.

Furthermore, you can sell this government bond anytime you like. Need to buy a tablet? Sell your government bond, and buy the tablet with the proceeds.

In a way, a government bond is like money. Not because you can buy stuff with it directly, but because you can exchange it for money whenever you like. So in a way, you could say that government bonds ARE money. We're playing with semantics a little.

Note that this doesn't apply to things like your car, or your bag of Doritos, because A. you can't trade those in for money easily and quickly, and B. they depreciate in value.

How Quantitative Easing Works

When the Fed engages in Quantitative Easing, it doesn't just print money and drop it off from a helicopter. Instead, it buys government bonds with printed money. Let's see what that does.

Imagine the U.S. had $15 trillion in government bonds, and $10 trillion in what we traditionally know as 'money'. Let's say that the Fed buys $2 trillion in government bonds. Then, we would have some $13 trillion in government bonds outstanding, and $12 trillion in 'money'.

So yes, the Fed is engaged in money printing, but the supply of 'money' that actually matters stay the same. It's really just an asset swap - a swap of one form of money for another.

This is why we haven't experienced hyperinflation. 

Then, you may ask, what's the point of Quantitative Easing? The point is to drive down long term interest rates. By buying long term bonds, the Fed is making long term bonds expensive. If you've read our book, you would know that bond prices and interest rates go opposite ways.

By driving down long term interest rates, the Fed is telling savers: 'if you just save money and do nothing else with it, you'll get hardly any returns.  So go now and spend it or invest it, but don't sit on it.'. If the savers do what the Fed wants them to do, the U.S. economy will grow.

Quantitative Easing is also a message to the banks to lend more. You see, when a bank receives money in the form a deposit, it has to keep a fraction of it, but it can lend out the rest. Government bonds don't count as 'money', so they can't lend against it. Therefore when banks have more cash instead of Government bonds, they can potentially make more loans if they want to. This increases the money supply and causes inflation.

However, banks won't lend just because they're able to. They have to see a lending opportunity that makes sense. So far, the banks haven't been lending that much. Hence, we don't have high inflation.

I hope this cleared up some misconception about 'Quantitative Easing'. In my next post, I'll talk about how paring back on bond purchases are hurting our wealth, at least temporarily.

 

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