On Thursday, the Federal Reserve announced a new round of bond purchases to ‘stimulate’ the economy. What does this mean?
It’s not good, as I will explain. But first, some background.
The Federal Reserve is the U.S. central bank. It manages the supply of dollars available in the economy. When the Fed wants to, it creates money ex nihilo: it simply declares new dollars into existence. The process is electronic, but is metaphorically called ‘money printing’ because the Fed may as well have just printed a pile of cash. The Fed sends the dollars into the economy by buying financial assets; most often, it buys U.S. Treasury bonds. The recipients of the money – usually banks or the government – then spend and/or loan the new money, and eventually it circulates to the rest of us.
It’s important to understand that the new dollars, when printed in large quantity, dilute the existing supply of dollars – just like a company dilutes its stock, if it issues a lot of new shares. The new shares tend to push down the value of existing shares. It’s not an absolute; but normally (or other things being equal) each share will be worth less. Likewise, when the Fed creates a lot of new dollars, the buying power of a dollar is given a kick down. For example, instead of a dollar buying 1/20 a barrel of oil (like it did ten years ago, when oil was roughly near $20/barrel), in time, a dollar might only buy 1/90 a barrel of oil (like today, when oil is roughly near $90/barrel).
The Fed has printed a LOT of new dollars in the last couple of decades; and especially since the financial crisis of 2008. They have a euphemism for it, “Quantitative Easing” or QE. The euphemism is meant to suggest that, because the Fed boldly printed money in quantity, we’ll have easier financial and economic conditions. What the Fed announced Thursday, is that they are going to print a lot more money.
Naturally, Pravda (the left-leaning, pro-government New York Times) makes it sound like bold government officials bring us help and hope:
WASHINGTON — The Federal Reserve opened a new chapter Thursday in its efforts to stimulate the economy, saying that it intends to buy large quantities of mortgage bonds, and potentially other assets, until the job market improves substantially.
This is the first time that the Fed has tied the duration of an aid program to its economic objectives…[showing] a determination to respond more forcefully [to unemployment]…
Note how NYT tries to bias discussion, by calling it an “aid program.” Who could be mean enough to oppose an aid program for the unemployed? Especially one from bankers with beards. How could the aid program’s motives be anything less than pure?
“The weak job market should concern every American,” the Fed’s chairman, Ben S. Bernanke, said at a news conference. The goal of the new policies, he added, “is to quicken the recovery, to help the economy begin to grow quickly enough to generate new jobs.”
Got it? You should be concerned! Uncle Ben is here to help YOUR concerns! The problem is, it isn’t going to help. The Fed’s money-printing is part of the problem.
Again, when the Fed prints masses of new dollars, it dilutes each dollar’s power to buy real goods, such as food or oil. That is why the prices of food and oil tend to go up, when the Fed does these large money-printing campaigns. Meanwhile, your wages didn’t go up. Your savings account didn’t go up. So you can’t really buy any more. The Fed says you can. The Fed says that it just “stimulated” your home’s price, and that makes you feel richer and now you buy more things. But YOU know the truth, that you’re poorer. Because your monthly bills for gas, groceries, heat, etc. are just shocking.
Also, your company’s profit margins and balance sheet didn’t get any better. So your company’s business suffers. Your company fears for the future, and feels like it must hoard cash – rather than hire people. That is the story of the last 3-4 years. The Fed’s money-printing is one reason (combined with Obama’s harmful actions) why the economic “recovery” has been so weak. Because of the Fed’s various QE programs, prices have largely remained at elevated “2008” levels, or higher. Now the Fed is about to boost them even more.
The Fed’s thinking is twisted. And whenever one is faced with a firm and widespread belief in vicious nonsense, one must ask the question: Who benefits? Who has an interest in promoting this nonsense and seeing it accepted as unquestioned truth? And the answer, here, is: Big Government and Big Banking.
When the Fed prints money, it takes people awhile to realize that their precious currency is being debauched (more), and that they should charge higher prices accordingly. (Modern economists call that “well-anchored inflation expectations”; earlier, more sensible economists called it money illusion.) So the people who get the new money first are the ones who enjoy its full power to buy stuff. They win. The people who lose are the ones who receive the new money last; in other words, the rest of us, who are faced with pay higher prices for food, energy, and other real goods, BEFORE we figure out how to grow our own prices, salaries, or savings to match. This effect is called the Cantillon effect.
Now, who gets the Fed’s new money first? As stated earlier, when the Fed creates the money, it buys bonds with it, usually U.S. Treasury bonds. Who does it buy them from? The biggest banks who serve as the primary bond dealers, and who buy them in turn from the U.S. Treasury. In other words: the government gets the new money first, with the middlemen – the biggest banks – earning commissions. The Fed’s money printing benefits Big Government and Big Banking.
I’ve tried to explain the basics here. I could go on to talk about a lot more: how Uncle Ben is targeting the new program toward mortgage bonds with insane hopes of re-inflating America’s busted housing bubble; how Obama-Bernanke policies encourage people to live in debt and guarantee that the middle class will be forever enslaved in debt; how the Fed’s actions guarantee us a financial and economic crisis worse than 2008; how to protect oneself from Uncle Ben (hint: keeping a chunk of one’s savings in gold); how the U.S. eliminating its vestige of the gold standard in 1971 has contributed to the decline of the middle class over the last four decades; and more.
But this post is already too long. I shall close with a thought about the big picture. After years of debauching the U.S. dollar, the Fed announced, on Thursday and in effect, that it is going to debauch the dollar even more – debauch it again and again – continually looting the pocketbooks of the prudent and the productive, to benefit Big Government and Big Banking – until finally, somehow, magically, prudent and productive people are moved to satisfy the Fed’s demand that they hire a lot more employees. Hmm… What famous saying does that remind me of?
I really don’t understand finance, mostly because of all of these different terms that seem to describe a bunch of abstract concepts that don’t seem to differ very much. Just because I would really like to understand this stuff better, I want to ask you a few questions, ILC (or if anyone else wants to answer, go ahead) (I understand if you are too busy, or just don’t want to, asnwer me).
So, when it buys bonds, it is basically buying “debt” that is owed to it from something that previously has the same debt owed to it (so the debtor must now pay the purchaser of the bonds instead of the seller)? Is that correct? If so, does that mean that the Federal Reserve owns a lot of assets, and the debtors are eventually required to pay money to the Fed (and do they have to pay interest payments periodically)? Or is it that it is sort of “empty debt” that the debtors don’t actually have to pay back (or do, in theory, but never or rarely do in practice), meaning this “loaned” money (the money that is used to purchase the bonds in the first place) is “new” money that is circulating through the economy and is offset by the debt (assets) that the Fed owns? Am I sort of on the right track, or am I way off?
Something else I’m wondering is what is money? I’m thinking that the amount of money one owns must be equivalent in value to the total number of assets one owns, so in the case of a country, the total amount of value that country has is equivalent to that country’s economy. So, if that is what the value of the total amount of money a country has, then it must be divisible by a unit of currency, and if that country “prints money,” then the total number of units of currency that the value of the economy can be divided into increases, so the value of each unit of currency decreases (since the value of the economy isn’t directly affected by the printing money). So, in effect, the real value of each unit of (fiat) currency is completely arbitrary (from the government’s, or the central bank’s, perspective). (I feel like I’m just pointing out the obvious here, but I want to make sure I understand the basic mechanics of a monetary system in more concrete terms).
Are you recommending that Americans buy gold as a guard agianst currency inflation? I would like to know so I know what to do in the event that Canada ever experiences rapid inflation (or perhaps it would better to buy things like gold or items that will appreciate in value instead of putting my savings a bank).
Also, I’ve been hearing that the stock market tends to react well to “quantitative easing,” and if the stock market is a good indicator of economic performance (at least theoretical economic performance (i.e. the economy is supposedly doing well, even though many people still can’t find jobs and their income is decreasing)), how is that reconciled with what you’ve said here? It doesn’t make sense to me that the stock market would react well to the value of the currency being diluted, or is it perhaps that the stock market performance is illusory in some way?
If the Fed bungles the delicate financial balancing-act that holding inflation at 2% while printing-money requires…hold onto your foil-lined hats. If it fails, the costs-due-impact of QE3 will rival the Gold Confiscation of 1933 that fundamentally devalued the US Dollar by 40% overnight. At-best it could signal a return to the Nixon-Ford-Carter inflation; the current US Dollar is now worth the equivalent of two-dimes when I graduated High School in the 1970s.
Oh, and that “financial mess Bush left me“…
Gas was $1.86/gallon, now $3.87/gallon.
Crude Oil was $46.34/barrel, now $96.62/barrel.
Hey Rattlesnake, here’s the way to think about this in your real life terms. You make $10 an hour today. A shirt is $10. It takes you one hour’s work to buy a shirt. The value of the shirt is one hour of your labor.
Then the Fed increases the money supply (imagine, if you can, you write yourself a check on your current bank account for $100 — you deposit it in the same account, it clears. You know have another $100!) The left hand of gov’t buys bonds from the right hand, with the palms of Wall Street greased by selling and buying the bonds — with money it created by writing itself a check.
But, your wages don’t go up — it remains $10 an hour. But the price of the shirt goes to $15. Now you must work 1 1/2 hours to buy a shirt. The value of the shirt has not changed, it’s the shirt, merely the price changed. This is inflation, which is why it’s a “hidden tax.” This is “quantitative easing”– or, in real words: inflation.
The Gov’t is inflating the dollar to raise prices, so it looks like we all have more money — and is asking everyone go out and buy stuff, at higher prices. And that’s because too many economists think that only buying stuff at any price is good for the economy. This is why Keynes always suggested priming the pump, to give money to people so they can spend it — without any regard for the relative worth of the money. The claim is added to in that this will “raise” gov’t revenues, for there’s more tax money – that must be spent on higher prices, alas, so it’s the worth, different number.
That is, $10 an hour for a $10 shirt is better than $15 for a shirt when you still make $10 an hour.
Yes. But I’ll add some detail.
When the Treasury needs to issue a bunch of new bonds, it auctions them off to the ‘primary dealers’ (basically, the biggest banks). They put up the money, in expectation of being able to re-sell the bonds quickly to someone else. They only bid because they have an idea of whom they can re-sell to. Say it’s the public. If the Treasury issues too many bonds (because the deficit is too high), the public won’t absorb them at low rates; the public will demand a higher interest rate before buying them from the primary dealers, who in turn will demand a higher interest rate from the Treasury. Now, enter the Fed. If it’s buying a lot of bonds, the primary dealers know they can offload bonds quickly to the Fed, and at low(er) interest rates. And that is what has been happening. This year, the Fed has been the main customer for the Treasury’s longer-term bond issues, buying 50 to 70 percent of most issues. The effect is that the Fed buys bonds from the Treasury, going through the big banks as middlemen.
Yes. Like any bank, the Fed has a balance sheet. On the liability side sits the stock of dollars that they have issued. On the asset side, sits some gold and a ton of U.S. Treasury bonds and mortgage bonds. Right now, their balance sheet stands at about $2.8 trillion. Under the new bond-buying program, the Fed balance sheet will expand to about $4 trillion by the end of 2013.
Yes, both. But keep in mind that the U.S. Treasury is not paying down its debt balance; it is adding to its debt balance more than $1 trillion per year. In effect, it pays off old bonds by issuing new ones – in ever-larger amounts.
Money is whatever a given society collectively wants to use as their unit of account, medium of exchange, and store of value. It could be beads, gold, or a fictional invention – like, say, euros or dollars. The picture is complicated by fractional reserve banking, which lets ordinary banks create additional money (defined as bank deposits) by their lending practices. But in all cases, the total stock of money in existence at any given moment of time, is finite.
Correct. In line with what I just said, there are various types/measures of money like M0, M1, M2 and MZM. In all cases, you can take the amount of money and divide it by nominal GDP, to get the percentage of GDP that is “backed” by that type of money. Flip the ratio around, and you have the “velocity” of that type of money: the number of times that each dollar must circulate, to support the nominal GDP. Printing new money tends to lower velocity at first, but as the new money circulates, velocity may return to normal and nominal GDP may go up.
One question is, how fast does velocity return to normal? If people just hoard the cash, it returns to normal but slowly (or not at all), and nominal GDP does not rise. Assuming it does return to normal, another question is why does nominal GDP rise: because real GDP is rising (people are producing more), or just because the general price level is rising?
In the U.S. situation, people (both domestic and foreign) have been hoarding the cash, keeping down both velocity and GDP. I argue that they have done so from fear of the future (or loss of confidence) created by Obama’s various destructive policies. I also argue that, as the Fed prints money again and again, people will eventually reach a tipping point where they collectively realize that “cash is trash” and disgorge their cash hoards, creating a sudden drop in velocity and a big rise in price levels (additional to whatever we’ve already seen). That is a classic pattern of how hyperinflations play out, and the Fed is doing all the ‘right’ things to take the U.S. down that road.
As I am not an investment advisor, I make no investment recommendations. I will only say that this quote of yours:
… is nothing that I would care to argue against.
In the short run, yes. Remember, the way the Fed does QE, the financial sector is one of the two sectors that gets the money first (the other being government). So a lot of money is sloshing around in the financial sector and, as interest rates (bond yields) are depressed, the money goes into speculation in stocks, commodities, real estate, etc. And Bernanke wants that. It’s part of his goal. He has said that he thinks it promotes recovery, by making households feel wealthier. The problem is, it only helps households that were wealthy to begin with (the holders of stocks, commodities and real estate); while other households suffer because now they must pay more for real goods of all kinds – such as food, gasoline, home heating, etc.
But it isn’t: I mean, not anymore… not with the Fed goosing the financial markets artificially through QE. It is now widely recognized in financial circles that the stock market is disconnected from fundamental economic and/or company performance. In effect, QE is large-scale market manipulation which destroys the markets’ ability to price assets on their true value (or prospects for future value); that is another great harm to come from QE.
In the long run, they won’t. In time, company earnings will be destroyed as input costs rise, and as malinvestment continues to accumulate (for reasons just stated) in the economy.
I believe it is.
Typo – the above comment should read:
People disgorging their cash hoards would mean a spike in velocity.
In addition to ILC’s expositions in his OP and his comments, here are a couple of additional items, excerpted from a post I have going up next Wednesday:
On top of this, though, the Fed is creating another time bomb, one which it has no hope of controlling. When interest rates rise, and the cost of borrowing goes up, for lending institutions as well as for borrowers, as the former search for funds to loan to the latter, those lenders still will be sitting on all those mortgage loans let at artificially low rates. Those low rates in a healthy economy (let’s skip over the high inflation, high interest rate economy) will be far below then-market rates, and so those existing mortgages, mortgages with which the lender still will be stuck, will not be generating enough income for the lenders to continue to loan. For up to 30 years in the mortgage market. Can you say, “S&L bankruptcy?”
and
[A]s Federal Reserve Bank of Richmond President Jeffrey Lacker said Saturday,
Channeling the flow of credit to particular economic sectors is an inappropriate role for the Federal Reserve[.]
Or for any part of the government.
Eric Hines
Ted, Jim, Eric – right as usual!
It is difficult to believe that Ben Bernanke´s injection of new dollars into the economy is not politically motivated. If Obama is reelected he keeps his job. If Romney is elected his days as Fed Chariman will be numbered. Governor Romney has already said as much. His plan to inject on a monthly basis is scarey. With the dollar so devalued inflation will be high, if not massive. So much printing of money and high inflation caused the collapse of Germany´s Weimar Republic. Will Bernanke´s policies collapse ours?
Thank you ILC, Jim, and Eric.
So, when does the Treasury issue bonds (that is, what, if anything, is the issuance of Treasury bonds dependent upon)? Does it issue them without regard to demand?
So he wants them to feel wealthier instead of actually being wealthier (and in fact making many of them poorer because of inflation), presumably just so they will spend more money (which thereby promotes indebtedness).
So, when does the Treasury issue bonds….
There are a couple of reasons for a government to issue bonds/sell debt. One, like businesses, is to cover short-term temporal gaps between irregular income (sales receipts for businesses, tax payments for governments) and very regular expenses (payroll, debt payments, supplier payments). So the government issues T-bills (although this isn’t the only reason the government issues these). Businesses issue long(er)-term debt to raise money for big ticket items, for plant expansion, and so on. Governments can issue long(er)-term debt for these, but Federal expenses tend to be for no longer than two years (constitutionally for the Army, but in practice for all expenses). In any event, the primary reason for the government to issue longer-term debt today is to cover the gap between total annual income and total annual expenses. And since the government has been running deficits nearly every year since FDR (and earlier, but with FDR it really got outlandish), the debt just keeps growing–which payments demand ever more debt to be issued.
As to when, the Feds issue their debt very regularly: monthly for T-Bills, quarterly and semi-annually for longer-term debt. ILC probably knows the details of this more than I; I don’t include Federal debt in my portfolio–never have.
Eric Hines
Good point to clarify. I’ve been using the phrase “Treasury bonds” vaguely, to mean any debt instrument that the U.S. issues. But technically, there are Treasury bills, notes and bonds, where the 3 terms mean different things, explained here: http://www.investinginbonds.com/learnmore.asp?catid=9&subcatid=50&id=101
Any government treasury issues debt instruments when they need to, for cash flow management. The Treasury continually collects taxes (with seasonal peaks like April), and continually spends money for budgeted government programs, or to pay off debt instruments that have matured. If a lot of debt must be rolled over, and/or if the government runs a large deficit (and the U.S. has both), then tax receipts will be nowhere near enough to cover outlays. I think the U.S. Treasury auctions off new debt issues, sized in tens of billions of dollars, several times per month.
Here‘s the nearby auction schedule for various durations of Fed debt instruments.
Eric Hines
At the recent Fed meeting, one Fed governor dissented from the new QE policy. From his press release: http://www.richmondfed.org/press_room/press_releases/about_us/2012/fomc_dissenting_vote_20120915.cfm
I couldn’t agree more.