Tuesday, 8 November 2011

Quantitative Easing - why now?

Previously we discussed what Quantitative Easing is, and I promised that I would go on to explain why you've never heard of it until the last few years and suddenly now it's everywhere. I'm also probably going to scare the living daylights out of you when you understand the eventual results. So, strap yourself in for another brief ride on the money rollercoaster ...

First you must understand there are two different types of 'money' in today's world.

  • There is 'base money': money that has been created by the Central Bank - in the UK the Bank of England, in Europe the European Central Bank, in the USA the Federal Reserve, etc. This is money that already physically exists as bank notes or coins, or money that's in the system which the Central Bank has committed to print or mint into coins if it is necessary to do so. This is money that will not go away.

  • There is 'credit money': created by high street banks whenever you or I take out a loan and promise to pay it back. This money doesn't physically exist and never will, because it is simply a record in the bank's database, stating that base money was passed to borrower X, who has promised to repay it at date Y, paying along the way a rate of interest Z. This is money that exists only for as long as the borrower keeps up the repayments until, hopefully, they make all payments and the full amount promised has been paid to the bank.
Once you understand the difference in the qualities of credit money and base money, you can move on to understanding that when you as a saver look to earn interest from your bank by leaving your money in a savings account, you are effectively giving your money to the banker. He (or she) can do with it as they see fit.

What they do is give it to someone else in return for a promise to repay it later, paying him a higher rate of interest than he has committed to pay you, the saver. You as the saver no longer have that money even though, if you're like most people, you still consider it to be your money. You expect to be able to take it out of the bank and spend it when you want to. But the money you gave to the bank has already been given to someone else, and they've already spent it. It is no longer accessible to the bank, so how can they pay it back? The answer is they cannot possibly pay it back to everyone at the same time. Or in fact to even 10% of  savers at once.

The rationale is that the money to pay you back will exist in the future when the borrower has earned more money over time and repaid the loan to the banker, who then can repay you the saver. A great system, as long as everything goes to plan. But you do need to understand that your savings are at risk if you leave them in a savings account with the bank. Because the banks no longer have all the money everyone has paid in. Even the most conservatively-run bank doesn't keep as much as 10% of depositor monies available.

There is not a big problem if one or two borrowers are unable to repay their loans. In fact the bank expects a few people to stop paying and they factor this into their interest rates on the loans. But in a serious recession, like the one we are in today, there are many more than one or two people failing to keep up the repayments on their loans, credit cards and mortgages. There are a LOT. This is why many of the banks are in a lot of trouble and governments have been frantically working with them to try to hide it from everybody. In the meantime Quantitative Easing (the process of issuing more base money) takes the heat off temporarily, giving the banks the money they need to ensure all savers can get their money back if they ask for it.

Once you understand that your savings are actually not just stuffed in a shoebox in the safe for you by the banks, but are being put at risk, you need to consider what will happen if a lot of borrowers find themselves unable to repay their loans after all, as has happened in recent years and is still happening today. The simple answer is that savers will find that their money is no longer available to them from the bank.

Think back to Northern Rock and the images on the TV and in the papers showing the queues along the street outside their branches, it was the first British bank run in centuries. Before the doors were closed and they had to be nationalised. Bailed out by the government (in other words by YOU, the taxpayer), via the magic expedient of Quantitative Easing. But it wasn't only Northern Rock that was in trouble, because Halifax Bank of Scotland, Lloyds TSB, and Royal Bank of Scotland also were in just about as much trouble. They were swiftly part-nationalised before a run on them took hold, setting off a chain reaction through the global banking system as confidence in all banks the world over came into question. The government stepped in to guarantee the deposits of all savers at all British banks. Without this assurance, there would have been a run on almost every bank in the UK. The lights would have been turned out on the British economy. Not only that, but the same story of bank panic, as the world wondered who these questionable banks had borrowed from, was playing out at the same time all across the Western world. It was unthinkable to see the global banking system crumble. This bailing out of the failed banks is what Quantitative Easing is really all about. It's not about you, the saver - although, ultimately, banks that don't fail are something of a benefit to anyone keeping their money there.

The sheer scale of failing loans in this recession has put many banks at the brink of collapse just like Northern Rock. It cannot be tolerated, while the money system of today presents no barrier to prevent the authorities simply issuing more base money out of thin air, for savers to lose their money that they think is in the banks. All the money the government needs to ensure all the savers get "their money" back from the bank, will be created to replace the credit money that went to money heaven when the borrowers stopped repaying their loans.

So that is why you've heard so much about Quantitative Easing in recent years. Unfortunately, since we are still stuck in a recession, you're going to hear a lot more too.

I also want to ensure you appreciate another difference between 'credit money' and 'base money'. You can spend 'base money' right now, today, but you have to wait to spend credit money that is locked up in a savings bond or a savings account with a notice period (which we agree to because these are the only ways to get a decent rate of interest). This is why you will notice the pitiful interest paid on your current account — it's a bid to tempt you into a savings account instead, so the banker can loan out your money and make a bit himself for the trouble.

The 'velocity of money' (the number of times the same money changes hands between different people over a given period of time) will increase as a result of Quantitative Easing. This is because so much of the locked-up credit money has been converted into easy-spending base money. Not only does the banker find he has access to the money he should really have had to write off as a loss, but he even has access to the money earlier than scheduled — like now! He can either keep hold of it in his reserves to ensure that he has enough on hand to satisfy savers who might decide to take out their money, which is what is happening now. Or, if (when!) he is no longer afraid of this eventuality, he can reinvest the cash, which is burning a hole in his pocket, in new loans that will earn him more money again. If there is one thing you and I know about banks, it's that they won't wait longer than they feel they really have to, before they return to making as much money as possible.

Once enough of us realise that under today's money system there will never be a shortage of money after all — because more base money will simply be created in the system to replace the savings lost through bad loans — then the recession will be over. People will stop worrying where they will get money to pay their bills. They'll stop taking money out of the banks to put it somewhere they think is safer for them. The banks will start making loans easily available again. People will quickly spend the money they have borrowed. And other people will therefore have a job to make the goods and services the borrowers wanted to buy.

But you can probably already see through this I'm sure. More money in the system, chasing after the same amount of goods and services, will result in higher prices for those goods and services. Well, an increase or decrease in the velocity of money has the exact same effect as an increase/decrease in the amount of money in the system. If the same £10 note is spent twice as many times, it's the same as if there were two notes.

VELOCITY IS WHAT WILL SEND PRICES THROUGH THE ROOF, once people are no longer scared of recession. The current fear won't have a hold on everyone forever. When it subsides, are you ready to hold on tight as all this tucked-away money comes out to play and you get to watch the price of real things take off? Or, more accurately are you ready to watch your cash become increasingly worthless?

So it's still not clear to you why QE is inevitable? OK, how about this...

Let's assume, for the sake of simplification, that all of China's foreign exchange reserves are held in US bonds, plus also that the entire rest of the world doesn't hold any US bonds in their reserves.

This is of course totally bogus — because while China doesn't hold only US bond securities, they for sure comprise the lion's share of what they do hold. Similarly, it is ridiculous to say that the rest of the world outside of China hold no US bond securities. Not forgetting, for a start, "rest of the world excluding China" would of course include the US itself! :-)

Anyway, let's suspend our shared disbelief in this idea for a moment, because it is really only a device intended to massively simplify something we're about to look at together.

First: here is a List of countries by foreign-exchange reserves from Wikipedia, which is composed of data made available by the CIA. Remember, for the purposes of our simplistic illustration, China have only US securities in reserve; nobody else has any at all. China have $3.3 trillion owed to them by the US today. Pretty easy to get your head around this, right? The US owes China $3.3 trillion.

Second: here is a recent set of data from the US Federal Reserve, showing how many US dollars exist ("the monetary base"). As we can see here, according to the US Federal Reserve themselves (the controllers of this currency — so they ought to know if anyone does!), there are currently a little under $2.8 trillion US dollars that actually exist in the world.

The question: How does China get paid $3.3 trillion US dollars, when there are only $2.8 trillion of them in existence today? Even if every single currently existing US dollar were paid over to China to settle the debts to them, there would still not be enough.

And what about all the people inside the US, who need US dollars in order to go about their daily lives? Wouldn't there be a bit of a "shortage of money" (have you heard that anywhere before?), if China started demanding all of their dollars that are owed to them? Again, let's forget for now that US dollar-denominated bonds are today's primary world reserve asset, so in fact the whole world holds predominantly US bonds as their reserves — things are considerably worse for the dollar than our mega-simplification here.

Do you see it now? Do you see why QE is inevitable? Do you understand that massively more dollars in this world (as promised to bond holders) are going to chase after roughly the same amount of goods and services in this world, which can only lead to much higher prices for those goods and services?

If you're like most people, observing this reality leads you to the only rational course of action: to attempt to dump this currency (and bonds that will pay out the same) while you can still buy quite a lot with them. This, unfortunately, has a habit of becoming a self-fulfilling prophesy — the more people realise what is going to happen, the more rapidly it unfolds. The end of this story is a currency collapse, or 'hyperinflation'. This always unfolds at first slowly, then all of a sudden.

So, unless you like to be last in line and to pay the bills for everyone else who came along before you, I would humbly suggest you get to work finding a way out of this predicament. As in so many aspects of life: if you don't know who is the Patsy, it's probably you.

Has anyone ever told you, It's not coming true?

What's that you say? It's STILL not clear to you why QE is inevitable?!?!

OK, here is yet another, killer, reason for you then.

The rest of the world is no longer buying sufficient US/UK Treasury bonds (recycling their trade surpluses back into US/UK debt) to cover the entire budget deficit of the US/UK government. If we take a look today at the size of the US/UK trade deficit, take it away from the size of the US/UK budget deficit... we arrive at a number that approximates the size of Quantitative Easing. But that's just a coincidence, right? ;)

When the rest of the world is no longer willing or even able to mop up all the sewage we have spilling out of our toxic national balance sheets (or should I say, unbalance sheets), we just have to let it all soak in on the front laws of our own houses. Every single person holding Dollars/Pounds today, or even any assets denominated in them, is taking a bath in this shit. And most of them are begging their government not to cut the budgets — presumably because they just love the smell of bullshit in the morning?

Strap yourselves in, because this ends badly.

You do it to yourself, you do
And that's what really hurts

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