The long story about quantitative easing

quantitative easingIntroduction

The world of finance and economics may appear strange and complicated to an unprepared mind. Confusing terminology and the somewhat doubtful logic of economic theories make it easy to get lost in explanations of even the most simple things.

Quantitative easing is one of those things and below you will find all you need to know to understand it. We're going to explain what quantative easing is, why it's done and most importantly, how it can reflect your trading assets and charts.

First, a small disclaimer. It is important to understand that economic science is a world of theoretical models. There is only empirical data received from the observation of actual events, rather than controlled experiments. What economists do with the data is create economic models that explain the data, in the hope that those models could be used to predict the future.

As new data arrives, newer theories are suggested. The statements written below are not rules for economies to behave by, rather they are models that describe economies to the best of their abilities with the data that is available up until this point.

Grow fast or grow slow, but keep growing

Basically, there are two types of economies - developing and developed. Both types need to be growing at a more or less constant rate. If an economy stops growing or if its rate of growth slows, it enters stagnation or even recession.

This was an important line, so it is worth repeating. Unless the economy is growing at a steady or increasing rate it is in fact recessing.

The difference between developing and developed economies is really in the pace of growth. Developed economies, such the US, the UK, Japan, Germany consider a 2% increase in annual GDP to be a healthy number. Developing economies such as Brazil, Russia, India and China, also known as BRIC countries, are considered well off when growing at about 6-8% GDP.

Now, imagine, you are the government of a promising country. The task at hand is to make your economy grow at stable rate. What does it take? Three things.

The first thing is an increase in producing power. Your country needs to be producing more to meet the growing demand of your population. This can be achieved in two different ways - through an increase in the quantity of workers or an increase in their efficiency.

For example, you have one single farmer working his land with a plow. Whilst this may work for the farmer, the government can do better. You, as the government, can spend some government budget and grow the farming industry in your economy one hundred fold either by employing another 99 men with plows, or by supplying a bulldozer that will do all the work,and of course you will have to train the farmer to use the bulldozer.

There are a few things to note here.

One, the production in your growing economy has in fact increased, but for it to continue increasing at a constant rate, you need to continue adding bulldozers, or men with plows at a constantly increasing rate. Two, adding men is usually the case with developing economies that have access to plenty of man-power both now and in the foreseeable future, such as India or China for example.

Developed economies, such as the USA or Germany, due to the characteristically low rates of population growth and high levels of education and technology, prefer to provide bulldozers. As an economy matures from developing to a developed, technological advancement becomes its only way to increase production output with the desired speed

Let's also keep in mind that the farming land in your country is a finite resource as is it's agricultural yield. Thus, to support the growth of your producing power you need item number two - technological advancements.

The third item on the list is investment and this one is important.

Your economy needs money badly, because, as you have come to realise, both men with plows as well as men on bulldozers require money to start working and to keep working. This means that the financing of your growing economy needs to be growing at a constantly increasing rate as well.

You are faced with a problem - where do you get all the money to finance your growing economy at this ever increasing rate that is required?

The answer's simple - you create a banking system with a one big central bank. Now that you have a central bank, it can print you as much money as you can possibly want, but you don't get it directly. You get it via a network of privately owned banks. Here is how it works.

You create what are called government bonds - a unit of national debt. Then you arrange an auction where you invite smaller banks to buy your bonds. Banks will happily buy into these bonds, because being the government you are deemed to be a trustworthy debtor, not to mention you promise to pay handsomely to banks for holding your debt.

Now, private banks can hold your debt until you have repaid it all, or they can go to the central bank and exchange your your debt, for the actual money. This is how you get the money, while the central bank gets a note from you ( the state) that says that you owe them and the interesting part about that is that you can owe as much as you like.

This way, you simultaneously create both money and debt in your economy and you can do it over and over again.

Let's forget about the debt for a minute and concentrate on financing your economic growth with the freshly created money.

You quickly discover that there is a catch about creating money.

The more money you create the more money there is and thus the less value it holds. Basic supply and demand is at work here. The process of increasing money supply in your economy is called inflation. Now you want your economy to keep growing, so your central bank keeps printing money for you, but only at a steady rate.

Economies try holding inflation at a level optimal for their growth. Usually, it is from 2% to 5% annually. Anything below 2% is considered a deflation and is dangerous, because it might slow your economic growth just enough for you to have an economic crisis on your plate.

If there isn't enough money in circulation for your people to pay for the products your economy produces, businesses adjust, production slows and before you know it 30% of your country's population is unemployed and starving, all because you let the money supply drop by only a few %.

So we've gathered that low inflation is bad. What about high inflation? Any inflation above 7-10% is called hyperinflation and it is just as dangerous, as it invites another type of crisis.

If you create money too quickly, it will eat up its own value and you will end up with more cash that can buy fewer things. The hyperinflation in the Weimar Republic - modern day Germany - in 1921 made Deutsche paper marks so worthless and so plentiful that Germans burned them in their stoves for fuel.

Once you have figured out an optimal inflation rate for your economy, you set a target for your central bank. For example, 3% annual inflation is best for you. The central bank has a few ways to add cash to the circulation in the economy - both are indirect.

First, it can lend money to the government, and then the government can introduce this money to the economy through spending it on building roads, for example. This is called budget spending and governments do it a lot.

Second, the central bank can lend money to smaller banks, who will then lend it on again to people or businesses, thus, getting, the money to circulate through the economy. The second option is a somewhat trickier process, since private banks have their own economic interests in mind and if they find that borrowing money from the central bank isn't financially lucrative for them, they obviously won't borrow it.

Similarly, if banks don't find lending money to to people and business profitable, they won't do that either. This is one of the major ways that money can disappear from circulation.

So, how can your central bank tempt private banks to borrow money from it? By changing the interest rates. Low interest rates mean lower payouts from a private bank to the central bank for borrowing a currency and vice versa. So, simply put, low interest rates result in more borrowing which results in higher inflation. Higher interest rates result in less borrowing therefore ending in lower inflation.

A thing to note here regarding private banks is that they are key players in the money supply of your economy. If your central bank can add money to the economy, your private banks can multiply the money that already exists in circulation through a system called fractional reserve banking. It means that a bank can lend as much as it wants, keeping only a fraction of the funds left as collateral.

For example, Joe comes to a bank, starts an account and deposits $100. Thanks to fractional reserve banking system, the bank can now loan $90 of Joe's money, keeping only 10% in reserve. Jack, the next guy is interested in a loan, get's $90 to repay a bet he lost to Steve. Steve takes the 90$ and puts it on his own account in his own bank.

Now Steve's bank can loan $81 - to the next guy who needs a loan - Mark, and so on. We have Joe with a $100 on his account, Steve with $90 on his account and Mark with $81 in his pocket, totaling $271 in our little example economy. But in fact there is only $100. That is how money is multiplied by private banks, but only on the condition that it is loaned.

One last thing about the banking system. It is important to realise that despite the banking system being able to influence the supply of money, it can only indirectly influence the demand for it. Jack has to want to come to a bank for a loan and the bank, in its turn, has to want to borrow money from the central bank

However, individuals, businesses and banks only borrow and loan money when they feel secure enough to do so.

So, basically, it is only through creating a safe and stable economic environment that welcomes growth and development, that the government can influence the demand for money. A drop in this demand means less money is being added to circulation than your growing economy requires, which often leads to a financial crisis.

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What you need to know

This is the bare minimum in economics and finance that you need to know to understand quantitative easing, so lets briefly recap on what you have learned.

Economies need to grow constantly. The alternative is not stability, but recession. To grow economies need to increase their production output, their technological base and most importantly, the amount of money in circulation.

To ensure the economy gets the investment it requires, but that not too much money is introduced into circulation, a central bank can adopt various monetary policies. One of the most popular and effective tools in regulating the money supply available to a central bank is increasing or decreasing interest rates.

Additionally, private banks can multiply money in circulation by loaning about 10 times more than they actually have thanks to the fractional reserve system.

Finally a government, with the help of a central bank, can more or less directly influence the supply of money in the economy, but it cannot influence the demand for it.

How to spot a financial crisis and how to fight it

Thanks to the central bank type systems, economies can grow with great speed, over a short period of time and to immense proportions. However, due to the nature of how they function, such economies require that more money is constantly introduced. What happens when people or businesses no longer feel confident in borrowing money? Money multiplication stops.

Public spending decreases, the demand for goods and services declines, and business expansion slows down. Shortly after the demand,the supply declines as well, as businesses cut production and lay off personnel, adjusting to new market conditions. Unemployment grows, further reducing household income and so on in a downward spiral.

What happens when private banks don't feel confident enough lending money to people or business? Money multiplication stops.

If one too many or too big debtors (like Lehman Brothers holdings Inc.) go bankrupt, a bank may go bankrupt itself. One too many people come back to their bank to withdraw their money and the bank suddenly realises that they are running low on liquidity and avoid getting into an even riskier position by cutting back on lending.

Such behaviour proves to be highly contagious, since investors are easy to spook. The chain reaction continues until everybody's got their money under the pillow, waiting for a better day. Once again, public spending drops, business development slows and the economy is facing the same downward spiral into a recessional abyss.

At this point, or better yet, before this point, the central bank has to be aware of the belt tightening of private banks and increase money supply through lowering interest rates.

Quite logical, really.

If private banks have enough money to feel safe they will begin lending to individuals and businesses again, and money multiplication will resume, providing the economy with the necessary funds it needs to go on.

But what happens, when interest rates are near 0% and can not be lowered any further? This is when quantitative easing comes to play.

Quantative easing

The broad definition of quantitative easing is an aggressive monetary policy that involves a central bank purchasing significant amounts of financial assets in an attempt to stimulate the economy by adding cash to it directly.

In theory, quantitative easing is expected to achieve two things - an increase in the money supply in circulation, as well as an increase in the value of financial assets that remained in the market. Both lead to a bank environment that stimulates extended borrowing to people and businesses and less spending on purchasing expensive assets.

Quantitative easing comes in many forms, varying mostly on what assets a central bank should buy, from who and in what quantities.

The original easing and consequent implementation attempts

Quantitative easing is a relatively young concept proposed by a Japanese economist of German descent, and inspired by a growing real estate bubble in Japan around 1990.

Professor Richard Werner recognized that most money in the economy comes not from the central bank, but from private banks applying the money multiplier when making loans. Thus he argued not so much in favour of the central bank buying government debt, but rather in favour of the central bank entering long-term deals with private banks, aggressively buying assets from them.

In 2001 the Bank of Japan implemented an aggressive monetary policy, that they called quantitative easing, however it wasn't quite what Werner suggested. The Bank of Japan did exactly what Werner cautioned against - and purchased enormous amounts of government debt.

We now know that all those attempts to drive the world's third largest economy out of a decade-long deflationary period were futile and, arguably, lead only to the second decade-long deflationary period.

In 2009 the Bank of England introduced their own version of quantitative easing, simultaneously cutting interest rates to boost the effect. This was arguably, another failure.

Britain did more or less what Werner suggested in his theory, correctly pumping new money into the economy via private banks, only this did not stimulate lending. It stimulated financial trading and freshly created pounds sank in the vastness of the financial markets leaving nothing for the British economy they were meant for.

By 2014 the Bank of England has printed some $410bn and though the British economy is now showing signs of recovery, its inflation fell well below the projected level of 2% to record low 0.0% and is now at risk of deflation. Clearly this is the opposite of what was intended.

In late 2008 the US Federal Reserve Bank started by far the most ambitious quantitative easing program to date. Their idea was to buy as many financial assets as possible from everybody everywhere, starting with the cheap and numerous mortgage bonds that saturated the market, because nobody wanted them.

Those were exactly the same mortgage bonds that were the final snowflake to cause the financial avalanche of the 2008 world financial crisis. This resulted in additional 3.7 trillion US dollars being pumped into the US economy and eventually dispersed over the global economy in the five years that followed.

Many world economists consider this by far the only successful quantitative easing to date, although there is systematic criticism from non-government economic sources.

Nonetheless, the US economy is considered to have moved from a critical state to a state of recovery. By September 2015, the Federal Reserve is hoping to start gradually raising interest rates, despite inflation dropping in the US as it did in the previous cases.

In both 2013 and 2014, Japan again decided to attempt quantitative easing. Their program of pumping money into the Japanese economy is still smaller of that in the US in total, but proportionally it is much bigger.

The Bank of Japan has announced that through monthly injections it will purchase government debt totalling around $650 billion. There has been no significant improvement in Japan's economy since, only more deflation.

The Eurozone is embarking on a quantative easing program of it's own in 2015, in an attempt to inflate the shrinking EU economy. The ECB's quantitative easing policy will start with a modest $1 trillion. Modest that is when compared to the size of its economy.

The European Central Bank announced that they are planning to pump one third of what the US did, but this number may grow, if, as it did in the US, quantitative easing proves to have at least some positive effect.

The European Central Bank's idea is quite similar to the Federal Reserve's. Quantative easing will involve the purchases of financial assets, including the government debt of Euro Zone member states as well as assets from agencies and institutions. The inflation rate is being targeted at 2% annually as it was with all the above mentioned countries.

Criticisms of quantitative easing

First and foremost, the critics say that unproductive investment is by nature ultimately deflationary. This is why, 'dumping cash' into private banks that use it in the financial markets rather than in crediting the population is a failed maneuver.

Similarly, inflating other economies with your own government debt, as the US did with China is neither good for China nor for the US and both are equally to blame.

Another wing of financial experts claims that aggressive monetary policies such as quantitative easing, strip the economy of its business cycles and that by smoothing the recession, central banks also smooth the after-recession economic boom.

The Bank for International Settlements (the central bank of central banks), stays impartial and observant of national central banks, though carefully comments that the world has gotten much too dependant on economic stimuli.

The impact of quantitative easing on currency markets

There are two market reactions for fundamental news out there - the instantaneous spike when the news is realised, announcing a change, and an eventual adjustment of the price as the announced change starts actually influencing the market.

So, what happens when quantative easing is announced and what happens as it is applied to the market?

Theoretically, both would cause weakness in a currency, since more currency is added to circulation - increased inflation - upping the supply and lowering the price. However, is that what really happens?

The EU announced quantative easing on 22 January 2015. EUR/USD fell 500 pips over the next two days. As of this moment, the fall has paused, whilst economists debate the likelihood of achieving parity between the EUR/USD pair.

The UK announced quantitative easing in March 2009. GBP/USD dropped 600 points in two weeks, but rallied 3300 points in the next four months and ranged for the remaining part of the year.

The US announced the first round of quantitative easing in December 2008. EUR/USD gained 2000 pips in the following week, retraced to its original level in the next month, then grew steadily for half a year and started ranging with the slopes more or less corresponding to pit stops taken by the Federal Reserve in between Q1, Q2 and Q3.

Compared to gold, the US dollar was losing value from 2007 to 2011, and has been slowly appreciating since then.

Japan's new round of quantitative easing started in April 2013, causing JPY to drop 900 pips against the US dollar, however, the exchange rate stabilised for the following year and a half.

To sum up, the first reaction is to dump the inflated currency, but with time it appreciates despite the theoretical logic. So far quantitative easing statistically proves to be deflationary in nature for the Forex market.

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Conclusion

The data on the effects of quantitative easing around the world is being analysed constantly and the outcomes of aggressive monetary stimulation are anything but conclusive.

Various economies and their currencies have reacted differently to quantitative easing techniques adopted by their central banks and the definitive conclusions on the matter will take years to draw.

In most countries that attempted quantative easing, it has led to no inflation decrease, and sometimes even deflation. Trillions of dollars have been injected into the world's economy by various nations.

Mature economies have indeed recovered from their industry busts, but the newly created money has also traveled across borders, creating national-size economic bubbles in the developing economies.

The question here is, will and when will they blow?

The best advice here would be to keep a close eye on the markets. Further research the effects of aggressive monetary policies on the economy may be needed, but always remember that the economy might be improving despite the currency losing it's relative value and vice versa.

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