Friday, May 02, 2014

What actually happens when America introduces Quantitative Easing?

Quantitative Easing (QE) sounds like a respectable word. It seems to be a legitimate tool that can be used to stimulate the economy. So, it seems.

When the US Federal Reserve Board or FED introduce this term, it is a nice word for reducing the interest rate in the economy. This is achieved by printing money, and making large supply of US dollars available to businesses at low cost. The aim is to stimulate the economy.

It also benefits the US government by reducing the interest rate that the it has to pay for the debt, or government bonds that it has to issue to fund its deficit.

Normally, when a debtor increases its debts, it has to pay a higher interest rate to compensate the lenders for the risk of inflation and depreciation of the currency. But, it does not happen to America. The world and its lenders seem to have confidence in the US government, in spite of its increasing debts. They continue to be quite happy to take up the new issue of long term bonds, even when the interest rate is rather low and inadequate to compensate them for the risk of inflation and a small risk of default.

The lenders are the countries with large surplus in its balance of trade, such as China and Japan. They continue to invest in the debts of the US government.

After a few years, the lenders start to worry. They are holding on to too much US debts. They are not so keen to take up additional debts. They start to look for other countries to invest their surpluses.

What does the US government do? They need to have lenders to invest in the new debts that they have to issue to fund their deficits, and to refinance the maturities of the old debts. If it is clear that the foreign funds are not investing in the new debts, the interest rate will increase sharply. There will be a crisis - a loss of confidence.

Who can be counted to invest in the US government bonds, to replace the major lenders who are now feeling shaky about the quality of the debts? Who will not ask any question and invest in the bonds as a duty under "national interest"? Of course, it has to be the Americans - the corporations, fund managers and the individuals. It is important to protect the "national interest".

Unfortunately, these institutions and individuals are not so patriotic. The individuals and institutions have to look after their self interest. This is how the free market and private interest works.

There is one institution that can be counted to be the lender of last resort, that can take the burden of looking after the national interest. It is the faithful US FED. They can buy over the bonds that foreigners and even their own private investors are not keen to buy.

They introduce a new concept, called "asset purchases". The US FED will buy over the bonds and other mortgages that other investors are not keen to have.

The US financial experts are truly innovative. At first, they print money and issue government bonds at low interest rate. Later, when the foreign and private investors are not keen to invest in these bonds at the miserable interest rate, they get their own FED to take over these debts and give it a nice term, called "asset purchase".

The US FED is now reducing its "asset purchase" program, but it reality they are still continuing the buy the debts, but of a smaller quantity. The total debt of the US government continues to increase to a very large number, in trillions of dollars.

So far, so good. As long as the foreign investors are willing to hold on to the debts, and continue to invest in the new issues, it will be all right. But, what if they decide to panic?

Tan Kin Lian


ck said...

Mr Tan
Where does Fed get the money to buy the "asset purchase"?
Is it printing more money?

Kin Lian Tan said...

They print money. And beyond printing money, they use the money to buy their bonds, giving the impression that their bonds are quite popular among investors. It is a double whammy!

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