Out of Thin Air

Quantitative Easing is a funny old thing. It's effectively creating money out of thin air and it is currently seen as the method to rescue the global economies. It's such a great idea, it's a wonder that we don't do it ourselves - individuals that is.

But we have. More of that later.

The US Announcement

The theory goes that money, like matter, cannot be created or destroyed.

That's not entirely true. Today, the US Federal Reserve announced a package of $1.2trillion of Quantitative Easing in proposing to buy Government debt (Gilts or Treasuries) and mortgage backed securities over the coming months. It is effectively printing more money or creating more dollars in the economy out of nothing.

You see, the Fed does not have these dollars.

What it has is a Reserve of money or deposits and at any time it can use something known as Fractional Reserve Banking to say that at any one time not everyone will want access to that Reserve. In fact, so confident of this fact are banks, that they then create multiples of this Reserve as an amount of dollars or pounds to lend out to people. As long as they don't breach a certain ratio of circulated dollars to the Reserve then they can issue as many as they want. And this is what the Fed has done, as has the Bank of England.

Like my pyramid of champagne glasses analogy, the new money created cascades from the banks that hold the debts the Fed is buying, down to businesses and then onto consumers - and the one thing they then bet on is that like idiots we will spend this new money. We will receive it via greater lines of credit and lending from businesses and banks in the form of loans, mortgages and credit cards in the main.

Problem solved.

Not Quite

Of course, if you create more money, effectively you are reducing the value of money already in circulation and that is why the dollar took a sharp pasting from a range of foreign currencies in response to this. But it also has the effect of decreasing the yields on gilts (National Debt if you like) and again the US markets saw the sharpest ever drop on gilts yields in response. This has a big knock on effect for all people who are saving and wanting to retire as pension funds and annuities are very dependent on gilts - their value and their yields. As the Gilts market decreases, there is a large shortfall in pension funds created and in end salary pensions, the deficits sharply increase.

Quantitative Easing, just like increased long term Government borrowing, has a profound effect on the future earnings of individuals - and this time not just in tax payments but in actual retirement income. It is a short term fix which has a profound effect on the future of each and everyone of us and it is why it is a method of tackling the economy which smacks of deep desperation.

Quantitative Easing For Us

It is not quite the same but effectively in the last 10 years we, as individuals, have behaved like banks. We have leveraged our own 'reserves' which could be our property asset values, and raised more money to go and spend on other assets, lifestyle changes, holidays or consumables. As the yield on our own 'sovereign debt' was low in terms of interest, borrowing against our assets was relatively cheap and despite our own household disposal income actually shrinking over the same period, we actually made ourselves a good deal richer by releasing far more money to spend. In the wider economy this created a fantastic boost to GDP and corporate profitability and as long as our asset values remained high then there was no end to the cycle of getting more money.

The problem, of course, is that unlike the Fed our reserves were not deposits but variable value assets and their value had been artificially inflated due to the very process of releasing the locked up equity in them. The more we released, the greater their value became and the more we could release. It could not possibly be sustained - and there is a simple reason for it. The complex reasons which everyone had used to suggest it could never change was that even if there was a recession or downturn and the ability of people to repay the debt was changed, this could be accommodated for as things like unemployment could be less impactful while lots of incentives and creative lending practices could be used to keep first time buyers get in the game as someone had to be at the end of every chain.

But the simple reason was that the whole system was built on greed and that made sure that it got riddled with bad practice.

Criteria for loans went out of the window, which Gordon Brown points out was the cause or sub-prime, but it was not the primary cause as it was merely a symptom. The cause was the fact that banks were trading in debts many times over to create more profit and provide an endless supply of cash to lend for the next debt. It was the very system used to create the lending that was the problem, sub-prime became just a peripherary result that showed why the system was unsustainable. Banks had used the system of debt trading to access cash way above their own reserves which fuelled their profits and more lending and this became the principle method for growth and funding their business.

Sub-prime highlighted the folly and the availability of cash dried up immediately (The Credit Crunch) as no one had any idea who owned what asset and how much it was worth. In the UK some banks had lent 125% of asset value, some had increased earnings multiple criteria to 5 or 6 times earnings and included variable bonuses in it, some had taken external guarantees from parents or relatives, some had taken shares as security, then some had lent stupidly on the corporate market, on property - the fact was that each new loan they made had a fantastic, almost unbelievable return and this is waht produced a 162% rise in property value ove rthe 10 years.

And sure enough the whole thing collapsed.

For us, as mortgage holders who had leveraged the excess equity in our homes, the bottom quite literally fell out our world. Our money making machines - our homes - started to plummet in value and in conjunction with a lack of available credit to renegotiate the loans and a recession to threaten our abilities to repay, we saw the equity we had released turn into a massive loan with no security.

Our own version of Quantitative Easing had backfired on us spectacularly.

The Future

Real Quantitative Easing is different to how individuals raise their money but the principle of creating extra cash from thin air has real parallels. There are risks associated with Quantitative Easing as it can trigger higher inflation or even hyperinflation as Argentina has seen in its not too distant past. The Bank of Japan has used it in recent times in conjunction with zero percent interest rates to try to stimulate its economy - it has had no real tangible effect as Japan remains in a relative trough which has lasted for some years. The theory says that if this is done by Central Banks as opposed to Governments just printing money then the risks are less.

Tell that to the people who save and who are wanting to retire. They are shouldering all the burden right now to compensate for the greed of a few who could not help themselves and a set of Governments and Regulators who did not have the intelligence, gumption, fortitide and appetite to stop it.

Mervyn's Day At The Casino

In The Bank of England's incredible 315 year history no Governor has ever tried it, not even in very bad times before. Today Mervyn King will become the first man in British banking history to use the Fiscal Policy known as Quantitative Easing - for those of us who have not swallowed the Economics textbook it simply means to print more money.

Quantitative Easing (QE) - The Idiot's Guide

Imagine a pyramid made up of three layers of champagne glasses. QE is much like pouring in liquid into the glass at the top so that it overfills and cascades into the glasses below it which in turn fill and then overflow into the glasses at the lower level which also eventually fill and overflow. If you think of the top glass as the banks, the middle layer as business and the bottom layer of glasses as consumers, then what you see is pretty much the process of QE.

It's the idea that if you print a load more money, pour it into the banks, they will want to lend more to businesses who in turn offer us, the consumers, more credit.

Now the real dummies amongst us may point out that a great many transactions today do not use money and that therefore the process of printing more money will have far less relevance today than say in the period known as The Great Depression in the 1930s when the theory was honed.

All I can say is that the intelligent people who came up with this idea have pulled their heads out of the theory book, written all those years ago, and noticed that fact and have, of course, taken it into account. I think.

These intelligent people are the ones who have presided over the collapse of 5 major UK banks and pumped a great deal of money into the banking system already without any great effect but, keep quiet cynics, because now it's Mervyn King's turn - and he has kept a discrete distance from the fiasco to date, adding a few acidic words about policy every now and then. To a large extent, he has kept his credibility alive by doing so.

But today marks the start of his big gamble - one unprecedented in modern times. Let's all hope 'Big Merv' is right.

How Does It Work In Practice?

At midday today - as such is the pageantry of big banking business - an imaginary gong will go and the Bank will start to use its £75bn of new money it has printed to offer to buy £2bn of Government debt in the form of bonds from institutions.

It's some convenience to just go and print a load of new money and that's based on the concept of a 'Fractional Reserve'. This is vaguely about the notion that at any time The Bank of England has, say, £100bn in its coffers but it may print up to, say, £600bn of bank notes to go into circulation - remembering each bank note comes with a promise to pay the bearer the amount on the note its value should the bearer present it at The Bank. Fractional Reserve tells us that in practice no one ever does and certainly not at the same time - so we can print vastly more notes to go into circulation than their total promissory value held in the Bank's vaults. Quite how the Bank would pay these days as it no longer has any gold is another discussion entirely - but don't worry, our PM has thought of everything.

So the first of these bond auctions will start today and The Bank of England will be buying these £2bn batches of Government debt or Gilts. Two hours later, there will be a second stage when the institutions and banks will be allowed to participate in these reverse auctions - and similar activities will carry on twice weekly until all the new cash printed is consumed.

Gilt prices have risen sharply in the last few days as the financial system salivates at the prospect of more money being created out of thin air and being spent - it's just like a sucker walking into the East End with a wadge of new notes wanting to buy a car from Arthur Daley, there is not a chance in hell these Gilts will be a 'good deal'.

The top champagne glass is being filled starting today. The one snag in my analogy which is reflected in real life is that nobody knows how much the champagne glasses hold and so how long and how much money will it take to fill them all.

Deflation

This amazing gamble comes after The Bank has dropped interest rates to 0.5%, the lowest rate in history. This kind of Fiscal Stimulus goes into a new area known to some (i.e. me) as Fiscal Defibrillation - a series of very sharp and big jolts to the heart of the financial system to stimulate it into life. QE is the second major jolt, if you discount the meagre £1.3 trillion of bank bail outs, loans and guarantees on offer to the UK banking system. The disease that The Bank is trying to avoid is 'Deflation', the banking equivalent of 'MRSA' which is what the injured financial system may catch after its major surgery and tries to recover.

Thankfully, the financial system is not being treated by the NHS but by clever people like Mervyn King, Alistair Darling, Gordon Brown, Yvette Cooper and a host of really brainy, intellectual and incredibly greedy bankers. So our economy is in fine hands, as it has been for the last 10 years.

Deflation is a bit of a killer disease itself - it's the concept that just as the financial system is recovering then prices to start to fall rapidly - just as in the fire sales we have been seeing in shops. Consumers, of course, those irrelevant carriers of wealth that rich people would like to have, like lower prices - but we are not the important ones here. If bankers cannot make huge profits, where is the fun of loaning us money?

The perverse logic of deflation is that textbooks say that we, the evil consumer, will delay spending the cash given to us via our champagne glasses, in anticipation of yet lower prices - the concept that I will not go to the East End and buy that car off the nice man in the sheepskin coat and trilby this week as he will have a lower price next week. This of course has the effect of increasing the effect of the downturn.

When A Science Is Not Exact

The financial process of treatment and recovery is sadly not an exact science as we have seen so far from the vast bank bail outs across the globe, estimated at around $5 trillion and rising. Mervyn King grimly warns that he does not have any idea how long he has to keep printing money and how much will be needed to get us to spend again. All he knows, or should I say, thinks, is that eventually it will work.

That's why no one has ever tried it before. I don't know about you, but that really fills me with confidence.