What is Quantitative Easing?

You've probably heard the term "quantitative easing," or QE, in the news. You may have heard of QE1 and QE2, and now are hearing of QE3. You may understand that these have something to with the government trying to help the economy, but don't know quite what they are.

Quantitative easing happens when the Federal Reserve Bank buys long-term US debt or bad  private debt with newly created money.

In normal economic downturns, the Fed makes more money available in the financial system by buying government bonds, usually short term, on the open market with newly created money. This puts money out in banks, making more money available to be borrowed at lower interest rates. This, theoretically, encourages people and businesses to borrow and thus stimulates the economy. This effort is called "open market operations." When you hear of the Fed lowering interest rates, one way it does it is through OMO.

QE does the same thing, with a major difference. In OMO the Fed buys top-quality debt--U.S. bonds, considered the safest investment in the world. In QE, the Feb can buy longer term Treasuries. But it can also buy toxic mortgage debt, bad debt left over from the sub-prime mortgage crisis. This is like a person who has always eaten at Ruth's Chris Steakhouse suddenly switching to McDonald's.

In both OMO and QE the Fed creates money out of thin air and injects it into the economy. The difference is when the Fed decides to take money out of the economy, in OMO it is easy to sell the bonds it earlier bought. With QE, who is going to buy the toxic debt the Fed earlier purchased? That is a problem for the future, however, as the Fed has bigger fish to fry in the present.

QE involves massive amounts of money. QE1 in 2008-2009 totaled $2 trillion in debt purchases. QE2 in 2010 totaled $600 billion (but included no toxic debt). QE3 is projected at another $500 billion. That's total of $2.1 trillion, or one-eighth of the total economic activity (GDP) of the United States in 2011.

The Feb engages in QE both to place money in circulation and also to provide a haven for bad debt. This is intended to support the economy while it heals. Does it work? Well, it can protect from a complete meltdown in the short term when there is so much bad debt that the credit market freezes, as it did in 2008. But there is no evidence that QE actually stimulates a recovery. Japan has been depending on QE for twenty years, and their economy has remained in deflationary stagnation the entire time. In fact, QE may in the long run hinder true recovery.

The problem with QE is, again, it does not allow the markets to naturally unwind bad debt. It prevents the natural consequences of bad investments to correct so that the economy can truly heal. To wax a little gross, it's like giving someone with food poisoning massive amounts of Pepto-Bismol instead of just letting him throw up and get the toxic food out of his system. Thus the historic result of QE is ongoing malaise. Burp.

So, today (Sept. 13, 2012), the Fed will give some clue on whether another round of QE is in the works. Get ready for more Pepto-Bismol.