Common Cents for September 14th 2012

November 1, 2012, by John Norris

Yesterday, the Federal Reserve another round of what it calls ‘quantitative easing.’ This is an academics way of saying: “buying bonds with money the Fed created as though out of thin air.” Obviously, the former sounds a little more sophisticated and mysterious than the latter. Shoot, if Larry the Cable Guy were to describe quantitative easing, he would say something along the lines of: “You see, it’s when these guys buy up all this stuff and pay for it with money they just made in the back room. I don’t care who you are; that’s funny right there.”

But what does whatever you want to call actually do?

When the Fed buys bonds from the financial system, it takes those securities and gives the financial system cash. No duh, right? As far as balance sheets go, Bank A essentially exchanges one asset for another, with no real change to the bottom line. However, now it has this extra money that needs to do something, anything.

The bank can either buy another security, make a new loan, or keep it in cash. Since I would argue the highest and best use of bank capital is to make quality loans, the Fed is essentially goading the banking system to do just that. In so many ways, it is saying: “Take the dern money and do something else with it. Hanging onto that bond wasn’t really doing anyone any good.”

Now, if the bank lends the cash out, it flows into the economy and generates activity of some sort. In the process, the money supply grows, and all is well with the world, until it isn’t. If the bank buys another bond, that would help drive down interest rates, as the demand for debt increases faster than the supply. As we all know, the prevailing wisdom is low interest rates will encourage borrowing. Finally, if the bank simply leaves it in cash, it will get whatever the Fed is willing to pay the bank for it. Currently, this rate is around 0.25%, so it ain’t much. It is the modern day equivalent of the proverbial ‘coffee can,’ and no one really gets much benefit out of it…September 14 2012 Common Cents