In our recent study Perceptions and Understanding of Money – 2020, we surveyed Americans to gauge how well they understand the mechanisms of money, including concepts like quantitative easing (QE). We hope this “Everything You Need to Know” series will help improve understanding of money-related topics and issues that could not be more relevant today.
What is Quantitative Easing?
Quantitative easing is a policy that allows those in control of a money supply to increase the amount of currency in circulation. There are different motivations behind such policies (more on that later), and agencies such as the Federal Reserve can use different specific tools to implement quantitative easing.
One lever that the Fed can use to move towards quantitative easing is to purchase effects. Among which:
- Government bonds
- Corporate bonds
- Stocks, including exchange-traded funds (ETFs) and soon stocks, according to Forbes
- Assets such as mortgage-backed securities
By buying a security, someone essentially becomes a creditor to the entity issuing the security. The Fed, or another central bank-like agency in another country, may issue cash to financial institutions in exchange for such securities, thus providing more liquidity in the market. It is also expected that banks will lend this money and stimulate economic activity.
In addition to providing cash directly to the open markets, an institution implementing quantitative easing can also lower interest rates or lower reserve requirements. Lower interest rates can generally stimulate lending as the cost of borrowing is reduced. By lowering reserve requirements, banks need to hold less money, which means they have more money to borrow.
Banks generally borrow whenever they can as this is their main way of making money from customer deposits and loans received from the Federal Reserve. The Federal Reserve can even lend money directly to banks in the name of quantitative easing. In the school of QE, such lending is the main catalyst for economic activity in times of slowness or stagnation.
Who controls quantitative easing?
The ones who control a country’s money supply are generally the ones who implement quantitative easing. In the United States, this is the Federal Reserve. In certain countries, it can be a central bank, which can be controlled by the political party in power, or it can be a somewhat independent entity such as the Bank of Japan, Deutsche Bundesbank or the Bank of England.
The European Central Bank manages the money supply for 19 Member States and now plays a substantial role in European monetary policy since the widespread introduction of the euro. Each financial institution must decide whether to implement quantitative easing based on the effect it is likely to have on those using a currency.
What is the purpose of quantitative easing?
The stated purpose of quantitative easing is to stimulate economic activity through better access to credit, especially at times when economic activity has slowed or showed warning signs of slowing down. The logic is that more money in the hands of the public – entrepreneurs, investors, consumers – will lead to growth and expenditure.
This can usually be the case. Those who have money to spend in a valuable way, or simply to burn, tend to do so. And when it does, the goal of quantitative easing is achieved.
Criticism of quantitative easing
The main criticism of quantitative easing is that while it can stimulate investment, growth and expenditure in the short term, there is a very real cost to such policies in the long run, namely inflation.
Fractional reserve banking allows banks to lend money without taking that money out of their asset accounts.
This has a remarkable growth effect on a country’s money supply from an accounting point of view. Because quantitative easing both directly injects money into the money supply and lending, it tends to have a significant growth effect.
Every time you grow a money supply, inflation sets in. Generally, having more of something (including dollars) reduces the scarcity of that thing, as long as the demand doesn’t increase in line with the supply. As a result, each individual unit of that thing becomes less valuable. This is the core principle of inflation and illustrates why increasing the supply of foreign exchange decreases the value of each individual currency.
Since quantitative easing basically increases the money supply, the most valid criticism of QE is that it trades short-term incentives for long-term currency devaluation – a trade-off that many believe is not worth it. After all, there is no guarantee that the stimulus will work in the short term, while there is a guarantee that QE will contribute to inflation.
The Wharton School at the University of Pennsylvania explains that specific QE-related policies in recent history have had adverse effects in addition to inflation. For example, after the 2008 financial crisis, the Fed’s stimulus policy ultimately reduced direct corporate investment by banks, causing the 2008 quantitative easing to fail.
Quantitative easing can be like injecting steroids in the normal course of inflation with no guaranteed benefit to counteract this drawback.
The reason for cryptocurrency scarcity
The dollar’s purchasing power has fallen sharply over the past century, and the continued pumping of fiat money into supplies (the main mechanism of quantitative easing) has accelerated this decline. The guarantee of scarcity once offered by the Gold Standard is a vague memory.
Those looking for a return to truly scarce stocks of value can consider cryptocurrency and may have already invested in bitcoin. Unlike the dollar or euro, the cryptocurrency is fixed, with Bitcoin’s offer set at 21 million. While there has been debate about whether or not to increase the supply of Bitcoin and other cryptos, the type of exponential growth that has eroded the dollar’s value is unlikely.
Scarcity is a central tenet of cryptocurrency’s value, a fact that is not lost to those who profit from it.
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