Understanding Quantitative Easing and Its Flaws

COMMENTARY | Quantitative easing is a form of monetary policy where central banks purchase financial assets from banks and private sector businesses with new, electronically created money. Quantitative easing both increases the bank's excess reserves and increases the value of the financial assets that were bought by the central bank. The Fed is trying to avoid a third round of Quantitative Easing (QE) to help with the latest economic downturn, but is leaving the option on the table.

It is a very effective method of adjusting inflation, but I believe that since our economy is based upon free trade, federal interference more often than not just hampers the market's tendency to naturally achieve parity. Here is some additional information to better understand the role of QE in managing our economy.

* The easiest way to understand quantitative easing is to picture that you are in a store with $100. This store is the only place you can spend the money. Your only goal is to buy all the products in the store, including any stock that is received in the future, and the store's only goal is to get all of your money. If someone gives you an additional $50, you will spend the $100 more freely because you have an extra $50 to spend on future goods. If the store owner hears that you are going to have more money to spend, he is likely to raise his prices. Since there are known figures at work and the extra $50 is an arbitrary number that was created out of thin air, monetary authorities can adjust the amount to keep inflation on track steadily.

* The primary objectives of QE is to curb deflation, allow the Fed to exercise control of interest rates further out on the yield curve, and ease credit conditions, which in turn stimulate spending.

* The monetary authorities normally exert control by adjusting interest rates. However, when the interest rate is close to zero, normal monetary policy cannot be implemented.

* The term quantitative easing was most likely coined during the early 2000s, when the Bank of Japan used it to fight off deflation.

* The government can reduce the value of a dollar, thereby causing inflation, by just threatening to print more money.

* A major risk of the practice is that banks will not lend the money to consumers and businesses despite the injection of new money into excess reserves.

* It is easier to print more money before the onset of deflation than to have to deal with deflation after it has begun.

* Quantitative easing has never worked perfectly during an actual financial crisis. During both the U.S. depression of the 1930s and Japan in the 2000s, economists thought the policy was implemented too late.

* After the economy rebounds, uninhibited inflation is a serious risk if monetary authorities do not extract the extra cash flow or do so too late.

* Over the history of the U.S. economy, each cycle has seen interest rates break the previous cycle's low.

* Our economy has adjusted to historically high fuel and commodity prices as of late by increasing productivity.

* Our capitalist economy was designed to run without interference from the Fed, and will eventually achieve equilibrium if left alone.

* A healthy amount of deflation may lower fuel and commodity prices enough to stimulate the formation of new small businesses.

* Many people liken quantitative easing to "printing money."

Sources
-Step Away from Quantitative Easing, Business Insider
-Quantitative Easing: Printing Money Like Mad to Ward Off Deflation, Edward Harrison
-Quantitative Easing Explained, NPR, Adam Davidson and Alex Blumberg
-One Year Under 'Quantitative Easing', Masaaki Shirakawa