Quantitative easing – what’s the big deal?

Last week the US Federal Reserve, the world’s most powerful and influential central bank, announced a second huge tranche of “quantitative easing” – now nicknamed “QE2”. That in itself wasn’t news, but the amount – $600 billion – has come as a big surprise. It has economists in emerging markets around the world – including our own – extremely worried. Our own minister of finance, Pravin Gordhan, even commented publicly about his concerns.

What’s he so worried about? Surely America’s monetary policy is their own decision? Well, not quite. As the world’s biggest economy and the issuer of the world’s only truly global currency, what they do affects all 6.5 billion of us one way or another.

But let’s take a step back first. What is this quantitative easing stuff anyway? In many ways it’s a last resort. Normally when an economy is struggling to grow and create jobs – as the USA is now – the answer is to lower interest rates. Because the interest rate is the price of money (the cost of borrowing), by lowering it you encourage people to “buy” more money and use it to grow their businesses – including hiring more people. So the interest rate acts like the accelerator on a car – the lower the interest rate, the further in the pedal has been pushed.

But now the US (and many of their rich allies, like the EU) have a big problem. Their interest rates are already at very close to 0% – their monetary pedal is already on the metal. This is largely because of their quite shortsighted policies in the last decade where they allowed the rates to stay too low for too long – something they could afford to do because the Chinese (and, to a lesser extent, Japanese) were pumping money into their economy by purchasing their government bonds. In essence the Americans were borrowing money at long-term rates from the Chinese in order to keep buying their goods in the short term.

So much for history

The net result is that the US can’t lower its interest rates any further short of actually paying people to borrow money. And that, in a way, is what quantitative easing is about. The Federal Reserve prints more money, and uses it to buy back government bonds from large investors – typically big banks and investment houses – at favourable rates. Banks obviously can’t resist a good deal when they see one – particularly when it’s worth $600 billion. What this does is effectively inject money (aka liquidity) into the economy while simultaneously sucking long-term debt (bonds – which are “illiquid” because they cannot be used to buy other assets) out of the economy.

Think of it as pulling out the choke to make the fuel mix in the engine richer and give you more pulling power. If you are struggling to get up that hill, with the accelerator flat, the choke seems like your only option. And indeed QE can work. The ideal result is to make already cheap money even cheaper, and induce people to begin borrowing and spending – and finally bring that car to the top of the recessionary hill it has been climbing.

The problem is that both sides of the deal have to play by the rules in order for it to work as expected. What is much more likely is for US banks to take this “free” money and pump it into other economies, like ours, where they can earn seven or eight percent interest without doing a thing. That’s a pretty good deal – a guaranteed 8% on $1 billion is a lot more attractive to a US banker than lending it to an fellow American at 1%.

And that is exactly what is worrying Pravin and his counterparts in countries like Brazil and India. Billions of Dollars have already flowed into South Africa – which goes a long way towards explaining why the Rand is so crazily strong at the moment. In order to invest in our bonds and banks, American investors buy Rands and sell Dollars – this sucks Rands out of the global economy, driving down supply and driving up prices relative to the Dollar. That “price” is what we call the exchange rate.

Strong isn’t always good

So what, a strong Rand is good right? Well, a relatively strong Rand can be good, yes, but there is such a thing as too strong. While it makes petrol cheaper, and all imported goods more affordable, it hurts our exporters badly and makes our workers even more globally uncompetitive. That could spell doom for local industries like vehicle manufacturing and textiles, already struggling to keep their heads above water. Even worse, the money in question is “hot” money. As soon as the situation changes, a huge chunk of it will flow out again, driving up import prices suddenly and stoking inflation.

What can we do about it? Not a huge amount. We can, and should lower our interest rates, to make ourselves less attractive to hot money. We might, like the Brazilians, consider taxing all foreign inflows of money, though this has other unintended consequences, like making us less attractive to “real” long-term investors. What we all need to be aware of is that the best thing we can do for our economy is to keep spending, keep innovating and keep creating local jobs. We can also concentrate on making ourselves more competitive. If they can weather this storm, our exporters will be lean and mean, and ready to reap the rewards of the next global upturn.

But what about the individual? Well, the same good old-fashioned advice always applies: don’t borrow more than you can afford, invest wherever you can (with as much risk as you can tolerate), work hard and, if you can, start your own business. Interest rates are about to be at an all-time low. Don’t waste this opportunity on a flashier car and a bigger house – invest in yourself, and in South Africa.

(Still lost? Here’s a fantastic infographic, with narration and everything, from the Financial Times.)

One Response to “Quantitative easing – what’s the big deal?

  • Your assessment is correct in many respects, but you fail to acknowledge the disastrous effect that QE2 is already having on economies beyond the United States through the instant ramp in commodity prices, and the havoc it is causing in currency markets. We have just seen the beginning. Because it is debatable whether QE actually works [in spurring economic growth], this will more than likely not be the last time the Fed pursues such action. The only certainty is that next time it will have to be $1T+ to have any effect whatsoever.Velocity of Money is key. Whilst this is languishing, or stagnant, the Fed will continue to print. Or embark on QE programmes. Whatever you want to call it.

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