First of all, QE was a derivative, if you will, of the standard functioning of the Federal Reserve System (the Fed). Even among the most developed nations central banks have somewhat different functions in different monetary systems. That is especially true where the currency is the Euro, the Eurozone, where the monetary system is extra-national.
Also, the details of QE will vary from system to system where it is implemented. So what is said here about QE is intended to apply only to how it was accomplished in the U.S.
The Fed has several standard functions. One of them is to be the ‘lender of last resort’ to the national government. Individuals, businesses, pension funds, and other entities also lend to the national government (or government at any level) when they buy government bonds. Selling bonds is the way governments borrow money.
Here’s how selling bonds is a way of borrowing money (again, just making sure all of us are up to speed on this stuff). Suppose I come to you wanting to borrow some money. We could agree on a rate of interest for me to pay and have me pay you so much a month for so many months. You could require me to put up some collateral, like my car or my house, so that if I didn’t pay you back all the money I borrowed (plus interest) you could get my property.
Alternatively, I could give you an I.O.U. for the amount of money I am borrowing plus some extra amount of money. It would all be paid to you in a lump sum at a future date, but you would get nothing in the meantime. There would be no collateral or any other security except my promise to pay: my ‘bond’ (in the sense of being an old-fashioned word that sort of combines ‘honor’ and ‘promise’). That’s all a bond is: an I.O.U.
That premium/discount is called the ‘yield’ of the bond, so both the buyer/lender and the seller/borrower can use the same terminology (though, as we’ll see, that happy consonance does break down when bonds are re-sold).
Sellers and buyers of bonds of all kinds think in terms of two separate ‘markets’ for them. One is the primary market and the other is the secondary market. The primary market is the selling/buying of newly issued bonds, bonds that are being offered for sale for the first time. The secondary market involves bonds that have been bought previously that are being re-sold to other parties.
A bond might be re-sold for more or less than was paid for it, but the payoff remains the same. That means that the discount of the bond would change. (The premium can’t change because the original issuer of the bond always has to pay out the same amount of money to whoever owns the bond when the time comes for it to be redeemed.)
If, for example, a bond is re-sold for more money than was paid for it, since the new owner will get the same payoff but has paid more for the bond, the discount of the bond has gone down. Whether it has gone up or down when a bond is re-sold, the new discount is referred to technically as the rediscount rate. Also, the time between the purchase of a bond and its date of maturity—when the money can be collected—changes its rate in another way. If one pays the same amount for a bond that the original buyer paid for it, but will collect the money in less time, one has effectively increased the ‘discount rate’ of the bond.
As the lender of last resort to the national government, the Fed in effect guarantees that all of the bonds the national government issues will be bought. When the government issues those bonds it is called an auction, but the so-called auction is really just a formality. The Fed has been notified by the Treasury Department how much money the government is going to want and how many bonds of this or that duration, etc. The Fed has arranged with banks and other big buyers of those bonds (including foreign governments) beforehand to get the bonds sold. [That partnership between the Fed and government at that level is the basis of Modern Monetary Theory, a very readable account of which is provided by Dylan Matthews in “Modern Monetary Theory is an unconventional take on economic strategy” at www.washingtonpost.com.]
The Fed also determines how many of the bonds it will buy. Some of the bonds it buys will be purchased with funds it has on hand. It will also have the Treasury print some money that the Treasury will then hand to the Fed, which the Fed will use to buy some of the bonds.
Ideally, how much money the Fed would want the Treasury to print would depend solely on how much it wanted to increase the size of the money supply, which in turn would depend on what was going on with the economy at the time. In reality, the Fed’s own resources are finite, meaning it must also take into account its own financial state. It could be forced to have more money printed than the state of the economy would warrant. That could open the door for problematic inflation.
Once the money is in the economy, it is pretty much there to stay, which makes inflation all the more difficult to forecast. The Fed has some things it can do to deal with too much money in the economy, but once inflation gets underway, it has a way of sucking back into the economy any money that has been tucked away anywhere. In an inflationary economy money is losing value, so it’s “Use it or lose it”—which attitude fans the inflationary flames.
At any rate, before QE was invented the actions of the Fed in this area were limited in two important ways. For one, the only time anyone could accurately talk of money being ‘printed’ in the sense of creating money out of thin air to add to the money supply was when the Fed had it printed to use for buying government bonds. Also, before QE, the Fed only bought those bonds in the primary market.
In QE, the Fed had the Treasury print money for it to use for something other than buying bonds of the national government in the primary market. It used that money for two things.
Once the money is in the economy, it is pretty much there to stay, which makes inflation all the more difficult to forecast.
One purpose of QE was to add ‘liquidity’—money—to the financial system. That was deemed necessary to get the economy out of the Great Recession, as the most recent large-scale economic bust has been dubbed. The bonds and other assets it bought were purchased from banks and other large entities in the financial markets. In buying their assets the Fed was infusing them with cash, which, it was hoped, they would put to good use for the economy as a whole. (No explicit conditions were attached to the money, however.)
The other purpose for instituting QE takes us back to the actions that caused the most recent economic debacle. Remember ‘toxic assets’? Toxic assets were the infamous CDO’s (collateralized debt obligations). Those were bundles of ‘assets’ that the speculators were creating and using for more speculation. The other purpose of QE was to remove more of those toxic assets from the economy.
For the economy, the existence of those toxic assets was not only the cause of the initial crisis, but an ongoing problem. They were on the books of the banks and other financial businesses that had been holding them when the music suddenly stopped. They represented some nominal amount of money, even though they were worthless. In total, they represented trillions of dollars. They could neither be sold nor used as collateral for normal financial activity. They were clogging up the works, plaque in the arteries of the economy.
Into the breach rode the Fed with QE. Government had done some cleaning up of the mess through TARP and other programs, but the scale was nowhere near adequate. The Fed had tried other programs to absorb or otherwise remove toxic assets, but the overall performance of the still-moribund economy indicated that not enough was getting done. So the Fed decided to have the Treasury Department print money to use to get those ‘assets’ out of the system and into its vaults. It is worth reviewing how we got to that place.
In finance a standard ‘security’ is an interest-bearing asset. In other words, it is a loan. A person or business has borrowed money from a ‘commercial ‘bank (what we normally think of as a bank) or an ‘investment’ bank (banks that restrict their operations to large-scale and often higher-risk lending) or other private investor.
Borrowing money, by taking out a loan or, say, using a credit card, is ‘leveraging’ the amount of money that is available.
In the physical world, a lever is something that is used to increase the amount of force that a given amount of physical effort will produce. Using a hammer to pull a nail out of a board is one example of using a lever. The amount of force needed to pull on the hammer to get the nail out is a fraction of the force that would be needed to pull it out using one’s fingers (if it could be done at all).
In finance, leveraging is the same thing. It is a way of getting more out of the same amount of money. When individuals borrow we are leveraging our income to get more stuff, or more expensive stuff, than we could get with only the amount of money we have on hand. We then use that income to ‘service’ that debt.
Whenever money is lent the borrower has undertaken an obligation to repay the loan. Still, any time a loan is made there is some chance the lender will not get repaid. That is why most loans require collateral, some property with value commensurate with the amount being borrowed that the lender will get if the loan is not repaid.
Even so, just as the borrower is incurring an obligation, the lender is incurring risk. A lender is always taking at least a bit of a gamble, ‘betting’ the loan will get repaid. Requiring collateral is a lender’s way of ‘hedging’ that ‘bet’.
There are other things lenders can do to ‘manage risk’— hedge their bets. The most obvious example is to charge higher rates of interest for riskier loans.
Loans can also be sold. Just as there are markets for selling and re-selling bonds, there is one for selling and re-selling securities. They can also be divided up by selling ‘shares’ of the loans. Usually that involves bundling loans together and selling shares of the bundle. That process is called ‘securitization.’
Just as loans can be sold, they can be swapped; swapping loans is the basis of the truly evil ‘credit default swaps’ of which we heard so much when the bubble burst.
Hedge funds are large-scale financial enterprises specializing in helping large-scale lenders manage risk. The largest parts of their business are providing insurance and securitization. In providing their services, they are assuming risk, which they must then ‘manage.’
Managing risk is mostly about spreading it around, so that the potential burden (in case of default) is shared by many different entities. In the process of spreading risk around, however, new risk is being created—which must then be spread around, too. It becomes a never-ending series of ripples in water that is anything but still.
Keep in mind that all of these ‘instruments’ involve ‘securities’ that count as assets. All of that risk and the ‘instruments’ devised to manage it derive from the risk incurred in the original securities that were created when money was lent to people or businesses—hence the term ‘derivatives’.
On top of all that, the hedge funds sought to operate with the maximum possible leverage. Borrowing is not the only form financial leveraging can take. In the run-up to the Great Depression, for instance, there were holding companies. A corporation would be formed with some amount of assets as its capital. Those assets could include real estate, cash, stocks, bonds, etc. Based on that amount of capital the new corporation would issue stocks. As a holding company, that corporation would then use its own stocks as the capital for another corporation, then use the stock of that corporation as capital for yet another corporation, etc. In reality, the only assets in the entire chain of ‘holdings’ was that original amount of capital. If any company in the chain failed, it would take the entire chain down with it. After the Crash of 1929 holding companies were outlawed, for good reason. In the run-up to the Great Recession, hedge funds were doing essentially the same thing using collateral instead of stocks. Collateralized debt was being used as collateral, which in turn also became collateral, etc.
The process is ultimately driven by two conditions: (1) the greater the risk, the higher the rates of interest that can be charged and the more hedging that would be needed—and the more readily hedging can be accomplished the more financial risk is encouraged—and (2) the bigger the size of the transaction, the greater the amount of the fees that could be charged (which especially applies to securitization, i.e., ‘bundling’, i.e., CDO’s). The predictable result is a tendency for lots of big, high-risk deals being made, along with more and more ‘sophisticated’ (i.e., unintelligible) ‘instruments’ for managing the risk created. A point can be reached at which the risk being generated becomes greater than the risk against which it is intended to protect. In the end the process created ‘assets’ so tenuously derived and so interdependently collateralized that no one could know what any of it was worth.
All of the wheeling and dealing that went on needed standard securities to be created to sustain it. It would be best if those loans were large and highly-rated and carried real collateral and could be readily generated. Put those four things together and you get: mortgages.
Actually, mortgages were not so easily generated. So that had to be changed. The requirements for getting a mortgage were relaxed the point of dropping to the floor. People were pulled in off the street while pens were being pressed into their hands. That is an exaggeration, but this is not: It got to the point that purely fictitious mortgages were being created and sold as the real thing.
There are some among us who blame the crisis that ensued on people who should have known better than to have tried to buy houses that they could not afford. In fact, the word was that everyone, no matter what one’s financial situation, should be buying a house because real estate prices were never again going to fall. That was the word. On the street, on television, in the paper, on the internet, in banks and finance companies—in the pulpit, for crying out loud—that was the word. If anyone was unable to keep up the payments, or meet the balloon payment when it came due, that would be no problem because after a few months any house, anywhere, any time could be sold for a profit.
Reaching the point at which too much risk has been created can be an innocent mistake—in the way burning down the house as a result of playing with fire is an innocent mistake. What was done with those toxic assets was not an innocent mistake. Those were criminal activities that brought the entire global economy to the edge of the bottomless pit.
In itself, greed is not a crime. Fraud is. The turn to criminality came when the speculators somehow got the companies that rate securities to rate whole bundles of ‘assets’ based on the rating of the highest-rated security in the bundle. They knew what they were putting in the bundles: mostly stuff of unknowable value (but that represented some nominal amount of money) with a mortgage for a fig leaf to cover the uglies. They took such bundles to unknowing holders and issuers of assets with real value, mostly bonds, such as small pension funds, local school boards, and governments in small towns, and swapped their bundles of highly rated trash for good, solid assets. The whole thing was a confidence scam.
The criminals apparently thought that their scheme’s ongoing ‘success’ depended only on ever-rising values for houses, which the demand they were generating for mortgages would ensure. In the end, they learned to their dismay—and ours—that it also depended on everyone involved in the process continuing to have confidence in it. When a crisis of ‘confidence’ (conscience?) finally did manifest itself anywhere in the process, the scam collapsed.
The speculators took the value of houses down with them. As securities, before the speculators got hold of them, mortgages had been gold. The speculators had managed to turn gold into excrement.
So that is how the crisis happened. Was the Fed wrong to use QE as a response to its aftermath? For now we can only say that there was both good and bad in it.
It was good to get those toxic assets out of the economy, and especially good to accomplish that without increasing public debt. It was good, in a recession, to have money printed and get it into the economy—and, again, especially good to accomplish that without increasing debt. As noted above, increasing the money supply via printing money normally comes with an increase in the level of debt of the national government when it issues bonds. Using the monetary system to attempt to increase economic activity in other ways involves money being borrowed by individuals and businesses, also increasing total debt.
It was bad to let the speculators, who had brought the entire global economy to the brink of the bottomless pit, off the hook—especially when the Fed’s largess was not extended the small-fry suckers who were stuck with toxic assets. It was bad to have the money from QE enter the economy in the rarified atmosphere where it went; the individuals who have benefited the most directly from QE are the richest of the rich. The effect has been to create an ‘upper level vortex’ in the economy, where people are doing great. The widening gap between the rich and the rest of us demonstrates that. It does appear that enough money has finally trickled down for the rest for the economy to get moving again, but what is happening down here is still nothing compared to the good economic times people are having ‘up there’.
The worst thing about QE, though, is that a precedent has been set. From now on, the private financial system can count of being given access to the printing presses of the Treasury Department if push comes to shove. Indeed, private financial powers can demand access to those presses. The speculators have the wherewithal to force any nation at any time into giving them another round of QE. The amount of money they have in their control gives them the power to threaten any currency with ruin. The speculators have demonstrated beyond question that the only thing they care about is money, and more money, and yet more money. No one can say what the future holds, but to have arrived at a place where such power is in the hands of such people is a most ominous turn of events.
Photo retrieved from GlobalResearch.ca