Academicians are notorious for coming up with phrases like ‘quantitative easing’, ‘operation twist’, ‘expansive monetary policy’, ‘mortgage backed securities’ or the recently coined ‘QE taper’. These expressions find new advocates in the business community, most of whom hold an economics related degree. But by the time they reach the mainstream media and become part of daily jargon, laymen are either too embarrassed or too intimidated to find out what these phrases mean.
The attempt here is to describe using a simple ‘water cooler’ style of narrative what exactly the big deal is about ‘QE’ or ‘taper’.
Here’s where it all began…
Our story begins in the aftermath of the economic crises of 2008 - with unemployment in the US above 10%, thousands of borrowers defaulting on their home loans, pensioners under threat of not receiving their dues, companies unable to meet financial obligations and asset prices hitting rock bottom after the burst of the housing bubble which was fueled by sub-prime lending (making loans to people who may have difficulty repaying them).
Enter - The Federal Reserve (Fed) to do damage control.
Who IS Mr. Fed?
The Fed is the central bank of the United States and enacts two key features common to all central banks – regulating how much money there is in the economy and ensuring the stability of financial markets. Most actions taken by the Fed post 2008, and those expected to be taken in the next couple of years, emanate from an old academic idea attributed to the economist John Maynard Keynes - that business cycles and economic growth can be controlled through fiscal and monetary policy i.e. government spending, taxation and interest rates. The now outgoing Fed chairman Benjamin Bernanke – a self confessed Keynesian buff of the great American depression – received political approval from Washington to go ahead and implement his academic ideas.
And what did he do?
The Fed began by lowering interest rates to 1% with the hope that businesses would use this cheap money to fund expansion, which in turn would lead to more jobs and with these new salaries people will begin spending again and lead to an economic revival. Unfortunately for the Fed businesses weren't borrowing.
Why?
Because overall demand had badly been hit, a large majority of people just did not have any money with them and those who did weren't willing to spend it.
What next?
So when lower interest rates didn't do the trick, the Fed used another weapon in its arsenal. It decided to unleash QE. Simply put – it started printing money or at least the modern equivalent of printing money – i.e. adding digits to a computer screen, in effect crediting its own account with new money created out of thin air!
It then pushed this money into the economy by purchasing bonds (called mortgage backed securities and treasury bills, usually issued by the government) from holders of these bonds – i.e. dealers and commercial banks. This flooded the banking system with excess cash and helped the banks either invest in other assets like commodities, stocks or give out this money to businesses in a hope to kick-start economic activity. It also created an artificial demand for government securities which pushed up the prices of bonds and kept yields low. Low yields kept interest rates of home, car and consumer loans which are bench marked to treasury yields also low.
This was done in 3 rounds
The first round of this so called QE was to the tune of 1.25 trillion dollars. In the second round they bought treasuries worth 600 billion dollars.
But did the US corporations start borrowing?
Well, not really. Only a little of this new money was lent out while the rest was either kept with the banks to maintain higher levels of buffer or sent out into a few inflated global markets to fetch higher returns as domestic demand was still depressed and jobless numbers were still too high.
Enter Operation Twist
Not still successful in its mission, the Fed decided to do further twists and turns in its policy. This time it was called ‘Operation Twist’. Simply put, it meant the Fed sold short term debt coupons (1 to 3 years in length) or bonds that it already held and pushed this money back into the economy by purchasing more long term debt coupons (6 to 30 years in length). The Fed also reinvested its mortgage-backed securities that were to mature into new ones. The hope was that this would push long term interest rates lower (demand for long term coupons pushed up prices of bonds, and pulled down yields) and thereby entice business houses to borrow and spend.
Nobody is quite sure whether that happened, but slowly but surely, jobless rates started to drop and though a few people did cheer that, Bernanke’s skeptics attributed the improvement to people dropping out from the job’s list itself, not because new jobs were being created!
So. more twisting followed in the QE story – and QE3 was launched with a little disclaimer saying “We will continue to buy 85 billion dollars worth of treasuries and mortgage backed securities every month until required”.
The Taper…
Finally, with the US economy showing signs improvement, on December 18, 2013 the outgoing chairman announced an 11.76% monthly reduction in creation of money by reducing the amount it would print to $75 billion dollars from $85 billion. This is called the ‘taper’. However, the Fed also announced its commitment to keep interest rates at a record low until inflation hits their target of 2% or the jobless numbers reach around 6%.
The commitment to keeping interest rates low indicates that the economy is still quite sick and so the jury is still out on whether QE has had the effect it intended to. In fact there are claims that the 3000 billion pushed through QE if anything has created new problems for the world at large especially since cheap money that went to buy assets in fast-growing emerging economies and supported GDP growth in these countries will eventually come to a halt and could result in a sudden downturn.
As the taper in some sense begins the end of QE, history will remember Benjamin Bernanke as the man whose only solution to all problems was to throw in some more money. I will remember him as a father I wish I had.
Aniket Krishna is a mathematician & entrepreneur
