The Money Managers | In the News

Quantitative easing has a nice ring to it. The dramatic rebound in share markets around the world over the last couple of weeks indicates that collectively we all like it but what does it really mean? In America, the chairman of the Federal Reserve Ben Bernanke has announced a program of purchases of Treasuries and housing debt. He is using the Fed’s powers to print money and direct it at the area that will do most to lower borrowing costs. This in turn lowers borrowing costs in other countries including Australia. It seems too good to be true.

Longer term interest rates have always, up until this point, been set by the market not the authorities that have only had control over short term rates. Quantitative easing was always a possibility but was seen as a last resort because the consequences of getting it wrong would be too horrible to think about. In their battle against deflation the authorities are attempting to create just the right amount of inflation to counter deflation.

There is always a law of unintended consequences. Quantitative easing is actual monetary inflation caused by buying debt directly from the government. In the eighteenth century the French appointed a Scotsman called John Law to get them out of their troubles caused by too much extravagant spending. Law solved the problem by offering shares in his bank, Banque Generale, exclusively in exchange for the almost junk status, government bonds currently on issue. All taxes had to be paid with notes from Laws bank so he was assured of success. For the first time since its invention by the Chinese in 910 AD, paper money was issued and officially sanctioned by a modern government. The paper notes soon became more valuable and accepted than gold coins. The new currency boom boosted trade and commerce.

All Frances’ problems seemed to have been solved except that the temptation was too much. Why not print more and more notes? No new capital was being injected into the economy and no trade proceeds were evident but the sensation was one of a massive increase in spending and prosperity. So many commoners were becoming rich that a new word was used to describe them, millionaires! Unfortunately it was all an illusion and not sustainable. Turning on the printing presses could not save the situation or the country from bankruptcy.

There are a number of other examples where central banks have over done it and created run away inflation by printing too much money. Zimbabwe is the most recent example. Perhaps Bernanke will be able to do what no other central banker has done before and create just the right amount of inflation without overdoing it. The consequences for investors if he fails are immense. Gold has already shot up in price. Oil has passed $50 a barrel and the US Dollar has slipped in value but the share market seems to love it.

Anyone who has transferred their investments to cash is likely to see their wealth destroyed if inflation takes off as a result of the current actions. Even though a long term consequence will be higher interest rates this will not be enough to offset the erosion of inflation. The Fed has already pumped in over $800 billion of new money into the financial system in the last few months. They have now committed to create another trillion dollars or more in the months ahead. They will be buying the mortgage-backed securities backed by the government owned mortgage firms, Fannie Mae and Freddie Mac. The Fed will buy the bonds in the hope that purchases will drive down long-term interest rates and thereby make mortgages cheaper. They are trying to make the banking system expand credit to encourage spending and revive the financial system.

If they can inflate the currency, they cause debts denominated in the currency to evaporate. During the boom phase, we spent money we didn't have and ran up debts we can't repay. The economy can't grow until those debts are reckoned with. Inflation will reduce them. Of course, if it gets out of hand, it will destroy the entire world financial system. A sound strategy to cope with the new developments should be part of every financial plan.

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