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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Quantitative Easing: America’s Self Destructive Weapon

Posted by Muthu on August 23, 2010

America is injecting more and more dollars into circulation. What will happen? One day Dollar may be worth a toilet paper and do you know which other two countries would be mainly affected by this? China and Japan.

Foreigners, willing to own paper issued by the US government, now own about 25% of total US debt. China and Japan, alone, account for over 50% of the foreign government ownership of US Debt.

And there lies the problem for China and Japan – and the opportunity for India.

When you owe the bank a bit of money and cannot repay, you are in trouble – goes the old saying – but when you owe the bank a lot of money and cannot repay, the bank is in trouble.

As mentioned above, China and Japan own 50% of the US debt. Every analyst, every trader is watching what they do. If China or Japan start to sell their US Dollars, the currency traders will all rush to sell the US Dollar before China or Japan can hope to complete their trades.

Let’s say Japan sells 10% of its USD 787 billion in US Government debt at a “good” price. You can bet that when news of that trade hits the market – and it will, even if with a delay – the US Dollar will fall so sharply, that the rest of the 90% that Japan still owns will be worth a lot less. Maybe 20% to 30% less.

The truth is that no one knows how much the US Dollar can fall from here if foreign governments were to sell their US Dollar holdings.

China knows the US Dollar is a threatened currency, but it cannot sell its US Dollar reserves – it will destroy its own “wealth”.

So, China is buying mining companies and assets wherever it can and sending the military and navy for strategic protection of those assets. All a very expensive and round about way to own hard assets and to diversify away from the US Dollar.

The RBI is in a sweet spot and can get the same diversification as China seeks for a few basis points from investments in financial instruments.

Unlike China and Japan, the RBI’s holdings of US Dollars are small enough not to cause a scare in case the RBI begins to sell a bit. Though this action will be noticed.

After the RBI bought gold on November 2nd, 2009 at about USD 1,059 per ounce, the price of gold shot up to USD 1,215 per ounce by December 2, 2009. By February 2010 the price of gold declined to USD 1,062 as that news ran itself out and other more powerful factors occupied the mind of the market. This is proof that the RBI’s actions may cause a near term flutter but will be soon forgotten.

Quantitative Easing (QE) is a term we often hear in the news. What does it actually mean? Effectively, it means that the central bank will print money. In most cases, the central bank will buy government bonds with newly printed cash. QE is usually accompanied with a low interest rate policy. The four major central banks of the world (Federal Reserve, European Central Bank, Bank of England, Bank of Japan) are all following this policy to a certain degree today.

Let’s first understand the purpose of monetary policy and how a central bank can use it. An expansive monetary policy (low rates & QE) is used to stimulate the economy. The purpose of low interest rates is to encourage borrowing and investment. Low interest rates also discourage savings, and hence promote consumption. QE’s purpose is to inject cash into the economy. This should also stimulate investment and spending.

Only one thought should come into our minds now – Inflation. An expansive monetary policy must lead to higher inflation. After all, printing money means more cash in circulation for the same number of goods. So that implies prices should go up, i.e. inflation.

The four major central banks all want inflation. That is why they pursue a low interest rate policy combined with QE. Why do they want inflation? Well, the developed world is full of debt, both public and private. Inflation reduces the real value of the debt, so the central banks like inflation.

In economics, there is a useful equation that describes the relationship between cash and output.

MV = PY
M – Stock of Money
V – Velocity of Money
P – Price Level
Y – Real Output

The standard theory goes like this: If you increase M (i.e. QE) real output will not change, and only price levels will rise (i.e. inflation). It assumes V is constant.

As is the case in most of economics, theory and reality are two different things. What’s happening today is the variable V is falling. This means that if we increase M, it doesn’t mean that price levels will rise. QE doesn’t mean we will have inflation.

The velocity of money refers to how often money is turned over. So the faster we spend money, the higher the velocity is. So when individuals receive their salary, they go out and spend it. Someone else receives that spending, and then spends that same money. Money continuously gets turned over, and this is a measure of economic activity.

The reason QE is not going to create inflation for now is that money is not getting spent. Banks that are receiving fresh funds are not lending out the money. Credit is falling. Government bond yields are so low because any new money banks have is simply used to purchase government bonds. Lending isn’t taking place, and this is a function of banks and businesses both becoming more cautious.

When lending and spending doesn’t take place, the velocity of money falls. This can lead to deflation rather than inflation. In fact, the reason the central banks are so happy to pursue low interest rates and QE is that inflation is not a real threat. Because of the falling velocity, deflation is the real threat to the developed world today.

Deflation is much more dangerous for an economy than inflation. With deflation, the real value of debt goes up. For countries that are already heavily indebted, this is like icing on the cake. Falling prices also means that wages will fall, and demand will. Consumers put off spending in anticipation of lower prices, leading to further slowdowns in the economy and falls in prices.

From a trading point of view, what does this imply? First, gold will be affected. Gold is used as a hedge against inflation, and deflation can put downward pressure on gold prices. In fact, this applies to all commodities. Most commodities have a positive relationship with inflation, and will be affected by falling prices. US Treasury bond yields are extremely low, and according to many analysts it is a bubble waiting to burst. With deflation, treasury prices will only go higher (and yields lower). Japan is a good example of a country that has battled deflation and has some of the lowest government bond yields in the world.

Quantitative easing should cause higher prices in theory, but reality tells us a different story. Falling velocity and economic activity are more important determinants of prices compared to interest rates and money supply.

(with inputs from Ajit Dayal and an article by Asad Dossani- Equitymaster)

One Response to “Quantitative Easing: America’s Self Destructive Weapon”

  1. bizcon said

    Hi,

    Congratulations for your in-depth analysis of QE2 and other financial issues including inflation/deflation etc.

    Instead of keeping total forex reserves in dollar denomination, India needs to go for Physical goods or Resources and Raw Materials so that we can have both : use falling dollars and create value added production, which provides employment and strengthen value chain.

    Suitable Business Model for India needs to be promptly worked out, without wasting time.

    As for gold we do not have to worry about its intrinsic value, as envisaged by non-Indians. Here we keep it as life long investment and not “Ready for Sale”. It is a commodity meant to support, to tide over the Rainy Days.

    Best Wishes.

    Sharad Kapadia
    Surat

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