What Does QE2 Do?

Charles Goyette is the author of the lead story on LewRockwell.com today.  Goyette is the author of a great book called The Dollar Meltdown.  If I had to advise someone on what to do with their money, I would tell them to put a large portion, say 80%, in a permanent portfolio as outlined by Harry Browne in his book Fail Safe Investing.  With the remainder of your money, put it in the investments recommended by Goyette in his book.

Now let's talk some more about QE2.  The Fed is planning to buy $600 billion worth of bonds over the next 8 months, plus up to another $300 billion that it collects from its current assets.  We can forget about the $300 billion because it is really neutral as far as the money supply.  It is the $600 billion we need to focus on.

Does this new money run up the national debt?  No, not directly.  If the Fed didn't create this new money, would the debt go down?  No, at least not in the short-term.  So what does this money creation mean?

Basically, the Fed is buying government bonds from brokers.  The brokers buy the bonds from the government and the Fed buys the bonds from the brokers.  The Fed is basically handing over newly created money to the government, with a commission going to the brokers.  The government is handing over bonds (promises to pay) to the Fed.  The Fed's balance sheet goes up.  The money that goes to the government did not exist before.  This increases the money supply.

If the Fed did not do this, the government would have a couple of choices.  It could balance its budget (yeah right) or it could sell its bonds to others.  Other purchasers of bonds could be individual investors, the Chinese government, the Japanese government, or mutual funds (which would be bought by individual investors) just to name some of the most common.  Since the Fed has also gotten into the bond buying business, the Fed will bid up the prices of bonds compared to what they would have been.  In other words, this lowers the interest rates on the bonds.

That is what QE2 does.  It is monetizing debt and by doing so, it is increasing the money supply and it is lowering interest rates.  The only catch is that because it is increasing the money supply, it is also increasing the risk of the value of the bonds (being paid back in depreciated dollars) which serves as a reason for rates to increase.  It basically causes a tug of war with interest rates.

We'll talk more about what could happen with interest rates and bonds.  Although it is a tug of war and the Fed has a lot of power to keep rates low, it is unlikely that they will stay low for a long time, especially if the banks start lending out this money and we see massive price inflation.