Does QE really stimulate economic activity?

November 16, 2010 – Earlier this month the Federal Reserve announced its latest round of quantitative easing, long ago dubbed QE, but it should be called by what it really is – money printing.  The Fed buys US government debt and turns it into currency.  The process is somewhat arcane, but very simple at its core.

US government debt does not circulate as currency.  That would be too obvious a violation of the Constitution.  The framers scorned “bills of credit”, which were the IOUs given to merchants and other suppliers who provided goods and services to the Continental Congress.  These IOUs then circulated hand-to-hand as currency.  They are similar in nature to the warrants issued by the insolvent government of California to its suppliers, though as I understand it, these warrants do not circulate as currency.  Rather, these warrants are bought at a discount to their face value by banks in exchange for dollars, which then circulate as currency – which violates the intent and spirit but perhaps not the letter of the Constitution.  It is the same result for QE, except that the players and the debts are different.

With QE, the Federal Reserve buys debt from the banks in exchange for dollars.  These dollars do not come from a printing press because the banks are not seeking cash-currency.  Rather, the dollars are bookkeeping entries on the Fed’s balance sheet, and this newly created deposit-currency can be used by the banks to pay bills, make loans, or simply be left on deposit at the Fed to earn interest.

The explanation given by the Fed for this latest QE maneuver was to “promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.”  These platitudes sound good, but do they ring true?  Here is some data to help you judge for yourself.

Even though the first QE program was not announced until March 2009, the Fed actually started expanding its balance sheet in 2008 as a result of the banking crisis brought on by the Lehman Brothers collapse.  GDP for the 12 months ending that September 2008 was $14.48 trillion.  GDP for the 12 months ending September 2010 was $14.73 trillion, or only $0.25 trillion greater.  On an inflation-adjusted basis, the growth in GDP over this period was even less, just $0.04 trillion, or basically no growth at all.  Nevertheless, since the Lehman collapse, the Fed has increased its balance sheet by $1.3 trillion, clear evidence that this huge amount of QE did little to help economic activity.

Has the Fed done any better with regard to inflation?  If its mandate is to increase inflation, rather than keep it subdued, the Fed has succeeded.  For example, over the past twenty months since the date of its March 18, 2009 QE announcement, the CRB Continuing Commodity Index has risen 61.7%.  Gold has risen 54.0%, while the US Dollar Index has dropped -7.2% as people and central banks around the world exit the dollar for safe havens, which is the important message of QE.  Namely, the Federal Reserve is debasing the dollar, so avoid it and instead own safe havens like gold and silver.