Why quantitative easing is both a financial placebo and an unpredictable game of musical chairs.
In this episode, you’ll learn:
- What is a financial placebo.
- What is confirmation bias.
- How quantitative easing is like a game of musical chairs.
- How inflation can occur both with and without QE.
- How banks create money.
- Why QE is a failed and foolish policy.
Show Notes
Placebo Effect Produces Higher Test Scores
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Summary Article
Quantitative Easing: A Big, Fat Placebo
“A placebo is a story we tell ourselves that changes the way our brain and body work.” – Seth Godin .
For me, band-aids are placebos. Ever since I was a child, putting one over a scrape makes me feel better.
Since 2008, central bankers have administered the largest financial placebo ever. It’s called quantitative easing (“QE”).
Quantitative easing is a program where central banks, such as the U.S. Federal Reserve, the Bank of Japan and the European Central Bank purchase investment securities through their member banks or in the open market.
In the U.S., the Federal Reserve bought approximately $4 trillion of U.S. government bonds and mortgage-backed securities as part of its six year experiment with QE that just ended.
Meanwhile, Japan announced last week that xthey were expanding their QE program and will now purchase 8 to 12 trillion yen of government bonds per month (roughly $100 billion).
$4 trillion dollars here, $100 billion there. Those numbers sound massive and they are, but relative to the value of global capital markets they are a drop in a bucket.
The total value of global stocks and bonds is over $225 trillion according to the McKinsey Global Institute. The Fed’s QE program is less than 2% of that amount and even smaller when we factor in the value of global real estate and commodities.
QE Stories
Quantitative easing is a financial placebo because its impact is less about its size and more about the stories individuals believe about it. Placebos work because we gravitate to ideas, solutions or products that confirm what we already believe. That’s called a confirmation bias.
For example, phrases such as “central banks are flooding the world with cash” or “central banks have set off a global liquidity flood,” sound ominous and fit nicely into the narrative of investors who believe QE is dangerous because it will lead to a large pickup in inflation, the potential collapse of the dollar and a quadrupling of the price of gold.
Another story individuals tell about QE, particularly those in favor of it, is it will spur economic growth because the large amount of reserves that banks receive as part of the program encourages them to lend.
Or there is the story that central bank bond purchases artificially push down interest rates so when the program ends interest rates will jump.
What is ingenious about quantitative easing and, frankly, what is dangerous about it is its impact and effectiveness very much depends on what we believe.
Musical Chairs
QE is essentially a giant game of musical chairs. The chairs are government bonds and other securities. Investors, both individuals and institutions, own the chairs. Those chairs are their savings.
An investor can always sell a chair to another investor and take the money to book a stay at a beachfront hotel. The owner of the hotel could then take her earnings and save it by buying a chair.
In other words, investors are always swapping chairs and the value of those chairs varies based on how badly investors want to own them.
With QE, the central banks buy chairs from investors and take them out of circulation just like in a game of musical chairs.
If there are less government bond chairs but the demand by investors stays the same then the price of those bonds will rise and their yields will fall. Interest rates will decline.
But if many investors decide they want to own a different chair —not bonds but stocks, for example—then stocks might rise and bond yields might not fall after all.
Or investors might decide they want to take their chair money and buy a car. Or they might decide they want to buy a really nice car so they go to the bank and borrow money to facilitate the purchase.
Or investors might decide they want even more stock chairs so they borrow from their brokerage using a margin loan so they can use leverage to buy stocks.
The point is no one had a clue, including central bankers, what the impact of QE would be because the world is too complicated with so many moving pieces and shifting desires.
QE’s impact entirely depends on its placebo effect. What individuals and institutions believe its impact will be and what they decide to do as they act on those beliefs.
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