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What Is Quantitative Easing and Why Should We Care?

I don't recall quantitative easing being discussed even once in my macroeconomics courses. How, then, can journalists expect people to follow along despite not having any knowledge of the subject at hand?
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I have a confession to make: Despite having a masters degree (and almost a Ph.D.) in economics, I frequently resort to using Google to help me understand the business sections of the New York Times, Wall Street Journal, and, yes, even the Huffington Post. This strategy makes me think two things -- first, that I'm not as smart as I think I am, and second, that it's really difficult to fully understand a lot of what's being discussed in this arena without a good deal of background knowledge.

Take quantitative easing as an example. Now, I am well aware that I didn't pay as much attention in my macroeconomics courses as I could have, but I don't recall this concept being discussed even once. How, then, can journalists expect people to follow along despite not having any knowledge of the subject at hand? (I am ignoring the possibility that the journalists may not fully understand the topic themselves.) Therefore, I think it's only fair to give a little primer on what quantitative easing is, how it related to run-of-the-mill monetary policy, and whether economists think it will "work," whatever that means. Given my above confession, I feel the need to note that I've consulted with a few experts (some whose names don't even rhyme with schmoogle) to pull this together.

When we hear monetary policy news, it's usually of the form "today the Fed decided to raise/lower interest rates by X%." Have you ever stopped to think about how (and why) the Fed does this and what interest rate this statement even refers to? We live in a capitalistic enough society that interest rates are determined by the forces of supply and demand, so it's not like the Fed can just directly dictate what they are. Instead, the Fed has a number of indirect tools at its disposal. The most commonly used tool is open market operations, which is just a fancy term for "buying and selling government bonds." When the Fed buys bonds, it takes in a bond and puts money out into the system. When it sells bonds, it gives out a bond and takes money out of the system. Therefore, buying bonds increases the money supply and selling bonds reduces it.

As it turns out, an increase in the money supply lowers interest rates, and a reduction in the money supply raises them. Why is this? As a consumer, you probably don't keep all of your wealth in cash stuffed under your mattress, and the reason that you don't do this (other than bedtime discomfort) is that cash under the mattress doesn't earn interest. There is an opportunity cost of holding money, and this cost gets bigger as interest rates go up. It's not surprising, then, that interest rates go lower when the money supply increases, since the lower interest rates make people more willing to hold the extra cash.

Technically speaking, the interest rate that the Fed targets when it decides how much money to put into the economy or take out of it is the Federal Funds rate, which is the rate at which banks can borrow from each other if they are short on reserves. This may seem like an odd measure to use as a target, but it turns out that other interest rates in the economy that are more directly relevant to us as consumers and producers move in line with the federal funds rate, so the impact is more widespread than what one might initially think.

But wait a minute -- why would the Fed want to lower interest rates? (I know, so many questions.) Lower interest rates (at least theoretically) have a stimulating effect on the economy because they make it more attractive to borrow and invest and more attractive to spend rather than save. The downside of increasing the money supply as a means of stimulating the economy is that it, if left unchecked, will eventually lead to increased inflation as people acclimate to the increased amount of money in the system. (In other words, we'll eventually have more money chasing the same number of goods and services, so things will become more expensive.)

The above discussion shows how open market operations work in the normal course of the economy. It's relevant to mention, however, that this process has a somewhat severe limitation in that (nominal) interest rates can't go below zero percent -- i.e. policy makers haven't figured out a good way to induce buyers to invest in assets that will give a negative return. (I will acknowledge that the housing market inadvertently did this for us for a while.) We're currently bumping up against that zero percent threshold but still need to jump start the economy, so the Fed has to come up with a new plan of action. This is where quantitative easing comes in.

Quantitative easing is defined as buying financial assets (eg. bonds) from banks via open market operations in order to flood them with reserves (read, cash in the vault) in hopes that they will lend it out and start a virtuous cycle of investment and consumption. Hopefully you understand my confusion by this point since it's unclear how quantitative easing is any different from what the Fed does normally without us even thinking too much about it. (This is a thinly veiled way for me to tell people to calm down.) From what I understand, the difference is in the fact that the Fed is buying long-term rather than short-term bonds (as is done with typical open market operations) and that it has a money supply target rather than an interest rate target.

The million (trillion?) dollar question, as is with monetary policy in general, is "Will this work?" To answer this, I will quote a recent speech by N. Gregory Mankiw, former economic adviser to President Bush: "My textbook is organized in order of things that economists are sure about to things that they are less confident are correct." Furthermore, I will note that Monetary Policy is chapter 34 out of 36. The goal of increasing the money supply is to increase real output, and economists are divided on whether this relationship holds. Some economists believe that monetary policy can increase output and employment in the short run, but even they acknowledge that in the long run the economy will revert back to its original level and will have suffered increased inflation in the process. Other economists think that monetary policy can only trick people into producing and spending more if it comes as a surprise. (If that is true, then all of the hullabaloo around quantitative easing is probably not so helpful.) Still others believe that monetary policy only results in increased inflation and has a negligible impact on real output, even in the short run.

Economists are very smart people, but there are still a lot of questions in macroeconomics that remain unanswered. Sometimes, the best thing that economists and policy makers can do is to try something, see if it works, then decide whether to do more of that thing or to try something else. In other words, if you like watching House, then you should find the business section of the paper fascinating nowadays. (Though I have to admit that the average economist is not quite as attractive as Hugh Laurie. Sigh.) Luckily, the inflation created as a side effect of quantitative easing could actually be helpful in that it encourages exports from the U.S. to other countries and makes it more attractive to buy and invest in tangible goods rather than leaving the money under the mattress. Granted, that's a hard sell for people with investments that aren't indexed for inflation, but at least it's something.