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Quantitative Easing

October 23, 2012 in Economy

The Effects of Quantitative Easing on Currency Value:

In the age of the Roman Empire currency value was determined by the silver content of a coin or by the number of coins struck from a single block of gold or silver. During the first three centuries AD, from Nero to Claudius II, the silver content of the coins dropped from 93 percent to about 7 percent. Naturally, the goods that could be purchased with one 93 percent coin would require 13-14 7 percent coins to create equal value. The reason for devaluation lies with Nero’s attempts to increase the supply of money without obtaining more silver, but the end result was the devaluation of the currency and the weakening of spending power that went with unchanged salaries in terms of coin numbers. The phenomenon was not limited to classical times, but is being repeated today.

Inflation and Quantitative Easing:

Inflation and quantitative easing
What is Quantitative Easing?

The modern equivalent of the silver content trick or quantitative easing is currency devaluation. This remains an option for nations with an independent fiscal policy – i.e. those not in the Euro-zone like Greece, Italy and Spain. It is a risk that a government takes when cutting the value of the currency against others in order to increase the volume of coins at home. The payoff is increased liquidity, but the risk is hyperinflation as prices rise. A good example of this has been the Zimbabwean currency crisis of the last decade.

For Nero, the reason for beginning the devaluation process was pragmatic. The Roman Empire would not survive if the armies were not paid and the starving masses of Rome bought off with free food and entertainment. Furthermore, he would not survive if he did not pay off the armies. For Bernanke and any American president, there is military spending and there is welfare spending, but the biggest problem is business debt. This is why the Federal Reserve decided to spend $40 billion a month on buying up mortgage backed securities on artificially low interest rates.

The instant reaction to QE3 has been an upturn in stock market values, but has this increased liquidity into the economy as a whole? Or is the stock market acting like a financial sponge that is never squeezed? Or one that is at least not squeezed over the sink, but into a small bucket called bonuses.

The Dollar As A Reserve Currency

Consumers may think that quantitative easing is a far cry from actual currency devaluation, but it is not. In fact, the creation of new money to buy bonds acts in much the same fashion. Before we move on to the dollar as a currency, let’s look quickly at inflation and interest. The printing of new money creates inflation. This naturally affects the prices of things such as oil, food, energy bills and more. This is ably demonstrated by these graphs:

U.S. Dollar Price Movement:

US Dollar Price History

Example of Percentage Gains on Quantitative Easing (QE)

Example of Quantitative Easing and percentage gains
As it demonstrates, since QE3  (3rd round of Quantitative Easing) the value of United States Oil has begun to climb again, as has the value of the S&P 500. The second graph above shows how since this time the value of gold has risen by 2.43 percent, INR has fallen by 1.80 percent, and currencies such as the Euro (0.35%), Japanese Yen (1.34%) and the British Pound (0.29%) have increased in value. This fact can be found in currency comparisons across the world. The net effect is that is makes the dollar cheaper to buy, which is good for people buying the currency, but not in selling it. It also makes it harder for importers, while easier for exporters.

QE3 and U.S. Dollar Index

QE3 and Dollar Index
The above chart demonstrates how the value of the dollar fell quickly once QE3 speculation grew and then again when it actually occurred on the 9th of September. Since then the currency has recovered a modest amount, but remains far below the usual value prior to QE3 speculation.

This turn of events has led the Financial Times to speculate that the dollar’s role as the reserve currency of choice is coming to an end. Over the last century, investors and governments have found it profitable to store their assets in U.S. dollars as it was a stable currency in a stable economy in a stable country. In the last decade and especially since the financial crisis of 2007, money has been moving into gold reserves instead. This has created an upturn in commodities, but is threatening the dollar. The FT also puts this phenomenon down to increasingly bullish emerging markets and a general lack of liquidity in the American market. Yes, despite QE3, there is not enough money flowing around. This begs the question of where that money is gone and whether bond buying is the right way to increase liquidity.

 What is QE3?

The first quantitative easing or QE started during late 2008 (November 2008) in the U.S. when Federal Reserve started the purchase of Mortgage-backed securities to ease the financial crisis and control the inflation by injecting money to lower down the interest rates. The second round of quantitative easing was in 2010 and it was during that time that this round was termed as QE2. The third round of quantitative easing started on September 13th and it was termed as QE3.