This is part 4 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”. You can download the episode on iTunes or find it on our Listen page.
We’re excited you’re here. In case you missed the header, this is Part 4, so if you just got on the bus, be sure to go back and read parts 1-3 before jumping into this one. For those who’ve been on board since the beginning, welcome back! Now go grab an espresso and let’s get into it!
How the Fed’s Purchase of Treasuries Affects the Money Supply
Most people who pay attention to the economy have heard of “quantitative easing”. But in talking to lots of people and teaching this topic in seminars, we’ve found most people don’t really understand how it works. Since there’s been a lot of QE’ing going on, and potentially more to come, it’s important for all investors, real estate and otherwise, to really understand how it works. And the topic is especially relevant in light of the current debt ceiling debate.
As you should recall from previous installments in this series, the Fed has a Magic Checkbook. We explored how and why Big Ben is inclined to use it. Now we’re going to discuss what happens when he does.
The Sound Money Concept
Big picture economics can be intimidating and confusing. But a global economy is simply a collection of national economies. And a national economy is simply a collection of many citizens’ economies. So if you understand basic economic principles on a small scale, when everything blows up (figuratively speaking, at least so far), the numbers get bigger, but the principles still apply.
So, let’s imagine that you show up at a Treasury auction and you decide to buy Treasury bonds.
When your write your check and hand it over to the Treasury, they deposit it into their bank account (with the Fed) and the Treasury’s bank balance is increased by the amount of check. When your check clears, your bank balance is reduced by the same amount. What you have done is exchanged the cash in your bank for Uncle Sam’s bond. This is your basic everyday transaction. Just like buying furniture.
Now imagine that you and Uncle Sam are the only two people in the economy. If, between both of you, there were $100,000 divided evenly, then you would each have $50,000. When you buy $10,000 worth of bonds from Uncle Sam, you write a check and Uncle Sam’s now has $60,000 cash, while your balance is now $40,000. You have a $10,000 asset (Uncle Sam’s bond) and Uncle Sam has a $10,000 liability (the debt to you). But when you add it all up, it balances. This is a “sound money” system because after the transaction is closed, everything balances. That is, the same amount of money ($100,000) is in the economy is before, it is just allocated differently between the parties as a result of the transaction.
The Funny Money Concept
Now let’s look at what happens when Big Ben Bernanke buys a U.S. Treasury bond using his Magic Checkbook. Remember, Ben doesn’t have any money in his checkbook. He doesn’t need any because his checks never bounce. They’re magic.
Big Ben buys $10,000 worth of bonds from Uncle Sam. Uncle Sam’s bank account goes up by $10,000 and Big Ben gets the bond. Seems normal right?
Well, let’s take a closer look.
In our two person economy (you and Uncle Sam), you each had $50,000 for a total money supply of $100,000. But when Big Ben buys the bond, Uncle Sam gets $10,000 for a total of $60,000 and you still have your $50,000 for a total money supply of $110,000. The money supply just grew! The technical term for expanding the money supply in this fashion is “Quantitative Easing”. You may have heard of it. There’s a lot of it going on lately.
Take It Queasy
What is the effect of this “quantitative easing” on an economy?
Remember, you can’t use money itself for anything, so it’s only valuable when you can use it to purchase products. Money (for the purists: technically, “currency”, since real money is a product, which is what make it real) isn’t a product. Money is simply a means of storing value until you can convert it to something useful (i.e., buy something).
Let’s say that in our little economy, we have 1000 bottles of water, 1000 sandwiches, 1000 magazines, and 1000 more of 7 other things so there’s a total of 10,000 products. In the real world, the price of each product would reflect the effort to locate and convert the raw materials into finished goods, and then prices would fluctuate based on supply and demand. But to keep it super simple, imagine that all the products are priced equally, so the $100,000 in our economy is divided equally among the 10,000 products. Now each product is worth $10. $100,000 / 10,000 = $10
But if our money supply expanded to $110,000 courtesy of Big Ben’s Magic Checkbook (when he bought the $10,000 of Treasury bonds), then each product is worth $11.00 because $110,000 / 10,000 = $11.00. That’s inflation. More dollars divided over the same productivity.
So simply stated, inflation occurs when the amount of purchasing power (money, credit) goes up faster than the supply of goods (production). In a stagnant economy (one that isn’t producing more stuff), when you add new money, prices go up.
The important thing to know is that when people with regular checkbooks (like you) buy Treasuries, the transaction balances out because the buyer’s checkbook balance decreases while Uncle Sam’s increases. But when Big Ben uses his Magic Checkbook, NEW money enters the system because Uncle Sam’s balance goes up, while all the regular checkbooks stay the same. Again, this is Quantitative Easing and it’s inflationary.
In the real world there are lots of moving parts, but if you just stick to the basic principles, you can clearly see what’s happening. Because it all gets blended in with real world supply and demand dynamics (and confusing econo-speak), a lot of inflation can be hidden for awhile. But not forever. After a while it all “trickles down” to the man on the street and first prices rise (you know, like food, gas, clothing, etc.), and then eventually in wages (that one hasn’t hit yet).
If you want to understand this “trickle down inflation” better, listen to our 2/20/11 radio episode The Coming Wave of Inflation – Profiting When the Levee Breaks, available on iTunes.
So now that you have all of this under your belt (just think how much fun you’re going to have at your next cocktail party!), in our fifth and final installment, we will finally look at how all this affects the Great Debt Ceiling debate. And, we’ll unveil our bold prediction of what we think Congress will actually do about the debt ceiling.