Via John Hussman's Weekly Market Comment [4],
Putting QE into terms everyone should be able to understand... [5]
Decker, Bessie, Joe and you
Consider a simple economy. You use wood from your back yard to produce lumber, which you sell to Decker for $100 of currency (which Decker holds as evidence of past saving he has done). At the same time, Bessie produces milk on her farm, which she sells to Joe. But Joe needs currency to pay Bessie, and instead has a few shares of stock (which embody past saving that Joe has done). At current prices, Joe can get $100 by selling one share of stock to you in exchange for your currency. He then pays Bessie for the milk, and drinks it. Bessie is a cash cow, and adds the $100 to her stack of currency that embodies her past saving. We can assume that there are many others in the economy who have currency, stocks, and bonds that embody their past saving, but we don’t need to name them for this example. On the security side, you now own $100 of stock that used to be held by Joe, and Bessie has $100 of currency that used to be held by Decker.
On the real side, the economy has produced $200 of wood and milk, but only $100 of that output has been consumed. So there’s $100 of new saving in the economy. On balance, you and Bessie produced without consuming, and Joe consumed without producing, so you and Bessie are the savers, and Joe is the dissaver in the current period. Given $100 of overall saving, there must be $100 of new real investment. Who’s got it? Decker, in the form of unused wood inventory. Decker has neither produced nor consumed – he’s just traded his prior saving for current investment. Has there been any new security issuance? No, because neither you nor Bessie has intermediated your savings for someone’s use. The stock trade just represented existing securities changing hands.
Now suppose that Decker uses the wood to build a small stairway for a government building, for which he sends a bill to Uncle Sam for $150. If the government goes into deficit to pay that bill, it has to sell $150 worth of bonds to someone, in return for $150 of currency. Who has currency? Bessie, and she uses $150 of currency to buy $150 of freshly printed Treasury bonds. The government uses the $150 of currency to pay Decker. If you account carefully, the whole set of transactions has now produced $150 of real investment (the stairs) on balance, so the economy must have produced $150 in net new saving: your $100 and Decker’s unspent $50 profit. Yet in this case, $150 of new securities have been created in the economy, while there were no new securities created in the previous paragraph. That may not make sense until you realize that that’s the amount of savings that Bessie intermediated to the government. The net acquisition of securities is still zero, because the bonds that Bessie counts as an asset are the same bonds that the government counts as a liability.
If the Fed now launches QE, it does so by purchasing Treasury securities from Bessie, and paying for them with newly printed currency or crediting Bessie’s bank account with reserves (base money). Does that inject new purchasing power into the economy? No, it does not. It just changes the form of government liabilities held by the public, from bonds to base money. Is Bessie more likely to consume just because her savings take the form of cash instead of bonds? No – not if she didn’t have spending plans already, and not unless the economy was otherwise constrained by a lack of currency.
Now, there’s a central issue we have yet to address, which relates to changes in the value of existing securities. Once issued, all of these pieces of paper can vary in price later, so the saving that someone did in a prior period, embodied in the form of some paper security, may be worth more or less consumption in the current period than it was initially. That’s really the main effect QE has – to encourage yield-seeking speculation that drives up the prices of risky securities, but without having any material effect on the real economy or the underlying cash flows that those securities will deliver over time.
For now, keep in mind that money doesn’t go “into” the stock market – it goes through it from a buyer to a seller. The resulting price changes are purely changes in the relative value that people place on these pieces of paper, and amount to changes the amount of “paper wealth” in the economy. These changes should emphatically be distinguished from the real wealth of the economy, and the underlying stream of cash flows that will be generated over time. The relationship between those two quantities – between the price of the piece of paper and the underlying stream of deliverable long-term cash flows – tells us about valuation and probable long-term investment returns (even if speculative factors play a role in driving paper wealth over the shorter term). We’ll cover those valuation issues shortly.
