QE for Dummies by Chris Martenson + What Time Is the Next Crisis? - An Historic Warning From John Hussman

Understanding the most outlandish monetary experiment ever conducted by Chris Martenson

A PeakProsperity.com reader recently lamented:

I have been trying to get my head around the mechanism of QE. Not being an economist or experienced investor I don't really understand a lot of the jargon. The usual simple definition of QE as "thin air money printing" does not satisfy my need for understanding either. Have hunted for a description of QE for dummies that leaves me feeling like I get it, but with no luck. My difficulty is in understanding how thin air money gets into circulation.

So I'm going to do my best to answer this plea in as intuitive and straightforward a manner as I can. I, too, share the need to understand the mechanism of a process in order to feel like I have a grasp of it.  And I think it's critically important to understand QE (also known by its full name, "quantitative easing") and what it really represents. Because it is, without a doubt, one of the largest market-shaping forces of our times. 
Further, it presents extraordinary risks and may well turn out to be a decisive shaping process for the future, as well. And not in a good way.
Despite its sophisticated-sounding name, QE is nothing more complicated than the Fed buying "assets" from commercial banks and other private financial institutions.  I put assets in quotes because the Fed does not buy things like land, Stradivarius violins, diamonds, gold, or silver from these institutions, but rather various forms of debt.
The main forms of debt purchased are Treasury bills/notes/bonds and Mortgage Backed Security (MBS) paper. 
There could well be other forms, too, but we currently have no visibility into the composition of the sizable portion of the Fed's balance sheet that comprises the "other assets" line.  I'll get into that in more detail in a minute.

QE Explained

First, here's the an explanation of QE:

Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. 
A central bank implements quantitative easing by buying financial assets from commercial banks and other private institutions, thus creating money and injecting a pre-determined quantity of money into the economy.
Quantitative easing increases the excess reserves of the banks, and raises the prices of the financial assets bought, which lowers their yield.
(Source - Wikipedia)

The reason that QE differs from normal monetary policy is that, in the normal case, the purchase of various bond types by the Fed does two things: It lowers interest rates, and it increases the amount of money in the system.
QE, on the other hand, cannot lower interbank interest rates any further than they already are, because they are at 0%.  So a different name is used for the process in which the only thing being eased is the quantity of money.  Hence Quantitative Easing (QE).
This is just a fancy way of saying that the central bank, via prior errors and miscalculations, has found itself stuck in a trap where it has lost one of its most potent tools: the price of money.  And now it can only fiddle with the quantity of money.
Here's a simple picture that I drew to illustrate just how simple this fancy-sounding process really is:

When the Fed performs this trick, what happens is that the assets end up on its balance sheet as – well, assets of course.  Luckily the Fed provides reasonable clarity in a timely manner on the expansion of its balance sheet.  So we can see pretty well what's going on here as it happens.
In graph form, we can see that the Fed's asset balance had been holding steady at around $2.75 trillion for a bit over a year.  But then the latest round of QE (QE4) began, which has swelled the Fed balance sheet above than $3 trillion – and it's way to (at least) $4 trillion by year end (2013).

Here's a nice short description of the process of QE:

A central bank [performs QE]  by first crediting its own account with money it has created ex nihilo ("out of nothing"). It then purchases financial assets, including government bonds and corporate bonds, from banks and other financial institutions in a process referred to as open market operations.
The purchases, by way of account deposits, give banks the excess reserves required for them to create new money by the process of deposit multiplication from increased lending in the fractional reserve banking system.
The increase in the money supply thus stimulates the economy. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio.
(Source - Business Insider)

The Price of Thin Air Money

At this point you might be thinking, where did the Fed get the money to buy these assets?  The answer to that is simple:  It was created out of thin air.  Or ex nihilo, if you want to use Latin to make it sound more official. 
In these modern times, no actual paper money was created and exchanged, of course; just a few clicks on a computer keyboard.  And – voila! – billions and billions of dollars are created.
There are several critical risks to flooding the world with invented money.  Once we understand them, it becomes clearer how the Fed's decision to pursue QE has put it in a box, where its available options are becoming fewer and fewer.  And it explains why the Fed is continuing – and will continue until it simply can't – with its aggressive money printing. 
In Part II: Why You Really, Really Need to Care about the Implications of QE, we lay out these risks and identify the markers you can follow to track them. We then detail how the QE process is destined to devolve and the implications this will have for your wealth and well-being.
To make our situation clear, we are living through the largest and most outlandish monetary experiment ever conducted by humans upon themselves.  These are extraordinary times, and no matter how many times the mainstream press tries to convince you that a rising stock market or a rebounding housing market implies that we are returning to healthy economic balance, don't fall for it.
The Fed is in uncharted territory, having created a monster it can no longer control.  In the process, it is blowing new asset bubbles that are benefitting those with first access to the newly-printed money (banks and corporations) at the expense of savers, pensioners, and anyone exercising fiscal prudence.  This, of course, is creating a vast and growing inequality between the top 1% and everyone else.
When this misadventure in monetary policy ends, as both math and history says it must, it will be messy, uncontrolled, and very painful for holders of just about every sort of finanical instrument out there (stocks, bonds, derivatives, etc).  That's why understanding the root causes and risks of QE is so important, in order to identify the best shelters for protecting the purchasing power of your wealth through this transition.

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Additional:

What Time Is the Next Crisis? - An Historic Warning From John Hussman

"Present market conditions now match 6 other instances in history: August 1929 (followed by the 85% market decline of the Great Depression)...
"The enemy of the conventional wisdom is not ideas but the march of events." John Kenneth Galbraith
Submitted By Jesse: In every instance he cites with which I am familiar, any concerns about the gross mispricing of risk were lightly dismissed, because 'the market says that everything is all right.'   As if the financial markets were some prescient, infallible instrument, and not overtaken by the manipulation of insiders and the monied interests. 

The 'rising market' kept most criticism of the policy errors in the growth of the credit bubble cowed and quiet, until the inevitable market break and crisis. That the financiers have not yet completely destroyed the global economy is not particularly reassuring, while they are still working at inscribing their arrogance, writ large on the pages of history, chapter by dreadful chapter.

Or more cynically one can conclude that yes, things are getting out of control, but we must keep dancing while the music is playing, and say nothing while the money is flowing in order to 'save the system,' while disabling the smoke alarms and stuffing one's pockets.


As long as the Fed can keep printing money and delivering it to the Banks and the one percent, and not to the real economy, through its purchases of their (fraudulently) mispriced financial assets, this could keep going, while maximizing the damage.  While it does give the financial engineers some feeling of control, it really does nothing constructive except to delay the essential reforms.


The combination of constructively applied stimulus and sweeping financial reform was the genius of Roosevelt, and the lack of it is the failure of Obama.

And the big correction might not even show up all that readily, in nominal terms at least, in the equity markets for some time, being papered over by a blizzard of new money.  And so that implies a crash in the bond markets, as we saw a few years after the Great Crash of 1929.  But they are getting better at the cover ups, so who can say.

The tail of financialization and leverage is still 'wagging the dog' of the real economy.   After reading the current thoughts in mainstream economics, and Modern Monetary Theory, it seems quite likely that history is about to deal out another hard lesson in real wealth and value.

I am ambivalent to the exact timing since I cannot know it.    And so if another year passes and 'nothing happens' I may not be cheered by it while the fundamentals like median wage continue to deteriorate.  This is the mechanism in which bubbles develop, and we have seen more of them than most, and with increasingly intensity.

But I am more confident that the punchline to this comedy, if it continues unabated, will be the devaluation of the currency and at least a de facto default on the debt which can take several forms. And the usual yahoos will rise up and seek power, promising an hysterical people to take away their pain, while inflicting it on 'the others.'

"Present market conditions now match 6 other instances in history: August 1929 (followed by the 85% market decline of the Great Depression), November 1972 (followed by a market plunge in excess of 50%), August 1987 (followed by a market crash in excess of 30%), March 2000 (followed by a market plunge in excess of 50%), May 2007 (followed by a market plunge in excess of 50%), and January 2011 (followed by a market decline limited to just under 20% as a result of central bank intervention). These conditions represent a syndrome of overvalued, overbought, overbullish, rising yield conditions that has emerged near the most significant market peaks – and preceded the most severe market declines – in history:

1. S&P 500 Index overvalued, with the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) greater than 18. The present multiple is actually 22.6.
2. S&P 500 Index overbought, with the index more than 7% above its 52-week smoothing, at least 50% above its 4-year low, and within 3% of its upper Bollinger bands (2 standard deviations above the 20-period moving average) at daily, weekly, and monthly resolutions. Presently, the S&P 500 is either at or slightly through each of those bands.
3. Investor sentiment overbullish (Investors Intelligence), with the 2-week average of advisory bulls greater than 52% and bearishness below 28%. The most recent weekly figures were 54.3% vs. 22.3%. The sentiment figures we use for 1929 are imputed using the extent and volatility of prior market movements, which explains a significant amount of variation in investor sentiment over time.
4. Yields rising, with the 10-year Treasury yield higher than 6 months earlier.

The blue bars in the chart below identify historical points since 1970 corresponding to these conditions.

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