Understanding a bit about economics and how it plays a part in your investment strategy will go a long way towards growing your wealth over time. Quantitative Easing (or 'QE') is a word that gets thrown around a lot in the financial news, so I've written this post to explain:
The 2008 Financial Meltdown
The story starts with the global stock market crash of 2008. You may recall that investors lost a lot of money at this time after the colossal investment bank, Lehman Brothers, collapsed when news spread that they were securitising billions of dollars in complex, worthless loans.
You can visit our financial jargon page for a definition of securitisation, but for the purposes of this post you just need to know that these loans weren't as 'secure' as everyone (including most people at Lehman Brothers) had originally thought. Once this was discovered the loans became practically worthless overnight.
Since other large banks besides Lehman Brothers were similarly involved, this had massive contagion for global stock and bond markets.
After the crash investors, bankers and governments got pretty nervous to say the least. The Dow Jones Industrial Average (DJIA) lost 33.8% of its value in 2008. This set in motion a viscous downward spiral for the economy:
And so the cycle continued, resulting in a very prolonged and significant global recession.
So what did the governments and central banks of the world do to fix the situation? We'll look at three key steps they took here...
Step 1: bailout the banks to stop the bleeding at the source
Many big banks, which collectively securitised trillions of dollars in worthless loans, were close to going bankrupt. Governments therefore chose to bailout the banks with the taxpayers's money, knowing that if the banks closed, so too would the bank accounts of their many millions of customers.
Governments were quite successful in this regard. In the UK, the Royal Bank of Scotland was fed so much government rescue juice that by October 2008 58% of the bank was owned by the British taxpayer.
Although government bailouts gave the banks some breathing room, there was still widespread panic over the situation. By this I mean two things:
With all this panic, central banks stepped in...
Step 2: Lower interest rates to speed up the economy
If the economy is a car, then interest rates are the accelerator. If your car is going too slowly, you press your foot down, which lowers the accelerator and speeds up the car. This is like saying that when an economy is slowing or in recession, central banks lower interest rates to speed things back up.
If the economy goes too fast, the opposite is true; central banks raise interest rates to slow it down.
Side note: if an economy is growing too fast it can cause high inflation; people have more money to spend, so they buy more goods and services and the prices of those goods and services go up.
The diagram below gives a simple explanation of the relationship between interest rates and the economy.
It’s worth noting that central banks can lower interest rates by buying short-term government bonds. Because they usually buy lots of these bonds, they bid up the bond prices. As I explain in another post on investing in bonds, when the price of a bond goes up, the interest rate on said bond goes down.
Since the interest rates at which banks borrow money from each other mostly depends on short-term government bond rates, banks can then borrow money at lower interest rates. As banks can borrow at lower rates, they can then then lend money to their customers at lower interest rates and still make a profit.
Since lower interest rates mean more borrowing, more money becomes available for people to spend. Economists call this expansionary monetary policy.
The 2008 crash was unusual because central banks lowered interest rates by so much that they were practically zero. But even though such low interest rates might have encouraged people and businesses to borrow and spend more money, banks were still unwilling to lend.
Banks were still financially weak from the crash. To them lending out money when they didn't have much to begin with was risky business.
At the same time, large companies were reluctant to take on new investment projects, instead hoarding billions for the next rainy day. This sentiment was also shared by ordinary household spenders who, sceptical of the stock market, favoured saving their money over spending and investing.
It was evident by late 2008 that something more needed to be done to feed the starving economy.
So central banks did something they had never done before...
Step 3: Quantitative Easing
Quantitative Easing (QE) is like expansionary monetary policy on steriods.
A key difference between QE and normal expansionary monetary policy is that with QE central banks also buy other bonds besides short term government bonds; they buy corporate bonds and longer term government bonds. With QE, central banks print money to buy bonds.
The main purposes of QE are to:
Side note: QE weakens a country's currency because it lowers the interest rates of savings in that country. If interest rates are low in country X, then fewer foreign investors store money in country X. This means less foreign demand for the currency of country X, which lowers country X's currency price compared to the currencies of other foreign countries. Hence, country X's currency gets weaker.
Did QE work?
Did QE end the global recession? Who knows!
Is QE good for investors? So far, yes.
QE makes asset prices go up. If interest rates are nearly zero, as is the case with QE, then saving money in the bank won't earn you much interest. So you have to buy shares, bonds and other investments to make a return. If every Tom, Dick and Harry investor is doing the same thing, then asset prices go up.
Sure, there may be some inflation on the horizon, but I'm guessing interest rates around the world will stay low for some time. Given this fact, there's even more reason to stop saving and start investing.