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Current time:0:00Total duration:9:15

Video transcript

To get a better understanding of quantitative easing in the American context, especially the context that Ben Bernanke is talking about, I want to read this quote from a speech that Ben Bernanke gave at the London School of Economics on January 13th, 2009. So this is shortly after a lot of the craziness of the financial crisis was happening but it was still going on. And he's saying, "Our approach, which could be described as 'credit easing' -- resembles quantitative easing in one respect." He's saying it's not quite quantitative easing, although it really is. "It involves an expansion of the central bank's balance sheet." So just to understand what he's talking about, the central bank, it has liabilities and assets, like any corporation, and they have to, the liabilities, plus the equity has to match up to the assets. Just for simplicity, let's just have the assets and the liabilies lining up together. So let's say that this is the central bank's balance sheet right over here. This is their current assets, and let's say that is is their liabilities over here, so liabilities, and then this is their equity, although the federal reserve's equity is a little bit strange, it's not like traditional equity, that they get all the excess profits and all of that, all the excess profits actually go to the US government. But when the fed prints money, what they literally do is that they create offsetting liabilities and assets So when they print money they'll, so literally let's say that they're printing some money right over here, so that's money that they're printing, so this is literally, it would be federal reserve notes being created, so these are notes, which are essentially dollar bills. So these are dollar bills right here being printed, either physically or electronically. And then they have an offsetting liability which is just notes outstanding, which is literally saying that hey, these are notes that we've created. Notes outstanding is the other side of the balance sheet. So, just to parse the statement, when he says, "credit easing resembles quantitative easing in one respect it involves an expansion of the central bank's balance sheet." So this is the expansion of the central bank's balance sheet. Which is essentially the same thing as printing money. And the federal bank will get these notes into circulation by going out into the market and buying assets. Traditionally, when the fed is more focused on short-term interest rates, on overnight borrowing rates between banks, it will use these to buy shorter-term debt that increases the amount of currency out there the amount of dollars out there, and so it will lower the interest rate for people buying and selling dollars, or I should say borrowing and lending dollars, not buying and selling. Borrowing and lending dollars, the overnight rate for banks will go down because there's more dollars out there, the cost of borrowing them will go down. That's normally what the fed is concerned about. And they're saying, look, quantitative easing is just this idea of expanding that balance sheet. Let's keep reading: "However, in a pure quantitative easing regime, the focus of quality is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidential." So he's saying in traditional quantitative easing, the central bank says look, I just care about printing money I just care about printing money, So their liabilities increase accordingly. So this is notes outstanding again, And the height here is proportional to how much money they print, so maybe this is another trillion dollars they're printing. But what the federal reserve is saying, in traditional quantitative easing, all the central bank cares about is printing this money and getting it out there into circulation, and they don't really care what they're using this money for. So whenever they get this money into circulation they do go out there and they do buy assets usually treasury assets, and then they say even, "Indeed, although the bank of Japan's policy," -- so he's comparing relative to what Japan did when they kind of faced deflationary crisis. "Indeed, although the bank of Japan's policy approach during the quantitative easing period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves." So you're saying look, the Japanese were trying to fight a deflationary bank crisis, they kept printing money so they kept increasing the liability side of their balance sheet, they kept printing money and they did use this money for a bunch of stuff, they did use that money to go buy a bunch of assets, but their focus of their intervention was just, how much did they print? They didn't really care, they didn't really engineer where that money went to. They really weren't trying to change what happens in the markets that they were participating in. Let's keep reading what the fed is saying. "In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses." So what he's saying is that, we are mechanically doing the same thing that Japan did, we're increasing our balance sheet, which is analogous to printing money And we are also buying a bunch of stuff, just like Japan did, Japan had a multifaceted approach, that's how they put the money into circulation, but what Bernanke is saying is that our approach isn't just focused on the amount of cash that we are printing, our focus is where are we putting that cash toward, how can we use this cash that we printed to kind of, provide liquidity, to ease up things in certain parts of the economy. To understand what he's talking about, let me draw a yield curve right over here. Let me draw this yield curve right over here, so this is maturity on the horizontal axis, and this is yield, and I'm gonna draw the yield curve for treasuries. So let's say the short-term overnight borrowing for, let's say, let's do the yield curve for treasuries, maybe it looks something like this. So short-term interest rates are already pretty darn close to zero, and maybe you know this is some, I don't know what percentage, maybe this is like 4% or something. It's not accurate, but just gives you an idea. So this is the treasury yield curve. Now you could also have a yield curve for other types of debt. Maybe you have AAA corporate debt, a very safe corporate debt, a perceived safe corporate debt, but it's not quite as safe as US treasuries, so maybe it's yield curve might look something like this and this difference, for any maturities, maybe this is a 10 year, this is 10 year debt right here. This difference between this AAA corporate debt and the treasury, that is the yield spread. And maybe the fed is able to, through intervention, first they're able to print money, normally they buy shorter-term debt, maybe they start buying longer-term treasury debt, and maybe that helps get the yield curve, for longer-term treasuries down a little bit. Helps bring it down. But maybe the AAA corporate debts don't react, maybe the spread doesn't stay constant maybe the spread widens. Maybe the same thing for other types of debt. This is highly rated mortgage backed securities, maybe they have a slightly higher interest rate. And once again, even though the treasury interest rates are coming down, while they're intervening because of all the craziness that is happening in the economy, the spread between treasuries, and AAA mortgage backed securities, or the spread between treasuries and AAA corporate debt that widens, or another way to think about it is the treasury interest rates are coming down while these things aren't following it, so what Ben Bernanke is saying, look we are doing quantitative easing, we are printing money and we are using that money to go buy things in the economy and we're increasing the amount of cash that there is in the economy, but our point isn't to increase the amount of reserves, or increase the amount of cash, because it's really not changing the behavior of banks. What we are going to do is go buy things like highly rated mortgage backed securities, or things like commercial paper, AAA corporate debt, so that those things, the interest on those things goes down. Obviously if someone is willing to pay more for a certain amount of debt, and I've gone over this in another video, maybe it's not so obvious, then the interest rates on it will go down. And so what they're doing is, what Bernanke is saying, is he cares more about what winds up on the asset side of the Fed's balance sheet, because it takes these dollars that it printed, and goes and buys other stuff, and it wants to put some mortgage backed securities over here, it wants to put some AAA corporate debt over here. And maybe it also does some longer term treasury securities, or whatever else.