"Quantitative Easing"---Incentives to banks to start lending...My explanation with graphs!

     This is a follow up to my last post regarding the Federal Reserves possible use of "quantitative easing" as a way of stimulating the economy by increasing the money supply.  In a nutshell, The Fed is going to create an account and deposit money into it.  Well, not money as we know it,  but electronic credits.  However,  it amounts to printing money out of thin air (although The Fed does not actually print money...that is another lesson).  They are going to use that "money" to buy various financial assets.  The term financial asset is rather broad, but in the short term The Fed is going to purchase (1) non-performing assets on banks balance sheets, which a fancy way of saying their bad loans and (2) buying short term US Treasury's, which is a fancy way of saying US government debt.  Specifically, I will focus on US Treasuries for the purposes of this lesson.    

     Lets use an easy example.  Assume Congress needs $9,000 to finance some spending they want to do.  To get this $9,000 they are going to sell 100 US Treasury Securities with a face value of $100 for $90 each. They sell them for $90 with the promise to pay $100 at some pre-determined time in the future, so the owner of the security will make $10.  The supply and demand graph below illustrates this arbitrary equilibrium price I set. Notice the supply curve "S*B/T" is vertical at 100 bonds/treasuries. We will assume this is all there is in the market and no matter what the price, there are no more to be had (keeping it simple). 

     We know we make $10 from this security, but to get a more accurate measure of our investment we want to convert this into a percent.  Calculating this percent, also known as Rate of Return OR Interest Rate, is important because you can use it to compare across investments (compare Treasury returns to stocks, other bonds, commodities, real estate, etc). To calculate our interest rate we take our investment ($90) and divide it INTO our expected gain ($10) then multiple by 100 to put it in percentage terms.  We find in this example our interest rate is 11.11%.  What a terrific interest rate, yes??    

      What The Federal Reserve is finding out is that the banks like this too! Banks are borrowing money from the Fed at almost a 0% interest rate (aka "Federal Funds Rate), and instead of lending it out to consumers and businesses, like The Fed desires them to, the banks are putting the money in US Treasuries, or government debt. They are doing this because (1) banks are hesitant to make loans in an uncertain economic climate, (2) in this economic climate earning 2% on an investment GUARANTEED by the US government (borrowing at 0% and putting in Treasuries earning 2% is better than a sharp stick in the eye) is a very safe strategy. 

     Since being foiled by the dastardly bankers, The Fed is pondering "quantitative easing", which means they are going to intervene in the Treasury market themselves! This is SIGNIFICANT, because it is somewhat a "last straw" measure to get banks lending. 

    Review the first paragraph of this entry because I want to pick up from there.  The Federal Reserve wants to make Treasuries unattractive to banks and to provide them an incentive to loan out money instead of socking it away in Treasuries.  The way to do that is for The Fed to BUY Treasury's themselves which will serve to DECREASE the interest rates those Treasuries earn!  Say what?

   The Fed enters the market as a DEMANDER for US Treasury's.  As a new entrant with big bucks, they are going to INCREASE the demand for Treasuries.  See the graph below that illustrates this INCREASE in demand.

As happens when the demand for anything goes up relative to the supply, the price will INCREASE. The price of a $100 Treasury increased from $90 to $95.  What happens to our  rate of return or interest rate? We earn  $5 on the Treasury we bought for $95.  Using our formula, the new interest rate is 5.26%, considerably less than before!  KEY POINT: There is an INVERSE relationship between the price of a Tresury Security (or Bond) and the interest rate it earns.  As the price increases the interest rate decreases. The reverse is true also: as the price of Treasury (Bond) decreases, the interest rate increases. 

    With this lower interest rate, the banks MAY consider other investment strategies, like, oh, I dont know, LENDING money to people to buy houses, cars, big screen TV's or to businesses to replace capital goods, buy new capital goods, expand factory production, or build new facilities?

   The bottomline with employing quantitative easing is that lowering the Federal Funds Rate to virtually 0% has not loosened up the credit markets enough to spur sufficient economic activity (buying stuff).  If The Fed can make alternative, albeit safe investments, LESS attractive to banks, AND if they can relieve banks of non-performing loans so banks can loan out that money as well, then perhaps we can move forward.  It is risky and smacks of a last ditch effort...We will see how it works out!!!

The Federal Reserve meets tomorrow---You may hear a new term "Quantitative Easing"--Learn about it first HERE!!

This video explains in VERY simple terms (even I can understand it!) the concept of "Quantitative Easing".  From what I am reading, it is very possible the Federal Reserve tomorrow will report that they are going to use this method for "stimulating" the economy.  The video starts out a little slow.  He gives an overview of the important Federal Funds Rate before getting into quantitative easing, which you are NOT going to want to miss!!! :)

This definition of Quantitative Easing from Wikipedia: 

""The term quantitative easing (QE) describes a form of monetary policy used by central banks to increase the supply of money in an economy when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.[citation needed] A central bank does this by first crediting its own account with money it has created ex nihilo ("out of nothing").[1] 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.  "Quantitative" refers to the fact that a specific quantity of money is being created; "easing" refers to reducing the pressure on banks.[2] However, another explanation is that the name comes from the Japanese-language expression for "stimulatory monetary policy", which uses the term "easing".[3] Quantitative easing is sometimes colloquially described as "printing money" although in reality the money is simply created by electronically adding a number to an account. Examples of economies where this policy has been used include Japan during the early 2000s, and the United States and United Kingdom during the global financial crisis of 2008–2009....""

Where Americans have and have not spent money since the beginning of the recession---Fido and Fluffy have done pretty well...

Where Americans Are Spending More..

...and where we are spending LESS...

I have been under a rock---Is college expensive today?

Carpe Diem

Since 1978, the price of housing (red line) increased approximately 320% (3.2 times)  before "crashing" in 2007 wreaking havov on the financial system. The price of college tuition (brown line) in the same time period increased approx 920% (9.2 times)...Is it due for a crash also? If not, why not?  Can tuition increase forever? That was the thinking in the housing industry, and we know how that ended up. 

"What Can I Do To End World Poverty?"--That is NOT the right question to ask...

     As High School Economics teacher, sponsor of an extra-curricular activity linked to the D/FW World Affairs Council, and coach of the Model UN team, the opportunity for students to ask the question "What can I do to help solve world poverty?" presents itself quite often.  When I was in the Marine Corps I served as a US Embassy security guard for a total of 2.5 years, 1 year in Kingston, Jamaica and 18 months in Bamako, Mali (Northwest Africa).  I traveled overland  to Burkina Faso and Senegal too.  While only on the periphery as an observer on a daily basis, I was able to experience what life is like in poor/poorer societies (I am under NO illusions and make NO claim that I can identify with the folks I met/observed/lived amongst.  I certainly did not live "poor" while on duty in those places).  Not a day passes by I don't think about some aspect of daily life in either of those places, but Mali is on my mind more often than not.  I am not professionally qualified to give an adequate answer to the question posed above, but I do try to give students a layman's answer to the question based on my experiences.  However,  I always find my response lacking in substance and specificity.
     William Easterly, at AID WATCHERS, is an international aid expert and he struggles with the question as well:

  ""Inevitably, after every single lecture I have ever given, the first question is … What Can I Do to End World Poverty?  How to respond? On one hand, I want to (and usually do) salute the questioner for their willingness to give of themselves for those less fortunate. I admire their idealism and commitment.
   On the other hand, I find this question to be unproductive and frustrating. It sounds mean, but the honest response (which I have never given) is, ”look, the biggest problem to solve in economic development today is NOT what you can personally do to end poverty.” Poor people do not perceive THEIR biggest problem to be that rich people are agonizing how to help them.  More constructively, I want to say: Don’t be in such a hurry. Learn a little bit more about a specific country or culture, a specific sector, the complexities of global poverty and long run economic development. At the very least, make sure you are sound on just plain economics before deciding how you personally can contribute. Be willing to accept that your role will be specialized and small relative to the scope of the problem. Aside from all this, you probably already know better what you can do than I do.
   But I do salute you again, and I do believe when there are enough people like you, you will cumulatively make a difference.""

(What is in bold and highlighted is my emphasis.)

BP Exec says his family will eat Gulf Seafood---Reminds me of this scene from Erin Brokovich...

BP Exec: I Would Serve Gulf Fish to My Family

""BP's chief operating officer sought to give the southern US fishing industry a much-need boost Sunday, saying he'd "absolutely" eat Gulf of Mexico seafood after the massive oil spill devastated the region...." \

Reminds me of this scene from Erin Brokovich...

Adam Smith would be proud of this English Muffin...And I'm not talking about Mrs. Smith

Who would have thought making an English Muffin would require so much and be so technical in nature, and at the same time permit a relevant reference to Adam Smith?  Gotta LOVE Social Science!

NYTIMES: A Man With Muffin Secrets, but No Job With Them

""According to Bimbo’s filings, the secret of the nooks and crannies was split into several pieces to make it more secure, and to protect the approximately $500 million in yearly muffin sales. They included the basic recipe, the moisture level of the muffin mixture, the equipment used and the way the product was baked. While many Bimbo employees may have known one or more pieces of the puzzle, only seven knew every step.

“Most employees possess information only directly relevant to their assigned task,” Daniel P. Babin, a Bimbo senior vice president, said in a written court declaration, “and very few employees, such as Botticella, possess all of the knowledge necessary to produce a finished product.” ""

I was immediately reminded that I have heard this before---In so many words, Mr Babin is channeling the following quote from "The Wealth of Nations" by Adam Smith in regards to his famous Pin Factory analogy. 

""But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.""

How The Average American Uses Energy---Nice graphic!

I was a bit surprised at how little oil we use for generating electricity and how much coal we use...

How The Average American Uses Energy

"Amber Waves of Grain..." Not so much in Russia---What does the price of wheat in Russia have to do with you?

From WSJ: Russian Export Ban Raises Global Food Fears and Wheat Goes Up, Prices to Follow

"Russian Prime Minister Vladimir Putin, responding to the country's crippling drought and deadly wildfires, said on Thursday that exports will be banned from Aug. 15 until the end of the year..."

Look at what has happened to the price of wheat in the last few months:

NY TIMES

   Most people have a "ho-hum" reaction when it comes to commodities like wheat, corn, soy beans, etc.  But these are important inputs into so many finished food products.  When we have negative supply shocks like the one in Russia it affects the economy at both the macro and micro level.

     In the global market for wheat there has been a reduction in supply due to drought AND fires in the highly productive regions of Russia (Ukraine, especially).  Now added to the mix is a mandate by the Russian President that wheat is subjected to an export ban.  Graphically, the supply curve for wheat is going to shift to the left, indicating a decrease in market supply (at any given price, the quantity supplied is less than what it was before--graph those new points and you get a new supply curve (S1) that lies to the left of the previous one (S*).

As supply curve S1 shifts to the left, notice we MOVE ALONG the existing Demand Curve D*.  Demanders are responding to the supply reduction  by DECREASING the quantity demanded of wheat as the price of wheat increases, as the Law of Demand would suggest.  Think of it this way: as the price goes up then some demanders are simply not going to be part of the market as they were before because they are "not willing and/or able" to purchase the same quantities of wheat at the new higher price P1 (or maybe none at all now). The difference between market quantity  from Qe to Q1 illustrates this reduction in BOTH quantity supplied due to weather, fire, government policy and the quantity demanded due to the higer price. Here is an example of the decrease in quantity demanded from the article:

""The wheat price spike has forced the U.N. World Food Program, which helps feed more than 90 million people world-wide, to cut back on purchases, according to a spokeswoman""

They are not completely out of the market, but the higher price is limiting their ability to purchase the same amount as before, hence the decrease in quantity demanded. 
     On a Microeconomics level this is only the begining--how is this going to affect farmers/ranchers, aid organizatioins, food processors, retail and wholesale businesses in terms of the cost of production? On the Macoeconomics level--globalization, government policies that affect world trade, allocation of resources (as planting season approaches, is wheat a better bet than corn, soy beans, cotton, etc)? Is this a start of a broader increase in food prices resulting in harmful inflation? Will the rise in price for this essential input cause food riots in some countries?
      Something as simple as wheat can have a large impact on our lives is so many ways...This is why I love economics!!  So much to consider and ponder...

Where do you put all YOUR Stuff? George Carlin and I know...

For the past several years when teaching GDP I frame it in terms of "stuff" or material goods.  I first ask students if they have a garage and if at least one of the bays cannot be used to park a car because of all the stuff (maybe two, or ALL the bays). I then ask if their parents have space at a storage facility.  Most hands still stay up.  Our High School is located near a road with MANY large storage facilities within a 5 mile radius.  This explosion in material goods really took off in the mid-eighties.  Hmmm...why was that?  Anyone my age (50) and older can testify to this.  I am pretty sure almost no one would trade the quality and quantity of stuff we have today with what we had in the 60's and 70's.  If you have any doubt, browse this catalog and see for yourself. Only good ol' day syndrome would cloud the thinking on this, I believe. Below are some interesting data on the Self-storage industry.  I highlighted some of the more prominent numbers and information...Also, a video of George Carlin talking about "Stuff" (caution, some language you may  find objectionable)...

Self Storage Data
The self storage industry has been one of the fastest-growing sectors of the United States commercial real estate industry over the period of the last 35 years

There are now approximately 46,000 “primary” self storage facilities in the United States as of year end 2009; another 4,000 are “secondary” facilities (“primary” means that self storage is the “primary” source of business revenue – US Census Bureau)

The distribution of U.S. self storage facilities (Q4-09) is as follows: 32% urban, 52% suburban and 16% rural

Nearly 1 in 10 US households (HH), or 10% (10.8 million of the 113.3 million US HH in 2007) currently rent a self storage unit; that has increased from 1 in 17 US HHs (6%) in 1995 – or an increase of approximately 65 percent in the last 15 years


It took the self storage industry more than 25 years to build its first billion square feet of space; it added the second billion square feet in just 8 years (1998-2005)


During the peak development years (2004-2005) 8,694 new self storage facilities (approximately 480 million square feet of space were added)

There are approximately 58,000 self storage facilities worldwide as of Q4 – 2009; there are more than 3,000 in Canada and more than 1,000 in Australia.

Fewer than 250 new self storage facilities came on line in the U.S. during 2009; the trend in new construction is down significantly the last four years

Primer on Externalities---One of the more interesting and relevant concepts in Economics

Here is an excellent blog post that summarizes externalitites, negative and positive,  better than I can do...It is an extension of the blog entry I did just below this one.

I Suppose That This Is One Way To Internalize An Externality, Turbine Edition…(From: Econogirl)

Let me start with a quick recap of the whole externality deal, in bullet-point form:
■Externalities are side effects in a market, i.e. costs and benefits that accrue to people who neither produce or consume a product. For example, pollution is an externality because I am affected by pollution from factories even when I neither produce nor consume the products that they make.

■Externalities can be either negative (as with pollution) or positive (as would be the case if I lived upstairs from a bakery and got the smells wafting into my apartment…though I suppose that would get old quickly).

■When externalities are present, free markets left to themselves don’t produce the socially optimal quantity of a good or service. If there are negative externalities, the free market produces more than is socially optimal because it doesn’t take into account the cost it is imposing on society by producing. If there are positive externalities, the free market produces less than is socially optimal because it doesn’t take into account the benefits it is providing to society.

■In these situations, taxes and subsidies respectively can increase overall welfare because they move production and consumption to the socially optimal level. Taxing or subsidizing in the amount of the externality that a good creates is referred to as “internalizing” an externality, and taxes (and subsidies, I suppose) of this form are called Pigovian taxes.

■Note that it is not necessary for the tax revenue generated to be spent on fixing the externality for this setup to work, since the taxes and subsidies are in this case merely used as a vehicle to move the needle on production and consumption. For example, Pivogian taxes to reach the socially optimal level of pollution do not require that the tax revenue be spent on pollution cleanup, but there is an implicit assumption that the tax revenue is being used for something socially beneficial rather than being flushed down the toilet.

This is usually where the textbooks stop, which means that they ignore a number of relevant subtleties and complications associated with externalities and Pigovian taxes. First off, they act as though calculating the amount of the externality is easy, whereas I am pretty sure there is a shiny new Ph.D. and academic job waiting for anyone who has a good way of figuring this out. I mean, by what dollar amount are you inconvenienced by the pollution resulting from the production of one beanie baby? Yeah, I don’t know either. But wait, it gets even more complicated, since this answer technically depends on the framing of the question- people typically give higher answers to the question “how much would you have to receive in order to tolerate one more unit of pollution?” versus “how much would you be willing to pay in order to make one unit of pollution go away?” And this doesn’t even come near the fact that differences in income and whatnot mean that different people probably give widely varying estimates of this amount.

Even if we could put a dollar amount on an externality, we still need to address a few more things before automatically jumping on the Pigou bandwagon. (Okay fine, there isn’t actually a Pigou bandwagon…but there is a Pigou Club.) When we say that Pigouvian taxes lead to the “socially optimal” level of production, we mean that this level of production is best for society in the aggregate under the assumption that a dollar to me is the same as a dollar to you is the same as a dollar to Bill Gates. (I’m not sure why he is always my scapegoat for these types of comparisons, other than that is has a lot more money that I or probably you do.) This does not mean that *everyone* is better off under a Pivogian tax, just that the winners win more than the losers lose. For example, consider a gasoline tax to internalize the pollution and congestion externalities of driving- those with their gas-guzzling SUVs are certainly worse off, since they have to pay more in taxes than they get in benefits from cleaner air and more open highways. People without cars are better off, since there is less pollution and they aren’t paying the gasoline tax. It is important to note, however, that while they may enjoy some public services that are funded by the tax revenue, they aren’t getting compensated directly for having to put up with the remaining pollution that is still in the air. (I will allow you to make your own judgment regarding whether you’d rather have $1 in cash or $1 in government services, but I think I can guess where this audience is going to come out on that.)
Wouldn’t it be nice then if we could eliminate the governmental middle man and have companies tell people “we’re sorry we @#$! up your air, here’s some cash?” It turns out that that isn’t as unreasonable as you’d think. From The New York Times:

Patricia Pilz of Caithness Energy, a big company from New York that is helping make this part of Eastern Oregon one of the fastest-growing wind power regions in the country, is making a tempting offer: sign a waiver saying you will not complain about excessive noise from the turning turbines — the whoosh, whoosh, whoosh of the future, advocates say — and she will cut you a check for $5,000.

Hm. Theoretically, this should work if $5,000 is an appropriate estimate of the per-household cost of the externality. It probably reduces the number of turbines that the company puts up (since more turbines would mean more noise and thus a higher payout required to get households to comply), and, if the households agree to the deal, their revealed preferences show that they are being compensated adequately for their inconvenience. It’s interesting to note that the article implies that some households were refusing the offer out of principle, since they didn’t like the idea of being bought. (Are you surprised by now that people don’t act like economic robots?) If I were trying to strike this sort of deal, I think I would have approached the households before the turbines went in so that they felt a little more in control of the process.

Wind Mill energy provider is buying peoples silence...no, really they are BUYING silence! Very mob-like AND has economists seal of approval.

Wind mills apparently cause alot of noise...whoosh, whoosh, whoosh, all day and night long.  This noise produces what economists term a negative externality.  It is a negative by-product of production for which the producer does not explicitly pay for.  It makes the cost of production lower than what is should be and produces additional profits at the expense of society at large.  Often in cases like this  government steps in and either regulates the firm or imposes fines.  However, there is a market alternative that can take care of the problem.  The energy company can pay the people who are "hurt" by the negative externality for there inconvenience.  If an agreed upon price can be reached, then there is no need for government regulation.  Obviously, there are difficulties with this approach, but can be effective in the right circumstances for both the producer and the affected. 

NYTIMES: Turbines Too Loud for You? Here, Take $5,000

""Residents of the remote high-desert hills near here have had an unusual visitor recently, a fixer working out the kinks in clean energy. Patricia Pilz of Caithness Energy, a big company from New York that is helping make this part of eastern Oregon one of the fastest-growing wind power regions in the country, is making a tempting offer: sign a waiver saying you will not complain about excessive noise from the turning turbines — the whoosh, whoosh, whoosh of the future, advocates say — and she will cut you a check for $5,000.""

 Another simple example---lets say you want to have a party with a live band in your backyard.  This is going to affect your neighbors (assuming you are not inviting them to come) with loud music for half the night.  This is the non-monetary cost you are imposing on your neighbors and you are not fully accounting for all the costs for your party.  To keep them from calling the police and ruining your party, you could offer them compensation to not call the police.  If you can agree upon a price then you are fully accounting for all the the costs of your party.  You have eliminated the negative externality...The noise remains, but you have internalized the cost....

I may live to see this happen, though I hope not...

China Becomes Second Biggest World Economy
China has overtaken Japan to become the world's second-largest economy, the fruit of three decades of rapid growth that has lifted hundreds of millions of people out of poverty....Depending on how fast its exchange rate rises, China is on course to overtake the United States and vault into the No.1 spot sometime around 2025, according to projections by the World Bank, Goldman Sachs and others.

This is NOT an Onion story---Do you experience an "experience" at Chipotle? Apparently some do and they sued to get it...

Court: Chipotle restaurant violated disability law
SAN FRANCISCO — An appeals court has ruled that two Chipotle Mexican Grill restaurants in San Diego have violated a federal law protecting the rights of the disabled.
The 9th U.S. Circuit Court of Appeals ruled Monday that customers in wheelchairs are denied the "Chipotle experience" of watching their food being prepared because the restaurants' 45-inch counters are too high.
The company now faces hundreds of thousands of dollars in damages. The unanimous three-judge ruling overturned a trial court decision pointing to Chipotle's willingness to prepare a disabled customer's order elsewhere. The appeals court said that is still unfair.
The ruling was issued on the 220th anniversary of passage of the American with Disabilities Act

(HT: Carpe Diem)

Nice Interactive Graphic on the aging population---Too many "olds" not enough "youngs".

Click HERE to take you to this interactive graphic.  Watch the bulge in baby boomers work its way through the decades. Sort of like watching  the monster in Alien squirming through a belly...As a bonus you can compare the US to Europe/Japan/China.  This is THE fiscal problem for the young generation.  Are policy makers REALLY addressing this issue?

HT: Chartporn