FEBRUARY 19
The Cost of Cheap Money
The Tap and Nozzle Behind Economic Stimulus
The Signal
Central banks can make borrowing easier. Everyday banks can create spendable money through loans. If spending grows faster than the economy, prices can rise and money buys less.
The Reading
Imagine the money system as a hose filling a bucket. The bucket is the economy. The wall tap is the central bank. High interest rates turn the pressure down. Lower interest rates turn it up. The nozzle is the everyday bank. When it approves a loan, it can create new spendable money in the borrower’s account. Remember: the central bank changes the pressure. Everyday banks open the lending nozzle.
When officials want to encourage more economic activity, you may hear terms such as economic stimulus, monetary easing, monetary expansion or accommodative monetary policy. During very difficult ecenomic periods, central banks may also use quantitative easing, or QE. Under QE, the central bank creates new electronic central-bank money and uses it to purchase financial assets, often government bonds which are goverment debt. These purchases are designed to lower longer-term interest rates and make financial conditions easier, encouraging borrowing, spending and investment. QE is commonly described as “money printing,” although the new money is generally created electronically rather than as physical cash.
Cheap money can feel good. Borrowing gets easier. Spending rises. But money is not wealth. Creating more money does not create more houses, food, fuel or electricity. If spending power grows faster than production, prices rise. Your money buys less.
Same number. Less usefulness.
First Principles
Central banks influence how easy borrowing becomes.
Everyday banks can create new spendable money through loans.
If spending power grows faster than the economy, prices can rise and existing money can lose purchasing power.
Today’s Challenge
Put a little cordial in an empty bucket and fill a jug with water.
The bucket is the economy. The cordial is the purchasing power already there. The wall tap is the central bank. The nozzle is the everyday bank. The jug is emergency stimulus.
Turn the tap very low and open the nozzle fully. Little water flows. Think high rates, tight money, slow lending.
Now turn the tap fully on and open the nozzle fully. Water rushes in. Think lower rates, easier money, heavy lending and new credit.
Keep the hose flowing and dump in the jug. In a serious crisis, officials may use QE: another central-bank way of adding liquidity, commonly called “money printing,” although the money is created electronically.
Watch the cordial dilute as the bucket fills.
If money grows faster than the economy, what happens to the purchasing power already there?
Tomorrow’s Signal
Saving in a Melting Currency