Quantitative Easing, Explained

Everywhere you turn in the financial media lately, you hear people talking about "quantitative easing."

It's one of the more impressive financial phrases out there -- impressive for the distance between how boring it sounds and how dramatic it actually is.

It means creating massive amounts of money out of thin air with the hope of getting the economy back on track.

Economists -- at least some economists -- believe that when you want to improve the economy you need to get more money out there, circulating around.

The problem is, there are only a few ways to do this.

One way: Have the government spend money by, say, paying people to build roads or install solar panels. That would get money into people's pockets.

But we already did that, with the big stimulus last year -- and it's a politically unpopular idea at the moment, so Congress isn't about to do it again.

Option two: The Federal Reserve can cut interest rates, which makes it cheaper to borrow. So people borrow more, buy more, build more new things.

But we already did that, too. The Fed lowered interest rates all the way down to zero. Can't go any lower.

For almost all of modern economic history, policy makers have used those two tools -- government spending or Fed interest rate cuts. That's it. But with this financial crisis, for the first time in U.S. history, those two tools won't work.

Enter quantitative easing, an idea the Fed is borrowing from Japan, which used it a decade ago when it had a similar problem.

It works like this.

A big bank -- Bank of America, say -- has $50 billion in government bonds. They'd sell those bonds if anyone would pay enough for them, but nobody is willing to pay that much. So the bank just holds on to them.

With quantitative easing, the Fed comes along and says, "Hey, Bank of America, we'll buy those bonds for a little more than anyone else is willing to pay." Bank of America says, "OK, great, send us the money."

This is where the Fed gets to use central-bank magic. They pay for that $50 billion purchase in new money. They just invent it. That's what the Fed -- but nobody else -- gets to do.

So now Bank of America has $50 billion they need to do something with. The Fed is hoping that Bank of America will decide to lend that $50 billion to companies and people to invest or spend. That stimulates the whole economy.

It sounds great. Create new money, get it out there, everyone wins. But -- of course there's a but.

Nobody really knows if this works. It's still really controversial among economists. It's only been tried a few times and, as in the case of Japan, hasn't had the greatest results.

The Fed first used quantitative easing in 2008. It's now considering a second round, even though a lot of folks are against it.

While the economy is still this bad, the Fed really might only have two options: Do this as a desperation move, or do nothing.