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The Fed’s $600 billion QE2: Love Boat or Titanic?

What you really need to know about Ben Bernanke’s historic experiment — in plain English.

Can QE2 save the world economy? (Marwan Naamani/AFP/Getty Images)

Editor's update: The global backlash against last week's Federal Reserve decision to pump billions of dollars into the U.S. economy continues, with finance ministers from Germany, Russia and China roundly criticizing the move. Brazil's president-elect Dilma Rousseff went even farther: "The last time there was a competitive devaluation of currencies it ended up where it did, in the Second World War." President Barack Obama, meanwhile, played defense: "The Fed's mandate, my mandate, is to grow our economy. And that's not just good for the United States, that's good for the world as a whole."

BOSTON — In the first week of November, investors drove stock prices to pre-crisis levels, elated by the news that the U.S. Federal Reserve Bank was going to launch what’s been dubbed “QE2.”

In case you thought the U.S. government was suddenly getting into the cruise line business, here’s a primer on QE2, and an explaination of why you should batten down the hatches, pay attention to how this plays out over the coming years, and steer clear of the fallout.

Obscure as QE2 may sound, any working stiff should care about it for the same reasons that you should have paid attention to mortgage-backed securities in the 2000s: your job, your bills and your financial well-being may depend on it.

So here’s what QE2 is: the Federal Reserve (the U.S. government’s central bank) is essentially printing $600 billion, and using it to purchase U.S. Treasury bonds. This increases the quantity of money available in the economy, easing the pressure on banks and other financial institutions — the "QE" part of the name stands for "quantitative easing."

The Fed is trying this strategy for the second time (hence QE2). The first time came during the dark days of the financial crisis. Many economists lauded that first round of quantitative easing for helping to thwart an economic depression. This time around, the Fed is hoping that it will help the economy pick up steam.

But there’s ample evidence that QE2 is the wrong medicine for the what ails the economy – that the real problem is in part a lack of good ideas, as well as an obtuse and dogmatic unwillingness to see that the private sector can’t solve all the economies problems.

So how does quantitative easing work? According to basic economics, when a government prints money, interest rates drop and inflation rises. This is simply a matter of supply and demand: the same way that corn is cheap in the summer when it’s plentiful, the Fed is making it cheaper to borrow dollars, by flooding the market with them.

As a result of QE2, interest rates — which are basically the rent that borrowers pay to lenders — will (almost certainly) decline. Likewise, since there are more dollars out there chasing goods and services in the economy, prices will likely go up (i.e., inflation will rise).

Higher prices ward off the dangerous specter of deflation (when prices go down, causing the economy to slump and forcing companies to layoff workers due to sagging revenues).

Finally, flooding the market with new money makes it easier for foreign countries to buy dollars (again, it’s a question of supply and demand). This will cause the U.S. dollar to drop compared to other currencies, making our exports cheaper, hence easier to sell.

In a nutshell, the Fed is bolstering an era of easy money. This should help the economy grow.

But easy money is not without its risks. For most countries, printing too much money can be devastating. An extreme example of this is Zimbabwe, where strongman Robert Mugabe’s government attempted in the mid-2000s to pay off foreign debts by printing trillions of Zimbabwe dollars. Inflation ran as high as a billion percent — meaning that a product that cost $1 might cost a $10 million the next year. By 2008, US$1 bought some 10 billion Zimbabwe dollars.  Zimbabwe’s currency became so worthless that the government printed 100 billion dollar notes before finally abandoning it in favor of foreign currencies.

For the U.S., the situation is different. What the Fed is doing with QE2 is nowhere near as irresponsible as Mugabe’s printing-press mad antics. Compared to the $14 trillion dollar U.S. economy — by far the world’s largest — $600 billion