As expected the US Federal Reserve this week began the next phase of Quantitative Easing (QE). With $600 billion announced in addition to the $1.7 trillion of last year and $300 billion in train, markets are worried over where this will end and what the full ramifications will be not only in the US but also globally.

Essentially the purchase of additional government securities is the equivalent of “printing money” or effectively devaluing every dollar currently in circulation and committed to. The mechanism is relatively straight-forward for developed economies like the US. With a sluggish economy, which is struggling to get moving again, and no room to reduce interest rates below their near zero level, the Federal Reserve sees little option other than to increase the money supply through QE. The Fed will credit its own account with new money (from nothing), use this “new money” to buy financial assets, usually government bonds (Treasury Bills) in a process vaguely called “open market operations”. So the Federal Reserve makes more dollars and effectively deposits them with large financial institutions (Banks) and hopes thereby that the Banks will help kick start the economy via increased lending – in multiples of what was given to them (fractional reserve banking).

If this all sounds confusing it can be summed up as the Central bank prints more money out of nothing (it is only paper after all), lends it to Banks at tiny interest rates, and hopes that the Banks will use the deposits to create more money via loan (credit) creation thereby creating yet more money.

There are several dangers with this approach:

1. Where does it end? The QE creation of $1.7 trillion last year was supposed to provide the solution. It didn’t. While statistics show relatively low overall inflation, price hikes are beginning to appear in food and other commodities (real assets appreciate against ever increasing fiat papers). Some commentators believe that QE will not end here, the economy shows signs of dropping back into recession and the US deficit grows ever greater. There is a perfect storm brewing of no recovery, rising unemployment, growing federal and state deficits, and little real wealth growth to bail it out. In this scenario QE will merely devalue dramatically the value of the dollar, which is inflationary, and potentially hyperinflationary. One might reasonably ask when the policy gurus have gotten it right over their economic decisions, and can they control the inflation genie when it is out of its bottle?

2. The world’s largest debtor (the US) is running short of countries that will lend to it. China has for many years, but is now getting cold feet over the more than $2 trillion dollars of US Treasury Bills it holds. In inflationary/QE times these T Bill assets will devalue rapidly. The US may feel this is a clever way of paying back its debts with hopelessly devalued dollars. But in an ever smaller world, this will create severe problems in future re global trust and cooperation whether in trade or elsewhere. If the world cannot trust the custodians of the defacto world currency (US$) to manage it responsibly where else will trust be lost.

3. The US dollar is declining relative to other country currencies, which on the face of it should be positive for US exports (now costing less in foreign countries). However, the rest of the developed world is facing a similar problem and many too are also doing their own form of QE, and therefore devaluing their currencies in a desperated effort to kick start their economies. In a race to the bottom of the currency devaluation war, real asset inflation is the only winner. Jobs, the economy, trade and business confidence will all take a severe beating. The stakes are very high and if this doesn’t work confidence in the whole system will be hit hard.

4. Banks have not and are not lending in anything like the required levels. Furthermore there is not the appetite for relatively free credit as there was in the pre-recession boom period. The economies are not back on track and Banks are using the money given to them by QE to strengthen their weakened balance sheets. This is also counterproductive in a fiat money system which relies on steadily growing credit to keep business afloat, confidence high and recessions few and far between. The consumer is worried about keeping his job, his home, and is now saving what little he has after basic expenses. Hardly a recipe for rapid consumer led spending growth.

In essence the lessons learnt from the financial crisis have not been heeded. Governments, not being content to witness the largest uncontrolled growth in credit in history, and the creation of the largest house and asset bubble, are now hoping they can spend their way out of the problem. Yet the money is not there and needs to be conjured. It is hard to see anything other than a continuation of recession, and inflation if not hyperinflation.

Until the Islamic Khilafah is again established we are unlikely to see the stability of the gold/silver standard which precludes government action to debase the currency. With no interest, a clear and unchanging rule of law and a far more positive and open trading environment I think the Islamic state’s trading partners will also look forward to the real change Islam provides.