I find it amazing how many people still believe that QE is adding all sorts of liquidity to the markets.  There is still a widespread belief that QE is inflationary and an addition of net new money (despite the rather simple accounting behind a QE transaction).  Well, it looks like a few notable people are finally starting to get it.  Some recent commentary by notable central bankers makes it clear that some are beginning to notice that QE has no real relationship with higher inflation (via Warren Mosler)::

Don Kohn (Former FRB Vice Chair): “I know of no model that shows a transmission from bank reserves to inflation”.

Vitor Constancio (ECB Vice President): “The level of bank reserves hardly figures in banks lending decisions; the supply of credit outstanding is determined by banks’ perceptions of risk/reward trade-offs and demand for credit”.

Charlie Bean (Deputy Governor BOE) in response to a question about the famous Milton Friedman quote “Inflation is always and everywhere a monetary phenomenon”:

“Inflation is not always and everywhere a monetary base phenomenon”.

In this week’s letter John Hussman dispels the myth that the increase in the monetary base is adding new liquidity:

“From the standpoint of prospective investment returns, it is important to recognize that the main effect of quantitative easing has been to suppress the expected return on virtually all classes of investment to unusually weak levels. It’s widely believed that somehow, QE2 has created all sorts of liquidity that is “sloshing” around the economy and “trying to find a home” in stocks, commodities, and other investments. But this is not how equilibrium works.

Here’s how equilibrium does work. Every security that is issued has to be held by someone, in precisely the form in which it was created, until that security is retired. Period. That means that if the Fed creates $2.4 trillion in currency and bank reserves, somebody has to hold that money, in that form, until those liabilities are retired. The money ultimately can’t go anywhere. If someone tries to get rid of their cash in order to buy stock, somebody else has to give up the stock and hold the cash. In the end, every share of stock that has been issued has to be held by somebody. Every money market security that has been issued has to be held by somebody. Every dollar bill that has been created has to be held by somebody. None of these instruments somehow “find a home” by going somewhere else or becoming something else. They are home.

So what is the effect of creating an extra $600 billion dollars of monetary base by having the Fed purchase $600 billion dollars of Treasury debt? The same thing that happens anytime any security is issued. Somebody has to hold it, and the returns on all other assets have to shift by just enough to make everyone in the economy happy, at the margin, to hold the outstanding quantity of all of the securities that have been issued. In practice, the only way you can get people to willingly hold $2.4 trillion in non-interest bearing cash is to depress the return on all close substitutes to next to zero. So short-term Treasury bill yields have been pressed to nearly nothing.

I’ve been hammering on this point for 6 months now, but an increase in reserves has no impact on net financial assets.  As Mr. Hussman describes it merely alters the mix of assets.  This is not inflationary in the sense that some Friedmanites might have you believe.  And it certainly does not increase the odds of some sort of hyperinflationary collapse.  There really isn’t new money in the system.  And the notion that QE is helping to fund the deficit is beyond nonsensical and displays a terrible lack of understanding when it comes to how the US monetary system functions.  The only thing QE is doing is generating a huge amount of confusion, making investors believe the Fed is printing money and altering investor perception so as to to induce a speculative boom in commodities that is now helping contribute to global turmoil….


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Helix12

    Are you telling me when the Fed buys the bonds from the banks increasing the banks reserves that some of the money doesn’t go to the trading desk where higher risk assets are traded i.e commodity speculation which fules inflation. Is this not liquidity. Sure there may be no fractional reserve lending occurring but the money is still being used….money for the banksters by the banksters

  • http://www.pragcap.com Cullen Roche

    The bank that owned bonds before only had to sell the bonds if they wanted to buy stocks. The fact that the term structure of their instrument was changed from a 3% int bearing asset to a 0.25% asset did not give them more liquidity. It might make them more eager to own stocks (or comparable substitutes to bonds), but it did not give them more liquidity.

  • Hammertime

    OK, so the FED is not creating money with QE. I get it. However, the money IS being created by government deficit spending. More than 1.5 Trillion dollars per year as far as the eye can see. Does it really matter which government institution is creating the money? It does not matter. Still sounds like a banana republic to me. Why would anyone want to hold US dollars?

  • BK

    And the market is efficient they say….

  • http://www.pragcap.com Cullen Roche

    It matters quite a bit. The people making this insane QE=money printing argument are saying that the govt deficit spending could not have occurred without QE. That’s not correct. And let’s keep things in perspective here. While the deficit spending has been sizable it has not even offset the deleveraging. That’s why M3 is still contracting. So even if you want to make the (incorrect) argument that QE enables deficit spending then the argument that it is resulting in an exploding money supply is still wrong:

  • Mediocritas

    @Hammertime: there’s nothing wrong with the government spending fresh money into existence if that process is offsetting private sector deleveraging (paying off credit); the latter consigns money to oblivion.

    Base money is being increased to compensate for credit being reduced. As that money is spent, economic activity pushed by the government is compensating for economic activity lost in the private sector as a consequence of the 2008 crash.

    Remember that this process is EASILY reversed. All the Fed has to do is reduce the bond roll, which parallels with the government introducing austerity measures (shrinking govt departments) as the private sector recovers.

    There’s nothing inherently inflationary about any of this. Local pockets of inflation may appear as the government really stinks at allocating capital effectively (boosting some enterprise excessively), offset by other pockets that go under-funded.

    QE1 was intended to stabilize banks and ensure they continued to meet the capital adequacy requirements of Basel II.
    QE2 was intended to boost the public sector to make up for contraction of the private sector.

    Perhaps what they should have done is copy Australia and go for the helicopter drop, providing everyone with a flat credit thereby boosting the economy from the bottom up via the private sector rather than top down via the government. A few hundred million minds could probably decide where to allocate cash in a better way than a few hundred thousand in the government.

  • George H

    Count Barry Ritholtz as one of them.

  • http://www.pragcap.com Cullen Roche

    As one of whats?

  • http://ralphanomics.blogspot.com/ Ralph Musgrave

    I agree that QE is not the same thing as money printing dollar for dollar. On the other hand cash is definitely more liquid than government bonds. Government bonds are accepted instead of cash in the world’s financial centres, but you cannot buy a car or a PC with bonds. Thus I suggest QE does increase the total amount of liquid assets to a finite extent.

  • FDO15

    Banks don’t buy cars and PCs.

    Besides, reserves aren’t removed from the banking system. Banks can’t get rid of reserves. As Hussman said, these reserves are always held by someone. So even if a bank wanted to go buy cars they would have to sell their reserves to another bank and use the proceeds to buy cars. This is no different than what they would have to do with the bonds they once owned. There is no increased liquidity at all.

  • JNH

    With higher reserves in place, secured with QE2, deleveraging can go on without much trepidation, however this allows Banks to invest more freely and Wall Street too realize a “Black Swan” brought on by a major bank collapse in the near future will not materialize or odds are greatly reduce so they too get into the fray. The wealth effect based on gains on excess capital and not real demand revenue will ultimately be cause for higher inflation as we are seeing now. If this is the case why would business create more jobs when in fact there is no new demand created; higher earning and income does not neccesarily equate to more demand for goods and services, hence stagflation.

  • Anonymous


    you have to refine this argument. Currently it has the following flaws:

    – You look at one bank and assume all banks will act like it. But banks in aggregate will lose an income generating security, so they will look for a substitute and thus happen to bid risk assets currently
    – Let’s not consider the fact that reserves are slightly more liquid than US Treasuries. But only because there is no change in the liquidity, it does not mean banks in aggregate will not pursue inflationary trades due to the reduced income (see above)

  • Anonymous

    You assume that the level of activity was right and not an overblown, credit-induced, unproductive, corrupt, speculative bubble, which needs to be corrected. Keeping the status quo, keeps the patient chronically ill, by treating only the symptoms, not the root of the illness. It’s like taking aspirin for cancer instead of a chemotherapy.


  • Max

    Hussman gets one thing wrong: bank reserves at the Fed do earn interest, in fact more than t-bills. Why would banks want to get rid of reserves when the alternative pays less? Not surprisingly, they are happy to hold reserves. It’s a free lunch.

  • yo

    Over 300,000,000 people in this country decide that less money is needed in our system, and for VERY GOOD REASONS, and a handful of men in washington say, oh yes we do, and they create even more money than is being destroyed by the private sector.

    I’ll tell you what is insane. So many people thinking this is a good thing is what’s insane. And quibbling about whether the fed or the treasury is doing it is the absolute heighth of idiocy.

  • MattC

    I agree that the net amount of assets held in the private sector hasn’t changed, only their mix, but here’s the part that looks inflationary to me.
    Suppose there are only two private economic agents, A and B, each holding $10 in T-Bonds and nothing else. Now suppose A wants to buy stocks. In theory all A needs to do is sell its T-bonds, then use the cash to buy stocks. But you can’t just ‘sell’, you have to sell TO someone else — in this case the only other agent is B, and B already has T-bonds, no cash to buy any more. Enter the Fed, stepping in to exchange A’s T-bonds for cash. Now A can go ahead and buy $10 worth of stocks. A still has $10 in assets (just different form), B as well — looking at it that way, no money creation in the private sector indeed. But the Fed has facilitated a purchase of stocks that wouldn’t have been possible otherwise — or certainly not on the same term (in the real world there would be a price at which B would be willing buyer of more T-Bonds, even if it needed to borrow ‘cash’ in order to make the purchase, but that price would be less than $10, whereas the Fed generously pays full sticker). What am I missing here?

  • inflationation

    It doesn’t matter if QE does or does not = printing money. What it does do is create speculation and inflation expectation, which in turn is self-fulfilling. But a lot of this is being exported out to the emerging countries. So, QE IS inflationary in the end… just not in the US.

  • Mediocritas


    1. Don’t forget that the Fed pays interest on excess reserves. This emulates the coupon payment on the “lost” bonds.
    2. The Fed deliberately pays a premium on bonds acquired via the Primary Dealers.

    So there is plenty of incentive for PDs to play this game.

  • Mediocritas

    I don’t make that assumption at all.

    Greenspan’s era placed far too much faith in the integrity of market participants, believing that efficient markets would allocate capital perfectly, therefore the Fed opened the spigots and let it flow. This was a mistake.

    Credit can’t simply be extended to every bright idea because not all bright ideas are *actually* bright. Some degree of regulation in this regard is essential otherwise credit ends up flowing to ideas that default.

    It started with the .coms. The world grew far too excited about the potential of the web. Every geek with a plan was able to secure credit but, as we know, many of those ideas went nowhere at all (but the money stayed out there). The housing bubble seemed more sensible, mopping up that excess cash into homes, but that too grew out of control and was accompanied by credit being extended to “financial innovation” which, as we know, turned out to be just as hollow as the .coms.

    There are valuable lessons to be learned here, but we also have to be careful not to overreact and swing the pendulum too far the other way, making it excessively difficult to secure credit in the future for ventures that actually ARE sound.

  • Willy2

    QE 1 and QE 2 have caused PRICE inflation in a number of assets but it did not increase the price of e.g housing in the US. And PRICE inflation is an additional deflationary force in the current situation. Thanks to a rising EUR/USD price inflation has been less over here in Europe.

  • http://greshams-law.com/ Greshams-law

    It’s true that it doesn’t ‘go anywhere’ to bid up prices. But any expansion in the Fed’s balance sheet debases the dollar. This is because fiat currencies trade at discounts to par. They can’t increase their assets to the same degree that they increase their liabilities when they transact. Dollars trade at ‘discount to par’, so any attempts to print currency to buy assets (here govt bonds) will dilute existing dollars.

    This doesn’t portend inflation as the stock of IOU money is large and waning, but – strictly – it is still dollar debasement/dilution and it is not a meaningless policy.

  • Mediocritas

    The primary source of commodity price inflation is China government. This has little to do with the Fed directly although some may say that the Fed is exporting inflation through the Chinese currency peg. If so, then I’d counter with the fact that China doesn’t *have* to maintain that peg.

    Let’s look at cotton for example:


    An ENORMOUS price move. Now is this price move, in any way, representative of reality? Let’s see:


    I don’t see anything here to support the move in cotton. So why is it moving? Here’s an answer:


    So, I think it makes exactly zero sense to be long cotton here at 140 year highs based on no evidence of a real shortage (makes more sense to be short). This is eerily similar to the housing boom. Remember those claims of “housing shortages” being used to justify the ongoing rally in prices?

    Well there was no REAL shortage of housing, just as there is no real shortage of cotton. The actual inventory was plentiful but supply was being deliberately constrained by speculators withholding inventory from the market in the hope of higher prices, AKA a Ponzi market. When these things turn south it tends to be spectacular.

    It is much the same story for other commodities (although wheat has some merit). This is a bogus rally driven by herd mentality rather than fundamentals and all the inflationistas are going to get a rude shock when it eventually comes crashing down, just like they did in 2008. I remember that because I was one of them, difference being, I learned from it.

    I believe the Fed is being blamed unfairly for this and that the primary source of speculation is China.

  • Brick

    Arguing that there is no net new money is one thing, but arguing QE is not inflationary is another. Inflation as I understand it depends not only on the volume of money but the velocity of money. Here I think the Fed is trying to increase the velocity of money in the economy, and is failing, but this condition may not remain true into the future.
    Where I think I would differ I think is that altering the mix of assets can be inflationary. The transmission mechanism is not through the economy but through the reduction in maturity duration of debt and the ability of the financial markets to use leverage. Another transmission mechanism is through asset price increases and changes in the liquidity of assets held with some less liquid assets ending up at the Fed. This makes me think the FED is managing to increase the velocity of money within the bond, share and commodity markets but not in the economy. This is not really inflationary but more stagflationary.
    I also don’t think it is entirely true that it does not increase the risk of a hyperinflationary event, if you accept the argument that the velocity of money has increased within the share, bond and commodity markets.Stagflation affects consumer demand, which affects jobs, which affects tax receipts, which affects the perception of the value of currency and ability to balance the budget. Hyperinflation in my view is linked to perceived currency strength and at the moment there is no perception of weakness which would suggest a problem. I believe however that could change over time if fiscal deficits fail to be curtailed in the future with QE may be throwing fuel on the fire.

  • http://kiddynamitesworld.com Kid Dynamite

    cullen, the key is what you wrote in one of your first replies above in the comments:

    “It might make them more eager to own stocks (or comparable substitutes to bonds), but it did not give them more liquidity.”

    That’s exactly what I argued with you at length a few months ago, and it’s an essential point. As Hussman wrote:

    “Somebody has to hold it, and the returns on all other assets have to shift by just enough to make everyone in the economy happy, at the margin, to hold the outstanding quantity of all of the securities that have been issued.”

    I think he understated the impact of this – it means that when YOU get saddled with that pesky ZIRP cash, you have to entice me to take it into my portfolio by paying me more for my NFLX, PCLN, SLV, OPEN, LULU, etc….

  • http://kiddynamitesworld.com Kid Dynamite

    Hussman actually did mention this a few paragraphs later:

    “Of course, people also look at risky assets and ask whether they might be able to get higher risk-adjusted returns by holding those instead. In order to make people happy to hold the outstanding quantity of zero return cash, the prospective returns on other risky securities have also collapsed (securities are a claim to future cash flows – as investors pay a higher price, they implicitly agree to accept a lower long-term return). In my view, this has gone on to an extent far beyond what is likely to be sustained, but thanks to eager speculation, the S&P 500 is now priced, by our estimates, to achieve annual returns of just 3.25% over the coming decade. “

  • http://www.thompsoncreekwealth.com Lance Paddock

    I read the responses to you Cullen, and I can only assume they did not read Hussman’s piece. How do you debate people wo do not read what you are debating?

  • http://www.thompsoncreekwealth.com Lance Paddock


    On this Mises, Hussman and MMT all agree.

  • http://www.thompsoncreekwealth.com Lance Paddock

    I think you and Cullen werer talking past each other Kid, because my reading has been that that has been Cullen’s position all along.

    What is fascinating about Hussman’s point is that it might lead people to do that (though both he and Cullen would say they are foolish) but that it by definition does not lead to higher returns for those assets, but rather just raises current returns and lowers future returns.

    That sounds like a mathematical explanation of what Cullen has been arguing all along.

  • http://kiddynamitesworld.com Kid Dynamite

    “but that it by definition does not lead to higher returns for those assets, but rather just raises current returns and lowers future returns. ”

    yes – a point that cannot be understated.

    again, my focus is on the psychology of portfolio management, which is what causes this “substitution” shift in asset prices in order to redeploy the cash. I don’t think that the Fed can accurately model that behavior.

  • zell

    TRying to understand: Fed. buys Treasury debt. Treasury does not have to sell this debt elsewhere pressuring rates and pulling money out of circulation? Is that it?
    Iread Hussman every week but still am confused. I take his and your word for it but am missing something.

  • George H

    He is one who said “don’t fight the Fed”, “full of liquidity”, “do you want to make money or to be right”. But of course, he is a CNBC pundit.

    So I did not mean he got it.

  • http://ralphanomics.blogspot.com/ Ralph Musgrave

    The fact that banks in their own right don’t buy cars and PCs in huge volumes is irrelevant because the ultimate owners or holders of most monetary base and government bonds are other private sector entities: households, corporations, etc. And the latter DO buy cars and PCs in large volumes.

    I agree that when someone (bank or other entity) buys a car or PC reserves are just shifted from one bank to another. But that has no bearing on the central point of Cullen Roche’s article. His article considers the effect of INCREASING the monetary base (or “reserves”) at the expense of the private sector’s holding of government bonds. I.e. your claim that “banks cannot get rid of reserves” is not relevant to the central argument here. QE increases monetary base and bank reserves, while putting QE into reverse reduces same. Hussman did not say that the total of bank reserves is constant. As Hussman put it in his final para, “…what is the effect of creating an extra $600 billion dollars of monetary base…?”.

  • http://ralphanomics.blogspot.com/ Ralph Musgrave

    Re Don Kohn’s claim that “I know of no model that shows a transmission from bank reserves to inflation”, my answer is “neither do I, assuming banks behave responsibly.”

    But banks are clearly incapable of distinguishing between credit worthy and non-credit worthy customers: witness NINJA mortgages. Either that or they know taxpayers will rescue them when NINJA mortgages turn bad. Thus when everyone has forgotten about the credit crunch (that will in about 3 years time), and assuming banks still have their current bloated levels of reserves, my guess is they’ll use these reserves to fund stilly mortgages again. And there won’t be any regulations worth talking of to stop them, because banks have greased the palms of politicians with enough dollars to make sure no effective regulations are in place.

  • John

    I’ve been doing a lot of research online to try to understand the monetary system, QE, inflation, deflation, etc. It seems I find new opinions on how the “system” works every time I look into it. Instead of learning more, I am getting more confused.

    Assuming the assertion is correct, one thing I’ve learned is our “system” requires the continued acceleration of the money supply or the system collapses. If the Fed creating $ 2.4 trillion (or whatever it is) does not increase the money supply, then why do it? My basic understanding of QE is that the Fed is trying to compensate for the decline in bank credit taken up by businesses and consumers. So, this new money is not going into the economy; it’s going into asset markets. Is that correct? If so, there is less money in the economy (and so houses go down) but there is more money in asset markets, so stocks, bonds, commodities, gold, etc. go up.

    Isn’t that still inflationary? If monetary inflation is the creation of new money, how can $2.4 trillion of new money, not be inflationary? And aren’t we seeing these effects on prices in the real economy, just as if this new money was created by consumers? Oil. Food. Materials. Health care. Insurance. Utilities. All of these goods and services seem to be going up in price. My costs for these items are certainly going up. Is it all just because supplies are growing slower than demand? That would be quite a coincidence.

    I don’t know. They are creating new money and prices for stuff is going up. How is this not inflation? Or worse. It’s stagflation because the real economy is not growing fast enough to absorb the higher prices. Unless I am totally out to lunch on this (which I am willing to accept if someone can explain it to me) the whole debate seems semantic. Too many people are busy discussing the mechanisms behind monetary policy and missing the effects on the real world. We can see all the details on the tiniest leaf, but we’re not seeing the forest.

    Again, I don’t know the truth. I just know what I see. I see the economy is sluggish, but prices are going up. How can this happen if the money supply is shrinking? is this just a different type of inflation than what we know?

    Any help on this would be appreciated.

    Mr. Roche, thanks so much for your blog.

  • Mitch83

    “The fact that banks in their own right don’t buy cars and PCs in huge volumes is irrelevant because the ultimate owners or holders of most monetary base and government bonds are other private sector entities: households, corporations, etc. And the latter DO buy cars and PCs in large volumes.”

    It’s not irrelevant.
    The monetary base contains of reserves (=”real” “money” = Central Bank “money”) at the Fed accounts of BANKS (no other entities are allowed to have accounts at the Fed) and cash currency (again “real” “money” = CB “money”).
    Customer deposits at commercial banks are only CLAIMS on “real” “money” = CB “money” and don’t count as monetary base.
    As loans create deposits, and reserves are not “lent out” to non-bank customers (and cash currency is a vanishing part of the money supply), holders of the monetary base are NOT households or corporations, but commercial banks.
    So increasing the monetary base does not add any liquidity (for banks treasuriess are “money” just like reserves).

  • Mitch83

    The Fed is only allowed to buy Treasuries in the secondary market, meaning from the Primary Dealers (and not directly from the debt issuer in the primary market).
    The PD’s bought the Treasuries with reserves that already existed in the system.

  • Mitch83

    Banks don’t lend out reserves. They are capital constrained in lending, not reserve constrained.
    This also means that reserve requirements are unnecessary (consequently some countries abolished them some time ago, like AUS, NZ, MEX, CDN,…).

  • Mitch83


    Even if you have reserve requirements it doesn’t influence lending behaviour if banks hold the same amount of reserves or treasuries.
    If they hold treasuries instead of reserves and find a creditworthy borrower they just lend and look for reserves later (by doing repos with the Fed using their treasuries as collateral or by borrowing reserves from other commercial banks on the interbank market).

  • El Viejo

    Pardon my ignorance but, I thought Dr. Bernanke’s plan all along was to fight deflation with inflation, and as far as adding liquidity to the market, maybe it isn’t that much, but when the FED buys stocks isn’t that adding liquidity to the market? Sure, stockpiled money in banks doesn’t do much damage unless business can get at it, which is supposedly happening now that the fear factor is down and fundamentals are turing around.

    The FED buys Fannie and Freddie:

    Bernanke will soon make stock purchases an outright policy:

    FED Monetary Policy:

  • http://www.NapaWealth.com Tim Ayles

    Cullen –

    Thanks for all the work you do here. It has been an eye opener for me as you are aware. One thing I am still trying to get my brain wrapped around is the idea of creating liquidity. You have probably already answered this a hundred times, so maybe you could direct me to a link on your site where you have, rather than re-answer, but here is the question:

    I understand the idea that longer term bonds are in fact just money and that they earn more % than the cash. I also get that money that goes to buy an asset is just a swap, like if I give someone cash and they give me their stocks, the same assets are in the system. My first question is, does it matter that the swap is happening with the issuer of the currency (the money/bonds?) win which flows all creation or destruction of money?

    My problem, and where I get a little lost is here, pretend that the government created $1,000,000 by spending it into existence, but then wants to soak up $200,000 by selling “bonds”. Instead of offering long term bonds that pay interest for soaking up money in the system, they use government trees as their illiquid money soaking item. The citizens’ banks use $200,000 of this $1,000,000 economy and purchase trees that will bear food as their incentive. By buying this tree, they have exchanged liquid money they could have used to buy or lend on something else, and instead have exchanged it for the tree. The lendable reserves they used to have is given to the Fed/Treasury system and extinguished from society, unless it gets lent out in the future of course. Now there is only $800,000 of liquid money floating around in this economy.

    Now the Fed starts tree POMO and decides to buy a bunch of illiquid trees, so they create numbers in the accounts of tree holders and swap trees for reserves. There used to be $800,000 in available money, but now there is $1,000,000 again. The new money is not created until the new reserves turn into money, I get that also. But is it possible the banks are now armed with $200,000 in new investment buying power that they did not have before? When they owned trees, the economy had an illiquid option that had to “be”. Now that the Fed took the tree on their books, that illiquid option was no longer. The money that illiquid option used to tie up is now gone, and the liquid potential is there for either loans or money that can be invested elsewhere. Assume the banks all decide to buy 10 unit apartment buildings with the money that used to be tied up in trees. As the money gets directed towards these apartment complexes, the owners of those buildings are enticed to give up their apartments only when the price goes up. There was not as much demand to sell before as the banks needed, so price rises to find the liquidity point.

    Do you agree with most of this so far? Or where does my thought process break down. It seems that when a transaction occurs between two players within the system, say the local bank and a citizen, no new money is created, assets are just swapped at a particular price. But when the Fed/Treasury is one of the players in a transaction, liquidity gets created or destroyed.

    If I own a $100,000 30 year bond, which is used to soak up my liquidity in exchange for income, expires, it turns from illiquid to liquid on my maturity date. I used to own cash. When I buy the bond I exchange liquidity which means the holder cannot buy something else for 30 years, that turns back to cash when my bond retires. Is not POMO just speeding up this liquidity process? Turning illiquid 30 year assets into liquid assets in the hopes that it gets spent or lent?

    I expect this is an easy one for you, and again, you have probably answered it many times, so thanks for the patience ahead of time.

  • http://www.pragcap.com Cullen Roche

    I have never said banks won’t rebalance portfolios and speculate due to Fed action.

  • Rharaz

    Hussman states:
    “Now, if you’re looking at a zero nominal return on money-market instruments, as well as expected inflation over time, it’s natural to start hoarding commodities.”

    I agree with Hussman that negative real interest rates have helped push up commodity prices.

    Hussman also states:
    “Frankly, I also believe that a not-insignificant portion of outstanding credit market debt is essentially worthless, but is still carried on the books as if it has value. Overall, the recent bubble in credit was clearly not a reflection of productive saving and investment activity, and it is not clear that the economy has de-leveraged to the extent needed to put the burden of ongoing debt service in line with our productive means.”

    I’ve often wondered how much of this non-performing debt has been purchased by the Fed at “mark to model/fantasy” value in order to prop up certain sectors of the economy. My fear is that this type of moral hazard will continue to become more pervasive. Hussman seems to be concerned about this moral hazard as well, which I thought he expressed pointedly in his “An Open Letter to the Financial Accounting Standards Board” rant.

  • Mitch83

    You have to understand that banks buying 30y bonds don’t give up on liquidity.
    For them bonds are “money” just like reserves (= Central Bank “money” at the Fed account of the banks), no matter how the duration of these assets. Here’s why:

    First remember, you as a bank don’t go to the mall shopping like an individual.
    If you as a bank want to buy things, it doesn’t matter if you have reserves or US Treasuries on the asset side of your balance sheet. You just buy anytime you want by clearing an overdraft at the Fed. Then you either look for reserves
    a) on the interbank market by borrowing them from other commercial banks
    b) use your USTs as collaterals to do repos with the Fed (the Fed guarantees that they accept USTs as collaterals indefinetely)
    c) sell your USTs on the extremely liquid secondary bond market
    or you use your USTs for repos with other banks, that can use your USTs for further repos etc.

    If you as a bank want to lend to creditworthy customers, you just lend (no matter if you have reserves or USTs) and, if necessary, look for reserves later (again by doing a),b) or c)) to eventually meet the reserve requirements (some countries like AUS, NZ abolished them knowing banks are only capital constrained in lending, not reserve constrained).

    So as you can see there is a huge difference between trees and USTs.
    Unfortunately your example isn’t appropriate.

  • http://www.pragcap.com Cullen Roche

    Equity price increases are not inflationary….

  • http://www.pragcap.com Cullen Roche

    Yes. I’ve never said that Fed actions couldn’t result in speculation. I have said they wouldn’t lead to economic improvement.

  • http://wfhummel.net wfhummel

    “I find it amazing how many people still believe that QE is adding all sorts of liquidity to the markets. There is still a widespread belief that QE is inflationary and an addition of net new money (despite the rather simple accounting behind a QE transaction).” [Cullen Roche]

    This is simply false. Every purchase of securities by the Fed from non-banks creates a new deposit for the seller as well as new reserves for seller’s bank. The reserves themselves are not inflationary, but the new deposits could be. They are liquid assets held by the public which have the potential to raise prices.

    The reason we saw no dramatic increase in prices from QE was that most of the sellers were large mostly non-bank financial institutions and the wealthy whose propensity to save is relatively high, especially during a deep recession. If the proceeds of the QE purchases had gone to the large middle income class, the effect would have been much higher spending and potential inflation.

  • http://www.pragcap.com Cullen Roche


    We’ve never disagreed that QE could cause investors to do irrational things….

  • http://www.NapaWealth.com Tim Ayles

    Thanks for the response. I will try to wrap my brain around that. One thing I don’t get is your ending when you say “Unfortunately” – Are you giving the impression that it would be better or “fortunate” if my example were reality instead of being the way you describe? Or was that more of a “jab” type comment?

  • http://www.pragcap.com Cullen Roche

    Exactly. This notion that banks are going to start buying cars and PCs is not correct.

  • El Viejo

    That’s what I thought. Like stored potential inflationary energy that Dr. Bernanke said he could defuse at a later date when it becomes a problem, but I have trouble converting this mechanism to MMT lingo. Please help.

  • MMTer

    Now that is totally false. From the Chicago Fed’s handbook on reserves:

    “Expansion takes place only if the banks that hold these excess reserves (Stage 1 banks) increase their loans or investments. Loans are made by crediting the borrower’s account, i.e., by creating additional deposit money.”

    You’re double accounting before any new loans are made. Loans create deposits. Not reserves.

  • Mitch83

    If the Fed bought the treasuries from non-banks (which it doesn’t) it wouldn’t change anything. The Fed buys at the secondary market, no matter what (=asset swap). Remember, with what “money” did the non-banks just buy the treasuries at the auction? Yes, with the exact same amount (of deposits) they now have in treasuries.
    If the non-banks got back their deposits instead of USTs, would they just go out and spend them? Of course not. Otherwise they wouldn’t have bought the treasuries in the first place.

    But to come back to reality:
    Is it even realistic that the non-banks immediately sell their USTs after the auction? Not likely, considering the high transaction costs etc. (btw this is why the Primary Dealers have to make a market for the Fed, otherwise the costs of buying USTs would be much higher for the Fed, as the PDs almost always have better offers than the non-banks).

  • http://www.pragcap.com Cullen Roche

    Well said Mitch.

  • jbvo

    Agree that QE does not increase net financial assets in the system, but does it not increase gross financial assets?

    Fed purchases Treasuries from primary dealers which are non-bank entities — either securities firms in their own right or the securities subsidiaries of commercial banks.

    Prior to a QE transaction, the financial system has a primary dealer with a Treasury asset on its balance sheet funded in some manner. The primary dealer sells that asset to the Fed for which the Fed pays by crediting the primary dealer’s bank with a reserve which the bank uses to fund a demand deposit of the primary dealer.

    So, after the QE transaction, the financial system has a primary dealer with a demand deposit asset funded in the same manner as its previous Treasury asset, a commercial bank with a Fed reserve asset and demand deposit liability, and the Fed with the Treasury asset and reserve liability.

    The financial system appears significantly more liquid to me.

  • Alex

    Hey Mitch, how do you know/where did you find out AUS and NZ abolished reserve requirements? Thanks

  • Mitch83

    Hi Alex,

    don’t remember where I initially read it, but Wikipedia helps:
    http://en.wikipedia.org/wiki/Reserve_requirements (see “other countries”)

  • http://www.pragcap.com Cullen Roche

    The Fed is buying from the primary dealers. Not from the general public. So the sellers account is credited with reserves. There is no increase in net financial assets. So no, the public does not have more fuel with which it can now spend. That fuel existed beforehand.

  • http://www.pragcap.com Cullen Roche

    You appear to be double counting the financial assets. All they did was alter the term structure of their liabilities. Banks don’t use reserves to lend. They use reserves to settle payments and meet requirements.

    If you’re saying that UST’s are less liquid than demand deposits then that’s a different debate. I would argue the difference is negligible…

  • http://wfhummel.net wfhummel

    “The Fed is buying from the primary dealers. Not from the general public. So the sellers account is credited with reserves. There is no increase in net financial assets. So no, the public does not have more fuel with which it can now spend. That fuel existed beforehand.” [Cullen Roche]

    The primary dealers from whom the Fed directly purchases government bonds are middlemen. They are purchasing government bonds from other banks, firms other than banks, and households, in order to sell to the Fed. To the degree that those from whom the primary dealers buy are banks, then they have shifted from holding government bonds to reserve balances. To the degree that those from whom the primary dealers buy are not banks–are commercial and industrial firms or households–the quantitative easing raises the balances in their transactions accounts. In other words, households and firms selling the bonds have more money in their checking accounts.

  • jbvo

    Perhaps someone can explain to me how the Fed credits the bank account of the non-bank primary dealers whose Treasuries they purchase. The non-banks cannot hold the Fed reserve liability as an asset– only commercial banks can. Does not the transaction between the non-bank primary dealer and the Fed have to go through the commercial banking system?

  • jbvo

    Agree that the distinction of the seller being a bank or a non-bank is critical.

    But is not the relevant party as seller in a QE transaction the primary dealer acting as principal, not agent?

    And primary dealers are either non-banks or non-bank subsidiaries of banks.

  • Gerald P

    Thank you, I learn things this way.

  • http://www.pragcap.com Cullen Roche

    They absolutely do not have more money. That is like saying that when you transfer money from a checking account to a savings account that you now have less money. That is factually incorrect. There is no change in net financial assets via QE. If you want to argue that UST’s are materially less liquid than deposits then that is a different debate. But there is absolutely not more assets in the system. There was nothing stopping anyone from selling a tsy (arguably the most liquid security on the face of the earth) and buying a car before QE. This idea that there is now more “firepower” in the system is not accurate.

    What you’re arguing in essence, is that there has been a material decline in the public’s desire to net save following QE’s implementation. The rising savings rate should tell you that is quite wrong.

  • Gerald P

    But don’t banks sell the mortgages and are not affected if they fail?

  • jbvo

    You’re not addressing my questions.

    Please reread my 3 comments. I concede net financial assets are unchanged but believe gross financial assets in the system have increased due to QE.

    I don’t believe the gross size of the financial systems balance sheet is irrelevant. MMT focuses only on net financial assets, and I believe that to be a mistake.

  • http://www.pragcap.com Cullen Roche

    It would matter if reserves served as net new money. But reserves aren’t spent by banks. They serve only to meet reserve requirements and make payments in the intrabank system. So sure, if you wan to say that M1 is exploding then you are absolutely correct. But that doesn’t mean banks can lend more. And it certainly doesn’t mean customers have more money than they did before….

  • john

    The rising savings rate is just a result of a loss of credit. People don’t make enough to make ends meet due do rising prices exceeding income. Before you pull out your make believe government statistics to refute this, just walk outside. What is the point of QE? It has and will do nothing. We need to clear the debt and destroy the banks. We need to re-instate accounting standards and force the banks to mark the trillions in losses on their books and then shut down, where new banks will form. We NEED deflation to rebalance the economy and destroy everything over tangible book value. Who cares if QE1 2 or 7 is inflationary. Inflation is all about velocity which is all about emotion. ZIRP is destructive for all of these reasons, it forces malinvestment. You have to buy NFLX everyday and some silver just to keep up with gas. You have to buy gas to keep up with silver. It’s a circle jerk and the intention is to increase tax receipts to pay down debt to spend more without increasing the total debt so as not to ignite the viscous cycle of emotion that leads to ever more increasing velocity. It is a fine line the day that people just say fuck it to the FRB notes after they have transferred their currency into something other than notes and then accept anything but those notes as trade. That is the day the bank is gone, so these idiots will do anything in their power to persuade the blogosphere that what they are doing is in some way not inflationary, by explaining simply how moving one shell here to there is clearly not inflationary in itself, wipe hands together in a magicians gesture. I read your posts but you are severely confused of the implications of your ignorance. Follow the cups not the hands.

    By the way, what is your point in this article? QE does not add new liquidity to the market. The point here is, why are you wasting your time with something that does not matter regardless of your assumptions?

  • http://www.pragcap.com Cullen Roche

    Your rambling insult sounds like something I could have written:

    What is the point of QE? It has and will do nothing. We need to clear the debt and destroy the banks. We need to re-instate accounting standards and force the banks to mark the trillions in losses on their books and then shut down, where new banks will form. We NEED deflation to rebalance the economy and destroy everything over tangible book value.

    Any regular reader knows I have been making these same points for years now. So, the real question is, what was the point of this comment aside from beating your chest and sounding off?

  • circuit

    TPC – It always makes me chuckle when I read comments saying that you’ve contradicted yourself regarding the effectiveness of QE or other Fed policies. Believe me, I’ve been trying for a while to detect a flaw in your logic…it hasn’t happened. I find you’re one of the most consistent and coherent guys out there.

    As for the topic at hand, I find this 2010 working paper by Marc Lavoie entitled “Changes in Central Bank Procedures during the Subprime Crisis and Their Repercussions on Monetary Theory” to be really helpful for understanding the role of reserves and the current monetary transmission mechanism: http://www.levyinstitute.org/pubs/wp_606.pdf

    It’s not an easy read, but it’s definitely worth a careful read.

    Here’s a great excerpt: “The financial crisis has made…clear that nearly all of mainstream monetary theory as applied to central banking is nearly worthless, as is for instance the infamous money multiplier fable and presumed causal relationship running from bank reserves at the central bank to price inflation.”

    Right on!

    I’m sure you’re aware of the paper, but I just thought I’d put it out there.

  • http://www.pragcap.com Cullen Roche

    Lavoie is a genius.

    My argument is complex, but it is certainly consistent. People try to twist it to meet their own wants and needs, but they only misconstrue my words primarily due to a lack of understanding.

  • john

    It is not an insult

    My point is….. What are you guys trying to figure out? And once you agree you think you know what you are talking about, what are you going to do with your new found enlightenment? What is the point assuming you have mastered whatever it is you presume to have mastered, with regards to the topic of …QE ISN’T ADDING NEW LIQUIDITY TO THE MARKET.

    Are you trying to get people to stop buying commodities and equities on misguided beliefs? Is this a grass roots campaign? Once I have come on board, what is the benefit of the knowledge? Lets assume you are right, probably are, I have not even read your argument as I cannot get passed the title. I just want to know the point?

  • wh10

    What about when all banks have run out of excess reserves (all are at the max reserve ratio) and the discount window rate is too high for further lending to be profitable? Then wouldn’t QE matter, because it would substitute USTs, which don’t satisfy the reserve ratio requirement, with reserves, which do?

    Also, is it not oversimplistic analysis to say banks can simply just borrow from the discount window? I have heard that the discount window has a negative stigma attached to it, since it signals potential liquidity issues, and as such, banks are hesitant to borrow in this manner. They would much rather have cash or treasuries to repo. In this way, wouldn’t reserves “enable” lending since they’re preferred to the discount window?

    I understand the standard MMT position- just trying to challenge it.

  • http://www.pragcap.com Cullen Roche

    The point is to show that this is a fruitless and misleading program designed by the Fed. It is highly destructive to our society and only furthers the problems that helped get us here. It is based on false logic and only helps to exacerbate our problems. It is not a fix. It is not helping the people that need helping. If anything, QE can only work by further screwing the US economy.

    So what is my horse in this race? How about the well-being of us all? We have this institution that constantly meddles in things they barely even understand. The results of the last 30 years speak for themselves. No one in the media seems to be too pissed off about it. Well, I am. And this is my sounding board. If you don’t like it then don’t read it. Personally, I can’t sit by idly and watch the Fed perform these ignorant stunts and just keep my mouth shut….I don’t expect everyone to understand monetary operations and whatnot, but I hope the results will one day speak for themselves (if they haven’t already). These people need to be reined in. They are out of control.

    If I sound frustrated it is because I am. It is not directed at you. I am just tired of this institution justifying its actions by making up all sorts of garbage reports about QE creating 3MM jobs etc. The media eats it up. They don’t look at the facts. I still have to see any report showing facts that QE results in material positive economic change. Then you have this whole other group of people (equally confused) who are just using this as their sounding board to scare people about hyperinflation. It’s all a bunch of bull shit. It’s just politically motivated people using this event as an argument to prove a point and make some money or push their agenda forward.

    I have argued and backed those arguments with facts over the last 6 months. To this day there is zero evidence that shows QE leads directly to economic prosperity (or even hyperinflation). But no one stands up and says – hey these people aren’t helping! Well, I am.

  • Oz

    John, here’s another way to think about money creation and its inflationary effects… What if you could make perfect fake $100 notes and print billions of them. They’re all sitting in your basement – is that inflationary?? What about when you hit the town on a spending rampage? Absolutely!!

    Money isn’t inflationary until it enters the system – increasing bank reserves, which will simply sit idle on deposit at the Fed (earning a little interest) is the equivalent of the billions sitting in your basement.

    As Cullen, Hussman etc are pointing out – its the psychological impact that’s having the effect – there’s no real “money transmission” effect…

  • http://www.pragcap.com Cullen Roche


  • Gerald P

    I thought much of non-performing debt was failed mortgages still held by banks because there are no buyers.

  • http://blogfirstrider.blogspot.com/ first

    Why do they call it Quantitative easing if its not quantitative?

    The Federal Reserve actually buys back mortgage backed securities held by banks or other financial institutions. This in effect puts money back into the financial institutions and Junk bonds in to the fed. Other than Gov Bonds, Is there any way to know what the Fed as been purchasing from the Banks and what value it would have in the real world ? No way that part was a swap.

  • Gerald P

    But in extremis the reserve is drawn down, unless we know the debt is larger, then we have a zombie.

  • wfhummel

    The issue here is the effect of QE2 on liquidity, not on net financial wealth of the private sector. The quantity of reserves is irrelevant, since bank lending has never been reserve-constrained and is only a function of the demand for bank loans at the going rate.

    The purpose of QE2 is presumably to hold down interest rates on long term debt by purchasing long term Treasury securities. However any purchases from non-banks, either directly or indirectly through primary dealers, increase bank deposits and thus increase the liquidity of the private sector.

    Securities sold by banks increase total reserves without increasing their deposit liabilities. Since banks mainly hold short term securities like T-bills rather than long bonds, I suspect relatively little of the QE2 purchases are coming from banks.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    If banks run out of excess reserves, the Fed supplies any desired increase at its target rate. That’s what it means to set an interest rate target. And any new reserves will earn the same interest payment as existing reserves.

  • wh10

    What is the transaction that occurs by which they supply them?

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    I wrote a similar chapter for my book that Marc cited in that paper. I think he must have seen it after the paper was mostly written, since he said in a footnote he saw it rather late, or something.

  • http://www.pragcap.com Cullen Roche

    What you’re basically saying is that you have more liquidity when you have money in a checking account than when you have that same money in a savings account. That is far from true. Sure, you might be marginally more liquid, but you don’t have more money. People sell out of their savings every day to make purchases. It’s not difficult to do and it’s certainly not difficult to sell tsys. It all comes down to the public’s desire to net save. You’re basically saying that when someone owns a tsy bond they have lost their ability to spend. That’s simply not accurate. That spending power is there. It was always there.

    QE works through the speculative aspects of markets by generating a supposed wealth effect. The Fed can’t eliminate the public’s desire to save. They can make it less attractive, but they can’t eliminate it. QE has clearly has failed to cap long-term rates. Anyone reading here knew they never controlled the long end of the curve to begin with….

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    basic open market operations.

  • Gerald P

    Not only politically motivated but suspected bias due to indirect obligations bordering on dishonesty. It is not a coincidence where the fed comes from.

  • jbvo

    The point I’m focusing on is whether the primary dealers are banks or non-banks. As stated, I believe they are non-banks. If they are non-banks, they cannot take reserves for their Treasuries. Only banks can hold reserves. Thus, there needs to be a bank intermediary in the QE transaction. The commercial bank takes the Fed reserves and creates a demand deposit for the primary dealer. Net financial assets unchanged but gross financial assets increase. And, money is created.

    If anyone can refute, please do. But this is my understanding of the transaction.

  • Whatever It Takes

    Amen to that,Cullen,and many thanks for your patience and diligence.

  • Anonymous Comment


    Forgive me, Mr. Roche, for my bluntness… I really thought you were close to understanding how this works. But now I see you have really, really drunk the koolaid.

    There are so many contradictions in your various viewpoints I am starting to get dizzy. What about ‘too many fricking speculators’ in commodities? Hmmmm… what could that be a symptom of, I wonder?

    You are leading the drum beat of the next ‘whocouldanode?’ moment. Sad, really.


  • http://www.pragcap.com Cullen Roche

    I am not sure why it matters if they buy from non-banks. If the Fed came to me and took my tsys I would have cash. Big deal. That doesn’t mean I am going to go spend it. In fact, I’ll likely just go out and buy another replacement security that equally fulfills my desire to save. If I had wanted to buy a new car I would wake up, sell my bonds and write a check to the car dealership. Big deal. If I have the cash proceeds from my tsy sale to the Fed then we just performed the same step. Big deal. There is no added fuel here. No new money.

    It makes no difference that the PD’s act as an intermediary or not. The bottom line is the financial assets have been altered, but not increased. And as I’ve said before, the increase in bank reserves don’t matter….

  • jbvo

    I don’t think he’s saying that all. Again, the important distinction is a bank or non-bank selling Treasuries to the Fed. Given the primary dealers are non-banks, I believe a non-bank is the answer. If true, a demand deposit is created through the QE transaction.

    Before QE, the system balance sheet is that of the primary dealer consisting of a Treasury asset funded by some liability.

    After QE, the system has assets consisting of the Treasury (held by the Fed), the Fed’s excess reserve (held by the PD’s bank), and a demand deposit (held by the PD).

    The system appears a lot more liquid to me.

  • jbvo

    My comment below is relevant.

    “I don’t think he’s saying that all. Again, the important distinction is a bank or non-bank selling Treasuries to the Fed. Given the primary dealers are non-banks, I believe a non-bank is the answer. If true, a demand deposit is created through the QE transaction.

    Before QE, the system balance sheet is that of the primary dealer consisting of a Treasury asset funded by some liability.

    After QE, the system has assets consisting of the Treasury (held by the Fed), the Fed’s excess reserve (held by the PD’s bank), and a demand deposit (held by the PD).

    The system appears a lot more liquid to me.”

  • http://www.pragcap.com Cullen Roche

    How many times do I have to say that Fed policy almost always leads investors to do irrational things? Why, after so many months, are we still getting these trolling bull shit comments from people who have no desire to actually make an intelligent contribution? It’s clear that you haven’t taken the time to actually understand my argument so I’ll give your childish response a pass. If you want to insult me then fine. But at least do so in an articulate and intelligent comment based on an ACTUAL understanding of my position. This sort of nonsense just makes you look stupid. It’s very clear that you have no idea what I actually believe, yet you come here to tear me down….

  • http://www.pragcap.com Cullen Roche

    It makes no difference. As I said above, if the Fed comes directly to me and buys my tsys I have a cash deposit and they get my bonds. So what? I could have acquired the same thing by selling it at just about any hour of any day. It makes no difference that they transact with banks or non-banks.

  • jbvo

    You have a cash deposit created by a commercial bank which did not exist before the QE transaction. The Fed cannot deposit directly into a non-bank account because the non-bank cannot accept excess reserves — only banks can. Money has been created.

  • http://wfhummel.net wfhummel

    You can’t pay someone with a Treasury security. You must first sell it for money in your checking account. And when you sell it, the buyer has given up that much immediate spending power, leaving total liquidity unchanged.

    I define financial liquidity as the total of bank deposits (except term deposits) plus bank credit lines and circulating cash. Liquidity clearly increases whenever the Fed buys something from a non-bank, because it increases the seller’s bank deposit as well as the bank’s reserves.

    If you include any easily sold asset in your definition of liquidity, then we have been talking past each other. There would be no way to measure liquidity without a detailed definition of all that is easily sold, not a very useful definition.

  • http://www.pragcap.com Cullen Roche

    And therein lies our disagreement. I don’t believe there is a material liquid difference between UST’s and deposits.

    Firstly, an investor who sells tsys does so because they agreed to do so. Perhaps they want to sell their bonds and purchase some other form of savings. To imply that the aggregate level of savings has been reduced via QE is incorrect. The form of savings might change, but there has not been a net new injection of fresh cash that gives these savers a new desire to spend and reduces their savings….

    Also, let’s keep this conversation realistic. Most transactions are made in credit or checkable deposits – not cash. So it’s not realistic to argue that I have to sell my tsys to even place a transaction. All I have to do is prove to my creditor that I have a UST account holding $XX (something I likely did long before obtaining a credit card, but if I wanted to prove to my auto dealership it would be equally easy). To imply that I must sell the UST’s, transfer them to my bank, and then go to the ATM is a gross misrepresentation of real world transactions. In this modern world I can easily sell UST’s and write a check from the account or transfer them to another account overnight. I don’t think this change in assets is really impacting expenditures all that much though as the forms of liquidity are negligible.

  • http://www.pragcap.com Cullen Roche

    I am not sure what to tell you. You’re double counting the reserves as new money. So yeah, if you want to count the reserves as money then M1 is exploding. That doesn’t mean the private sector’s financial assets are also exploding and that aggregate demand and spending will rise….

  • Mitch83

    When examining balance sheets, I suggest you play around with this helpful tool (especially the operation “Quantitative Easing (Variation 1 – Households Sell)” and “government issues debt”):

  • Mitch83

    You really have to see what happens to the balance sheets when the non-banks (in this case households) buy treasuries in the first place (operation “government issues debt”) and then the Fed buys from these households per QE (operation “QE – households sell”): The balance sheets of the private sector are exactly the same before and after. Nothing added.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    And if you sold your Tsy to a bank, a deposit would be created as well. So what?

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    And if you sell your Tsy to a dealer, they haven’t given up “cash,” they’ve repo’d out a Tsy they already own to get cash–that is, TREASURIES ENABLE CREDIT CREATION, whereas DEPOSITS DO NOT.

  • http://wfhummel.net wfhummel

    Scott, are you saying that no new liquidity is created if the dealer repos out a treasury it owns in order to buy a treasury from say a hedge fund that it sells to the Fed?

  • circuit

    Scott, I noticed that footnote and I’ve put your book on my reading list. I also highly recommend your General Principles.

    By the way, shortly after Lavoie quotes you towards the end of the paper he concludes: “If central banks can control both the rate of interest and the amount of reserves, instead of one or the other as we were long led to believe, it becomes clear that the deficits of federal governments can be nearly indifferently financed either by issuing government securities or by forcing banks to hold reserves at a deposit rate that is close to the interest yield on Treasury bills. This certainly requires some more thinking.” Any thoughts on what else could be added to that open-ended statement? It’s been a bit of a mystery for me since I first read it.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    Just send an email if you want me to send the chapter.

  • flow5

    Rates bottomed on 8/31/2010. The monetary transmission mechanism is not QE2, it is via interest rates. Thus the degree of ease or restraint is related to the changing portion of the yield curve covered under the remuneration rate’s umbrella.

    The higher rates become, the looser policy becomes (as the portion of the yield curve which is lower than the remuneration rate @.25% continues to shrink). I guess you could call that fractional yield-curve banking.

    I.e., QE2 is not a neutral monetary policy. It is an increasingly easier monetary policy. The banks are not reserve constrained. As long as it is profitable for borrowers to borrow, & lenders to lend, money creation is not self-regulatory. That’s why the Great-Recession is called a balance-sheet recession.

  • The Dork of Cork

    Could the speculative inflation we are seeing simply be due to the enormous amount of deposits built up during the credit boom.
    These were not defaulted on during the bust of 2008 (these bank liabilties would have declined if the assets behind them were written down to reflect their true cost) and so therefore are seeking a yield in a world without real capital investment.
    In a world without capital investment it is wise to buy commodities as they decline over time in this environment.
    Whats the point in holding on to deposits at 1% when resourses are going south at a faster rate then this yield ?
    I think its called opportunity cost if I am not mistaken.

    Long term investment cannot survive the onslaught of the “markets” – there is no place for multi decade utility investments as they quite rightly are seen as having a low yield potential.
    However without these utilities companies cannot survive for long in a degraded economic ecosystem and so therefore its best to speculate on the 4 horsemen rather then some shiny knight.

    Utilities will have to become low yielding or zero yielding institutions before wealth / capital can be restored – then bean selling companies will be in a postion to make a real profit but not before.

  • flow5

    IORs are the FUNCTIONAL EQUIVALENT of required reserves, not short term T-bills. T-bills are settled upon maturity, or are liquidated at a discount. IORs are bank earning assets (investments).

    IORs sport a “floating” overnight remuneration rate (currently consonant with the 1 year “Daily Treasury Yield Curve Rate”).

    I.e., the policy rate “floats” (like an adjustable rate mortgage), via a series of cascading or stair-stepping interest rate pegs. I.e., as with ARMs, a “note is periodically adjusted based on a variety of indices”.

    “Among the most common indices (for ARMs), are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).” – Wikipedia

    I.e., the remuneration rate is the Central Bank’s target rate’s “floor” (see the “Friedman rule”).

    “When the effects of financial intermediaries and credit spreads are taken into account, the welfare optimality implied by the Friedman Rule can instead be achieved by eliminating the interest rate differential between the policy nominal interest rate and the interest rate paid on reserves by assuring that the rates are identical at all times.” – Friedman Rule

    “The Central-Bank Balance Sheet as an Instrument of
    Monetary Policy” — April 11, 2010

    As Dr. Richard Anderson (V.P. St Louis FED), states: “Remember that “excess reserves” is an accounting concept, not a physical item. The physical item (asset) is deposits at Fed Res Banks. These deposits may be used to satisfy statutory reserve requirements; any “excess” deposits are labeled as “excess reserves.” This terminology dates from the 1920s, and I find it obsolete.”

    Those who point to the “monetary base” which is not now, nor has ever been, a base for the expansion of new money & credit, are the: “could have, would have, should have” dinosaurs.

  • wh10

    This is what I saying then. By buying treasuries in this instance, and increasing reserves, the Fed actually enables more lending.

  • http://www.pragcap.com Cullen Roche


    I am not sure if you are agreeing or disagreeing with me :-)

  • flow5

    The “Friedmanites” (quantity theorists), may be iconic, but do not espouse monetarism. The St. Louis FED reports that the latest M2 “money velocity” figure turned over only 1.7 times in the 4th quarter of 2010, & that M1 “money velocity” turned over only 8.2 times (all “FRED’s” velocity figures are declining).

    It is obvious that while INCOME velocity (FRIEDMANITE’s contrived figure), is declining, the money actually exchanging hands (IRVING FISCHER’s transactions velocity of money) is patently rising. Thus, according to the monetarists, QE2 is not neutral.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    Hi William,

    First, I’m actually saying the opposite.

    Second, I think “liquidity” is one of the most misused terms there is, like saying “money.” “Liquidity” isn’t spending power in the aggregate. In the aggregate, “liquidity” can always be created by the non-govt sector, except in a crisis.

  • The Dork of Cork

    I think yee guys get too entangled in monetory mechanics to figure out what this money stuff is doing even if it goes beyond the FED.
    I don’t really see real capital formation since 71 – the entire matrix is net energy negative.

  • flow5

    Yes & no. It’s a convoluted topic. From the standpoint of the banking system your analysis is indeed correct. I read you because of your focus & understanding.

    But consider that Investors discount (company earnings), i.e., nominal gDp (up to 9 months in advance), by purchasing equities. It is equally probably that the buyers of commodity ETFs do exactly the same thing (which does increase aggregate demand). Whether prices are “sustainable” (& not supply-side shocks), depends upon whether the “administered” price increases are evenutally (in succeeding years), “validated” by the FED’s subsequent policies.

    But is that foresight driven by QE2 expectations, normal reflation, or the anticipation of even an anemic recovery?

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    No, because even without QE it would do it anyway. There’s nothing gained from QE in that regard.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    And thanks for the recommendation.

    Regarding Marc’s quote, I explained that in “interest rates and fiscal sustainability” and then a bit differently in “the operational realities of the monetary system” (toward the end). I would actually go a step further than Marc and say the govt is indifferent. As an analogy, if you were told you could have an overdraft at the bank for X%, or that you could issue your own debt in the mkt at roughly X%, would you care which one you did?

  • http://wfhummel.net wfhummel

    Cullen, to be sure I understand your position, with the Fed buying $600 billion worth of Treasurys under QE2, other things equal, you are saying that has no effect on the total of bank deposits. Is that correct?

  • http://www.pragcap.com Cullen Roche

    I am not saying it has no effect. I am saying that it does not change the liquidity position of the participants involved.

  • wh10

    Perhaps I should use my terms more carefully – I just meant the purchase of treasuries, a form of monetary policy, in this specific instance, actually enables more lending. This is a form of OMO, no? Isn’t QE simply just this, but in a zero interest rate environment?

  • jbvo

    Not so. Private balance sheets are increased by the size of the QE and are more levered. Same can be said for the govt sector.

    As I said earlier, gross assets in the system increase as do liabilities.

    Given the size of QE is over $1.5 trillion and going higher, I don’t share the MMT belief in its irrelevance.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    “in this instance” it doesn’t, because that’s what the Fed does, anyway, in EVERY instance. Further, in normal times, RR are essentially optional at any rate with retail sweep account technology.

  • Alex

    I am not sure if my comments are exactly correct, but I’ll give it a go.

    Total bank deposits MAY change, depending on who is the eventual net seller of the Treasuries. Though the QE transaction is between the Fed and banks, banks may have bought the Treasuries from the household/corporate sector beforehand, meaning that banks are just the middlemen.

    If this is the case, and households are the net sellers, then yes, bank deposits will increase. The swap (for the household) will simply be Treasuries for cash. The bank will then have an increased deposits liability, and an increased reserves asset.

    This will increase the broader ‘money supply’, however this does NOT mean the transaction is inflationary. This is because:

    – net financial assets have not changed (the household’s equity remains unchanged)
    – grandma might now have cash instead of bonds, but that does not mean she going to buy a new TV. If grandma wants to save, that is what she will do. Not only that, but if she wanted to spend whilst she had the bonds, a simple trade in a very liquid market would be the only thing stopping her.
    – this is quite comparable to the issue of debt after government spending (in the reverse way though). Officially, the issue of debt reduces the ‘money supply’ back to where it was pre-spending, however net financial assets have still increased – which is potentially inflationary. This means that government spending is no more inflationary if it is not followed by bond issues, than if it were. Hence, at least in this issue, it is the net financial asset number that is important, not the number of bank deposits, or composition of assets that alters the ‘money supply’.

  • Alex

    Oh, and if it were the banks that were selling the bonds (if it had nothing to do with the household/corporate sector), then bank deposits would remain unchanged. So it depends who is the eventual net seller of the bonds.

  • wh10

    I think I understand. Is what you are saying that the Fed is required to exchange Treasuries for cash if banks request it? Thus large scale OMOs wouldn’t explicitly be necessary if banks ran out of excess reserves, since they’d already be exchanging their treasuries?

    I guess I was lost in the trees and unknowingly stating the obvious, but having been mired in online MMT blogs recently, I have had the idea “that treasury purchases don’t enable lending” hammered into my head. Perhaps it was my mis-interpretation, but that isn’t the technically correct way to state it, since banks are always actively trading treasuries in order to obtain reserves so as to lend (and from this perspective the acquisition of tsys does enable lending). Your/Cullen’s point is the explicit exercise of QE is not necessary for lending to occur.

  • wh10

    I guess I should modify the word “enable,” since you would say banks lend first then worry about reserves. Nevertheless, they do worry about hitting their reserve requirement, which sometimes necessitates the selling of tsys for reserves.

  • http://www.pragcap.com Cullen Roche

    Right Alex. We can actually go into the Fed website and see that demand deposits have increased. There is no question that QE has altered deposits to some degree. But that didn’t make these savers dissavers.

  • Joe Bridges

    The author writes as if the perception is unimportant. If a policy is not clear and transparent, as obviously quantitative easing in its current form is not clear and transparent, then it is a flawed policy on its face. It will continue to produce unintended consequences and should be ended immediately if not sooner. Duh!

  • http://www.pragcap.com Cullen Roche

    ANOTHER comment from someone who has no clear idea what I believe. I have written EXTENSIVELY about the unintended consequences of QE….

  • Mediocritas

    You’re welcome. I’m learning too…always.

  • flow5

    The FED finally got religion. EVERYBODY has missed their hint.


    “For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of R-E-Q-I-R-E-D reserves, money supply and credit outstanding”

    The Federal Reserve has never gauged the volume and timing of its open market operations in terms of the amount and desired rate of increase of member commercial banks COSTLESS legal reserves, but always in terms of the levels of the federal funds rates (the interest rates banks charge other banks on excess balances with the Federal Reserve).

    By using the wrong criteria (interest rates, rather than member bank reserves) in formulating and executing monetary policy, the Federal Reserve was always the bubble’s engine.

    While IORs may initially continue to fool the masses, the technicians at the FED will gradually change the course of monetary history that has existed since 1965. That actually might mean MMT’s toast.

  • Mitch83

    “As I said earlier, gross assets in the system increase as do liabilities.”

    If you mean an expansion of the balance sheets of the banks when looking at QE with non-banks, then yes, there is an expansion in contrast to QE purely with banks (no expansion).
    But this doesn’t lead to more “liquidity” in the system or is inherently inflationary (households don’t spend more, regardless of having demand deposits instead of USTs, and banks etc. shouldn’t fundamentally be more eager to buy assets, regardless of the level of the expansion of their balance sheets).

  • jbvo

    We’re going to have to agree to disagree. I’m not as sanguine as you when it comes to the results of QE in the private sphere: a larger, more leveraged balance sheet which has substituted demand deposits for Treasury securities and increased the money supply. With QE approaching $2 trillion by June 30, I think MMT underestimates the effects of its impact on the private sector.

  • Simple Explanation

    1. Fed’s QE buys bonds from Government due to deficit spending – this is money printing due to Government spending requests and is inflationary. This inflationary process is more than offset by the deleveraging that is occuring in the economy.

    2. Fed’s QE buys bonds from banks to increase their reserves – this has no effect on the inflationary aspect of the economy because banks are not able to make loans due to lack of demand for those loans – a balance sheet recession.

    3. Senitment towards QE is what is driving trends. But the underlying fundamentals do not agree with the perceived inflationary trends.

    4. Velcoity – The rate at which money exchanges hands is very important, and since 1995 velocity of money has been collapsing which is deflationary. It continues to fall.

    5. M1 minus M3 – a large part of this difference is the reserves held at the banks. As long as banks cannot lend out their reserves, it is deflationary.

    6. The US Dollar will rally to all time record highs on any deleveraging crash as a rush to sell US Dollar based asset ensues and puts the largest credit crunch bid on this currency.

  • http://www.zenforexportal.com/ Adam Smith Forex

    I think QE is still adding all sorts of liquidity to the markets and they will continue doing it in the future.

  • Batshwing

    Take out the Fed for a moment and assume a fixed money supply where bank lending and bank debt cancellation are in equilibrium: The flow of funds in the primary Treasury market is that REPO cash funds flow from holders of cash deposits through primary dealers into Treasury’s general account joining funds collected as tax receipts and then emitted back into the economy via public sector spending. REPO cash is then replenished from that portion of savings which flows into public debt. This flow of funds increases when government runs deficits and debt accumulates. More savings divert into public debt and out of private assets….see Japan. The result: Private asset price deflation, public asset price inflation, private sector investment down, public sector investment up.

    Now add the Fed into the mix. The Fed effectively displaces a portion, all the way from a tiny to a progressivly signficant one during quantitative easing, of the total amount of private domestic and foreign offical savings otherwise destined for Treasuries. The act of purchasing Treasuries from primary dealers replenishes dealer cash ultimately used to repay a REPO loan. To the extent that this cash comes from the Fed, it displaces cash that would otherwise come from private domestic and foreign offical sources. That cash ends up elswhere inflating other asset class prices.

    Now to inflation: The main question to ask is if there is a link between consumer price inflation and asset price inflation. Commodity price inflation leaks pervasively into consumer prices to the extent that products and services are affected by commodity use and producers pay higher prices which they are able to pass on to customers.

    So is there a link between QE and inflation? Absolutely!
    Is the Fed monetizing government debt with QE? Indirectly yes.

    The confusion arises due to the indirect link between base money reserves and broad money deposits which traditionally are linked via bank lending. If net bank credit is stagnant or even contracting, increasing reserves would not inflate the money supply absent other channels through which incomes and credit can be extended. However, government deficit spending is the Keynesian compensation channel for a private sector-bank credit contraction.

    Even though the net effect of a public sector-monetary intervention may seem non-cumulative when balanced against a private sector-bank credit contraction this is not the case. Public sector spending is not effectively sanitized by productivity growth to the extent that private investments are. The net effect is that the economy while quantitatively running on the same money supply is qualitatively less efficient….and that leads to inflation and even stagflation.

  • http://ralphanomics.blogspot.com/ Ralph Musgrave

    “holders of the monetary base are NOT households or corporations, but commercial banks.” OK then. If $X worth of my Treasuries are quantitatively eased, the Fed issues monetary base in return, which I deposit in my commercial bank account. And the latter’s account at the Fed is boosted by the same amount. So who is the ultimate owner or holder of that base money? It’s me, isn’t it? My commercial bank is simply a “go between” – between me and the Fed.

    I now have $X of cash rather than $X of Treasuries. And cash is a bit more liquid than Treasuries because cash buys cars and PCs, whereas Treasuries don’t. So liquidity has risen a bit.

  • Batshwing

    So clearly the difference between Japan’s deflationary decades and us despite identical circumstances otherwise (RE price bubble followed by collapse and the resulting monopolized zombie bank system sitting on the side lines while the private sector delverages its balance sheet) is that the Fed is quantitatively doing what the BofJ did not: (Indirectly) monetizing government deficits created by the spender and investor of last resort (as part of classic Keynesian intervention) and thus reflating private sector asset and consumer economic transaction prices by QUANTITATIVELY displacing private capital from the public sector capital market (as dictated by neo-Keynesian doctrine) thus undercutting the natural rate of interest on private capital by increasing its supply.

    Austrian economics points out that fiat monetary systems by nature undercut the natural cost of pooled savings turn capital which would prevail otherwise based on the supply of savings. That unhinges the relationship between consumer prices and the proclivity to save on the one hand and the cost of capital and the proclivity to produce on the other. The Fed did this by first controlling the supply then the cost of capital available to banks in the form of reserves yet both paradigms failed to prevent credit floods and inflation of either consumer or asset prices. Since 2008, interest-on-reserves has empowered the Fed to control reserve flow independent of reserve supply making it possible to buy large quantities of assets from private and public markets without affecting bank credit formation.

    Only those who still look at the new Fed in terms of the old Fed will interprete QE within the framework of the banking sector, ie as harmless with respect to inflation. This erroneous focus is by design to divert attention away from what QE is really all about.

  • dlm

    my question is this- If the government spends money into existence- by what mechanism is it forced to issue government bonds? You state that government bonds merely soak up excess liquidity created through government spending as a means of controlling inflation- and you may be correct, but this is clearly not the thinking of most treasury officials. Clearly treasury officials feel that their spending is constrained- even if as you point out it is an artificial constraint. Given that they feel the need to issue debt, then surely QE is necessary as it lowers return on the debt to a level where the interest payments do not take up too large a part of the tax take?

  • Anonymous


    The Fed is not buying USTs from you but from the PDs.


  • circuit

    Thanks Scott – I’m definitely with you on that.

    BTW, I really enjoy your work and find your contributions on this site very helpful.

  • circuit

    In the upside down world in which we live, it could be argued that in fact the critics have it the wrong way: the deficit spending of the past (issuance of Treasuries) made it possible for the Fed to implement QE (as deficits created the bonds that the Fed was able to swap).

  • Anonymous


    such posts with clear statements make much more sense than the technical discussion if QE is adding new liquidity (is inflationary) or not. By saying that it is not inflationary, it may sound as an endosement.

    Now your position sounds much more clear and I fully agree with it. On the other hand you seem to endose government spending filling the void of the burst private credit bubble, which I do not agree with (except for food stamps and UE benefits etc.). My point is that it has a similar aim and results as QE.

    I would love if you could give more detail on your points (malinvestments, political interests etc.), incl. examples, the same way you discuss the “QE is not adding liquidity” issue.

    Thanks for the effort,

    For example

  • Greg


    One thing I see you missing in your example is this; Where is the stock to buy? You present a simple two person scenario with only bonds but then magically a stock appears. One of the two must have had the stock at the beginning.

    This is the type of thing I see done all the time. All financial assets are currently owned by someone. There is already an owner that would want to sell for you to be able to buy. If you want to pay more than the previous owner payed he will decide maybe to sell to you, but this is not putting new money into a stock market. It simply is a swap. Only the govt can add new money to the system. QE is an asset swap just like all others.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    Thanks. And, I meant to say that the govt is always (largely) indifferent, in my view, which would be stronger than Marc put it.

  • Greg

    Investor X

    When you say

    “You assume that the level of activity was right and not an overblown, credit-induced, unproductive, corrupt, speculative bubble, which needs to be corrected. Keeping the status quo, keeps the patient chronically ill, by treating only the symptoms, not the root of the illness. It’s like taking aspirin for cancer instead of a chemotherapy.”

    There is a lot of assumptions here. How is any level of activity “right” or “wrong”? In a free market arent we supposed to buy what we wish? Were we unable to produce what was being demanded? I think not. Yes some people ran out of income to service their debts as result of becoming unemployed. Does this make them unproductive or corrupt? The root of the illness is “private debt” substituting for income which has been whithered away over the last three decades by explicit policy choices that led to offshoring jobs to cheap labor markets, diminished worker protections here (union busting) and accumulation of income and wealth in the top 5-10%. Not because these guys work harder but becasue they get to dictate policy choices which benefit them. This is no accident. This is the result of policy decisions. It can be reversed by policy decisions as well. Fighting against govt spending (as opposed to private credit creation) will NOT help the worker. It will put them further in debt. Govt “debt” is an asset to the non govt. Yes we should resist the benefits of the govt spending going to the usual suspects but we should not resist “new money” creation by the govt.

  • Anonymous

    This is the best summary so far. Great!


  • El Viejo

    Thank you for your two comments: (too entangled in mechanics and speculative inflation) I think you are spot on.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    “Is what you are saying that the Fed is required to exchange Treasuries for cash if banks request it?”

    No. Under normal circumstances, whenever the banking system desires more reserves at the Fed’s target, they are provided via repo’s or open market operations. It’s not banks “requesting” anything. It’s the Fed hitting a target rate. When the Fed thinks it’s necessary, it announces its intentions and asks for bids from dealers, and the highest bidder(s) win.

    “Thus large scale OMOs wouldn’t explicitly be necessary if banks ran out of excess reserves, since they’d already be exchanging their treasuries?”

    It’s not necessarily the banks exchanging anything. Some dealers are banks, some are not. When the Fed purchases the Tsy, the banking system gets the reserves–if the selling dealer was a bank, then it no longer has the Tsy; if not, then the bank has the dealer’s new deposits on its liability side.

  • http://www.pragcap.com Cullen Roche

    I simply accept the accounting realities of govt spending. For instance, right now we are running a -3% CA deficit. So, if the pvt sector wants to save in USD the US govt MUST run at least a 3% budget deficit. So, it’s more a matter of accepting reality. Anyone who says they want a balanced budget or surplus simply fails to understand basic economic realities. To say that you want a balanced budget is to say that you want us to go into recession – I’d love to see some of these political hacks confronted with that reality! I think they’d change their tune pretty fast.

    That said, I don’t think govt should just spend recklessly. They must spend some amount of money, however, it should be efficient. If you were a reader during the healthcare debates, cash for clunkers, homebuyers tax credit you’ll remember that I hammered the Obama administration for these programs that I believed were wasteful during a time when we had such high unemployment. There’s no rule of thumb for efficient spending – it must be taken on a case by case basis, but I generally think that govt should serve to motivate and encourage pvt sector productivity. Hand outs, bailouts, etc are not the govt’s role. That creates complacency and only furthers our problems.

    The Fed is the worst kind of malinvestor because they work directly through enriching the banking system at the loss of the household sector. In addition, they cause speculation and manipulate rates in an attempt to only further increase debt levels for us all. In the end, this is the only way the Fed can really work. I don’t necessarily blame Bernanke – he is trying to implement the tools he has. But he doesn’t have the tools to create economic prosperity….

    I have been meaning to write much more on all of this one day….I’ll get around to it eventually…

  • wh10

    “If banks run out of excess reserves, the Fed supplies any desired increase at its target rate. That’s what it means to set an interest rate target. And any new reserves will earn the same interest payment as existing reserves.”

    All I’m trying to say is that at the theoretical point at which there are no more excess reserves (all banks have hit their reserve ratio), OMOs or repos with the Fed are necessary to enable more lending, at least loans that could only be made at a rate cheaper than the discount window rate. Otherwise banks can’t meet their reserve requirements and they can’t lend. If the more appropriate term for this is “setting an interest rate target,” then fine, but if the Fed were to buy a bunch of treasuries at a time in which excess reserves = 0, I don’t understand why that wouldn’t trigger more lending if there were loans out there to be made. However, I keep reading reserves don’t enable lending, but I don’t quite understand how that is 100% true if in fact there is a reserve ratio requirement, EVEN if loans create deposits and reserves are not the direct funding for loans. The example I am trying to come up with is trying to illustrate a scenario in which a bank needs to secure reserves before they can keep lending.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    The point is, there is no difference, except that the Tsy can be repo’d over and over again, and thus create more “liquidity” than the deposit can.

  • http://blogfirstrider.blogspot.com/ first



    To the extend that banks are swapping longer term negotiable government securities M2 in exchange for the shortest notes “cash” M1

    At this time banks still do not seem to be lending out against their reserves but could we say that if we where in a more prosperous period banks would be able to lend out more money from a QE operation “swaps” ? Banks can not use M2 money to create M1 but they can use Cash (time 9)and increase M1.

    I know that this is not the goal of the FED at this time since the reserve certainly do not need to be increased and the FED most likely wants money to be moved from Sleepy Town to more aggressive investments but my question as more to do with the consequence replacing longer term bonds with cash (other than changing maturities and influencing rates)

  • Mitch83

    I have the feeling you (and some others) look at the process upside down.

    You must remember that you as an individual just bought the USTs in the auction, meaning you decided to save this amount for a specific time frame.
    Why would you buy USTs in the first place if you didn’t want to save but spend the money?
    This action of buying USTs wasn’t forced upon you, and it took place before the Fed engages in its operations.
    IF the Fed now bought from you directly after the auction (assuming you agree upon selling and the price), would now take these deposits and go out and spend them?
    Of course not. An hour before you wanted to save this amount. This can’t have changed just because now you have deposits instead of USTs.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    “All I’m trying to say is that at the theoretical point at which there are no more excess reserves (all banks have hit their reserve ratio), OMOs or repos with the Fed are necessary to enable more lending,”

    Again, not necessarily. This assumes that deposits created by a loan always remain a deposit. But they often don’t–if corporation A gets a loan and spends on machinery built by corporation B, corporation B might hold this as a money market account balance, which has no reserve requirements, or any other number of near “monies.” And, as I said, banks can almost always avoid reserve requirements via sweep accounts.

    Also, the Fed always provides reserves to meet reserve requirements at a penalty rate, so the only “limit” would be an increase in the cost of lending.

    Finally, this isn’t “all” you’re trying to say. This whole discussion started with you saying:

    “What about when all banks have run out of excess reserves (all are at the max reserve ratio) and the discount window rate is too high for further lending to be profitable? Then wouldn’t QE matter, because it would substitute USTs, which don’t satisfy the reserve ratio requirement, with reserves, which do?”

    That is unequivocally incorrect. QE doesn’t matter compared to normal operations. You can’t compare QE to operations that never actually occur and have it be meaningful or applicable. That’s basically like comparing QE in our system to banks under a gold standard. Yes, those are different, but not any different than our normal system vs. banks under a gold standard. Pointless.

  • wh10

    Okay- thanks for the lesson, Scott. I understand, except your last paragraph. I’ll stop wasting your time for now though. I read in this thread you have a book on this topic- what is it called? I couldn’t find it after some brief googling.

  • RobertM

    re:”The Fed is only allowed to buy Treasuries in the secondary market,”

    Would it be clearer to simply say “The Fed is only allowed to buy pre-existing Treasuries in the secondary market, Treasuries that have already been paid for, thus there is no increase as the cash that was used for the purchase already exists”?

  • dlm

    ok i understand they are self imposed constraints… but given that you need to issue debt to reduce the money supply to prevent inflation, then surely when you have an explosion in government spending and a corresponding increase in debt issuance to control inflation… you do need QE to keep the interest payment cost down. Ok theoretically you could spend more money into existence to pay the interest payments but then you would need to issue more and more debt. So in effect despite the fact that the US is not spending constrained by the amount of debt it issues, QE does in fact enable government spending. I am trying to get to a point where I accept your theory of the way the monetary system works, and at the same time say that QE is facilitating deficit spending…

  • Mitch83

    “but given that you need to issue debt to reduce the money supply to prevent inflation”
    Loans create deposits. Reserves do not. This means you don’t control the money supply (and don’t prevent inflation) by issueing “debt” = USTs (which soak up reserves), you only control the overnight rate at which banks lend reserves to each other. But when you pay IOR = interest on reserves you don’t need to issue USTs at all.

    “you do need QE to keep the interest payment cost down”
    US Bonds are no fiscal financing tool.
    The US can ALWAYS pay the interest on bonds, no matter how high the yields are. You don’t need QE to hold yields down to be able to “finance” the US.
    The US can and will always be able to soak up the reserves spent into existence by deficit spending through UST issuance. This is because for banks USTs are always “better” than reserves (higher interest, no “liquidity” disadvantages) and reserves can’t be redeemed for Gold or something else (like under the Gold Standard).

    So this:
    “QE is facilitating deficit spending”
    is wrong.

  • Batshwing

    first and DIM

    The act of quantitatively creating new reserves displaces deposits away from the public money cycle (income–>savings—>buying public debt—->government spending—->public sector spending recipient income) and into the private money cycle (income—>savings—>private investments—-business spending—->private sector income). This effect is independent of bank lending. In fact this is what neo-Keynesian doctrine is based upon. It is the countercyclical reflation channel used by the public sector and the Fed when the private sector contracts threatening to shut down the fiat system of credit creation via the banks.

    To the extent that these displaced deposits end up in commodities they are inflationary to prices. This is exactly the intent of QE2, not just an apparent coincidental occurance.

  • IamSamIam

    You are dead wrong and so is John Hussman who I really respect.
    If you knew what Qunatitative Easing is, you wouldn’t say that.