QUANTITATIVE EASING: “THE GREATEST MONETARY NON-EVENT”

The topic of quantitative easing (QE) has rapidly become the most important discussion in the investment world.  As deflation becomes the obvious risk and the economic recovery looks increasingly weak investors are again looking to the Fed to save their skin from a Japan style deflationary recession.  The irony here is so thick you could choke on it, however, like some sort of sick masochist, investors continue to return to the trough of the Federal Reserve so they can gorge on half-truths and misguided policy responses.

There is perhaps, no greater misunderstanding in the investment world today than the topic of quantitative easing.  After all, it sounds so fancy, strange and complex.  But in reality, it is quite a simple operation. JJ Lando a bond trader at Goldman Sachs has eloquently described QE:

“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”

Some investors prefer to call it “money printing” or “stimulative monetary policy”.  Both are misleading and the latter is particularly misleading in the current market environment.  First of all, the Fed doesn’t actually “print” anything when it initiates its QE policy.  The Fed simply electronically swaps an asset with the private sector.  In most cases it swaps deposits with an interest bearing asset.  They’re not “printing money” or dropping money from helicopters as many economists and pundits would have you believe.  It is merely an asset swap.

The theory behind QE is that the Fed can reduce interest rates via asset purchases (which supposedly creates demand for debt) while also strengthening the bank balance sheet (which entices them to lend).  Unfortunately, we’ve lived thru this scenario before and history shows us that neither is actually true.   Banks are never reserve constrained and a private sector that is deeply indebted will not likely be enticed to borrow regardless of the rate of interest.  On the reserve argument the BIS explains in great detail why an increase in reserves will not increase borrowing:

“In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.

The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 – by far the most common – in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively.

The main exogenous constraint on the expansion of credit is minimum capital requirements. By the same token, under scheme 2, an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. This is true in both normal and also in stress conditions. Importantly, excess reserves do not represent idle resources nor should they be viewed as somehow undesired by banks (again, recall that our notion of excess refers to holdings above minimum requirements). When the opportunity cost of excess reserves is zero, either because they are remunerated at the policy rate or the latter reaches the zero lower bound, they simply represent a form of liquid asset for banks.”

The most glaring example of failed QE is in Japan in 2001. Richard Koo refers to this event as the “greatest monetary non-event”.  In his book, The Holy Grail of Macroeconomics, Koo confirms what the BIS states above:

“In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession.  If there were many willing borrowers and few able lenders, the Bank of Japan, as the ultimate supplier of funds, would indeed have to do something.  But when there are no borrowers the bank is powerless.”

In the same piece cited above, the BIS also uses the example of Japan to illustrate the weakness of QE.  The following chart (Figure 1) shows that QE does not stimulate borrowing (and the history of continued economic weakness in Japan is coincidental):

“A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly.”

(Figure 1)

Koo goes a step further in describing the failure of QE to promote private sector recovery.  His simple example is one I have used often:

“The central bank’s implementation of QE at a time of zero interest rates was similar to a shopkeeper who, unable to sell more than 100 apples a day at $100 each, tries stocking the shelves with 1,000 apples, and when that has no effect, adds another 1,000.  As long as the price remains the same, there is no reason consumer behavior should change–sales will remain stuck at about 100 even if the shopkeeper puts 3,000 apples on display.  This is essentially the story of QE, which not only failed to bring about economic recovery, but also failed to stop asset prices from falling well into 2003.”

Koo continues by emphasizing how ineffective monetary policy is during a balance sheet recession:

“Even though QE failed to produce the expected results, the belief that monetary policy is always effective persists among economists in Japan and elsewhere.  To these economists, QE did not fail: it simply was not tried hard enough.  According to this view, if boosting excess reserves of commercial banks to $25 trillion has no effect, then we should try injecting $50 trillion, or $100 trillion”

After years of placing more apples on the shelves the Bank of Japan finally admitted that the policy had been a failure:

“QE’s effect on raising aggregate demand and prices was often limited” (Ugai, 2006)

That all sounds too eerily familiar, doesn’t it?  No, no – Mr. Bernanke hasn’t failed.  He just hasn’t tried hard enough….But perhaps the reader believes Japan is different and not applicable.  This is a reasonable objection.  So why don’t we look at the evidence from the last round of QE here in the USA.  Since Ben Bernanke initiated his great monetarist gaffe in 2008 there has been almost no sign of a sustainable private sector recovery.  Mr. Bernanke’s new form of trickle down economics has surely fixed the banking sector (or at least bought some time), but the recovery ended there.  It did not spread to Main Street.  We would not even be having this discussion if we were in the midst of a private sector recovery.  The surest evidence, however, is in the Fed’s own data.  We can also look at the Fed’s recent Z1 to show that households remain hesitant to borrow (see Figure 2).  Friday’s consumer credit data was yet another sign of contracting consumer credit and a lack of demand for borrowing.  Despite the Fed’s already failed attempt at QE (see Figure 3) we are convinced that Mr. Bernanke just needs to throw a few more apples on the shelves.  The historical evidence is clear – QE will do little to stimulate borrowing and help generate a private sector recovery.

(Figure 2)

(Figure 3)

In addition, there is one great irony in all of this misunderstanding.  The hyperventilating hyperinflationists and those investors calling for inevitable US default are now clinging to this QE story as their inflation or default thesis crumbles before their very eyes.  The new hyperinflationist theme has become a story of “if this, then this, then THIS!” – the ludicrous 3 step investment thesis that the economy will become so fragile that the government will pile on with more stimulus, which will worsen matters and force them to stimulate further which will then result in hyperinflation and/or default. Most investors have enough trouble predicting what the next event will be – connecting the dots two or three steps down the line is not only ill-advised, but is hardly even worthy of consideration….Let’s just call a spade a spade – the inflationistas have been wrong and the USA defaultistas have been horribly wrong.

What is equally interesting (in addition to the fact that QE is not economically stimulative) with regards to this whole debate is that this policy response in time of a balance sheet recession is not actually inflationary at all.  With the government merely swapping assets they are not actually “printing” any new money.  In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits.  This might have made some sense when the credit markets were frozen and bank balance sheets were thought to be largely insolvent, but now that the banks are flush with excess reserves this policy response would in fact be deflationary - not inflationary.  Why would we remove interest bearing assets from the private sector and replace them with deposits when history clearly shows that this will not stimulate borrowing?

All of this misconception has the market in a frenzy.  Portfolio managers and day traders can’t wait to snatch up stocks on every dip in anticipation of what they believe is an equivalent to the March 9th 2009 low that was cemented by government intervention.  As I have long predicted Ben & Co. have failed.  If there is one thing that we know for certain over the last 24 months it is that Mr. Bernanke’s monetary policy has done very little to get the private sector back on its feet.  This man failed to predict the crisis (was in fact oblivious to its potential), initiated the wrong trickle down policy response and yet now we turn to him to save us from a double dip and his Committee responds with more discussion of QE?  Will we ever learn?

In describing the negligence of such monetary policy Richard Koo uses the analogy of a doctor who simply tells his patient to take more of the same medicine he originally prescribed:

“At the risk of belabouring the obvious, imagine a patient in the hospital who takes a drug prescribed by her doctor, but does not react as the doctor expected and, more importantly, does not get better. When she reports back to the doctor, he tells her to double the dosage. But this does not help either. So he orders her to take four times, eight times, and finally a hundred times the original dosage. All to no avail. Under these circumstances, any normal human being would come to the conclusion that the doctor’s original diagnosis was wrong, and that the patient suffered from a different disease. But today’s macroeconomics assumes that private sector firms are maximizing profits at all times, meaning that given a low enough interest rate, they should be willing to borrow money to invest.. In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession.”

Dr. Bernanke has misdiagnosed this illness one too many times.  At what point does someone tell him to put the scalpel down and step away from the table before he does even greater harm?

References

BIS (2009) http://www.bis.org/publ/work292.pdf

Koo, R (2009) The Holy Grail of Macro Economics

Ugai, H (2006) Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses.  Bank of Japan Working Paper Series no 6-E-10

This paper is also available for download in PDF format at SSRN:  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1655039

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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  • LVG

    This is a top notch piece of research TPC. Well done.

  • slightly_skeptical

    TPC I agree 100% with the analysis specially the rationale for why it will be a non event, the only thing that I think you may be wrongly assuming is that the Fed will pursue QE for the purpose of increasing lending. I know this is the official reason given by the Fed, but unofficially it is just another mechanism to shore up bank balance sheets, exchanging assets (no not the treasury notes but instead GSE debt which in reality isn’t worth 100c on the dollar). I suspect that the real reason the Fed will pursue QE is that they are expecting more deflation and they want to make sure that banks remain solvent by pumping in money in exchange for less valuable assets.

    Obviously the Fed won’t acknowledge that cause, as it’ll spook the markets more and potentially cause even more deflation. Bernanke & the Fed foolishly didn’t see the debt bubble that caused this financial crisis, but I don’t think he or the Fed are as ignorant this time around in thinking that pushing more reserves into banks will lead to more lending specially when folks and small businesses are already maxed out debt wise given the economic uncertainty ahead. The Fed is now the only bailout mechanism available to banks as it’s unlikely that another TARP will be passed by congress.and how much more can FASB do to help banks hide losses on their assets. The Fed is the banks only hope if things deteriorate further and QE is the mechanism of choice to transfer fictitiously overvalued assets for hard cash – which they can then put to work via their proprietary trading desks (skimming profits) or simply buy more interest bearing treasuries. After all, who has been buying the $3 Trillion in treasuries the government has issued over the last 2 years?

    If the Fed pursues more QE, I expect this to be a sign for more deterioration in the broader economy and more deflation.

    The other thought that did occur to me which is even more scary is that QE could be just another temporary measure to get treasury purchases funded (i.e. so we don’t have a failed auction). Like I said who has and will be buying the trillions of treasuries being issued by the government? I thought everyone else was broke? So who’s been buying? And how do we get them to keep buying? The Fed pursuing QE solves this problem, but it’s all an illusion and how long can they keep that going? Another year, maybe two?

    Deficit spending 10% of GDP to get an anemic growth rate of 2-2.5% is crazy, they can’t sustain that for very long, and as you pointed out (as of today) they have not printed money out of thin air, since it still needs to be debt backed. So they still need someone to buy that debt (treasuries) to fund operations. This ponzi scheme cannot go on forever. It’s also interesting to note that the Fed is/was considering to balloon it’s Fed balance sheet via QE to the tune of $5 Trillion ($3 Trillion more than what’s on it’s balance sheet today), which would theoretically fund government deficits at the current rate for another 2 years. I’m starting to think this is the more plausible reason why the Fed is planning to pursue more QE.

  • Mozaic

    An extrememly impressive bit of work.

    Its just a shame that nobody in a position to make a difference will care. Reality is for the little people.

  • Bruce

    Merely an asset swap? If the Fed were to buy 5 trillion of Treasuries, you would call that merely an asset swap? Where do you think all that cash would go? Bank deposits? You think Pimco and Calpers et al are going to reinvest their freshly printed FRNs in bank deposits? No way.

    The cash will go into anything with a perceived return in daisy-chain fashion, as the more conservative treasury holders are forced to buy corporates, and the corporate holders decide to maybe tiptoe into dividend paying blue chips, and the blue chips take a bit off and buy some 50pe multiple amazon, and the now ecstatic amazon holder says hey I’ll go spend some of my winnings in Vegas, baby! Which makes it’s way into a newly built condo for some hotel employee…..

    Of course this mere asset swap is inflationary. It’s just that most of the inflation is in asset prices. In japan, all the qe did was stoke up asset prices abroad. Here the qe is so massive it stokes up asset prices everywhere, with a bit of trickle down into the real economy.

  • F. Beard

    The historical evidence is clear – QE will do little to stimulate borrowing and help generate a private sector recovery. TPC

    A classic catch 22 caused by our money-for-debt scheme: Businesses won’t borrow while the economy is deflating and without borrowing the economy continues to deflate.

  • Max

    slightly_skeptical, the Treasury can “quantitatively ease” just as easily as the Fed (easier, in fact). They can simply stop selling long term bonds. The Treasury and the Fed are both parts of the U.S. government and should be viewed as a single unit for economic analysis.

  • jt26

    Agree with slightly_skeptical … it’s all about the asset and the bank balance sheets. Just like the relaxation in mark-to-market FASB, there was no expected boost to the economy.
    Agree with Bruce … the biggest event in QE2 is already in evidence … EM assets. (QE1 was SPY and stabilizing house prices.)

  • Steve

    QE is not printing money, providing the Fed’s balance sheet is appropriately shrunk as the purchased assets mature. That is where we dont yet have any clarity.

    If buying treasuries, gse debt, etc helps lower rates and pump liquidity into the system, then maturing or selling these assets should have the reverse effect. If the economy remains sluggish, the Fed is then forced into a cycle of ongoing asset purchases and an ever expanding balance sheet. As the Fed’s balance sheet becomes ever bigger, the impact on the economy of unwinding all those purchases becomes unthinkable. At some point the Fed may simply writeoff a bunch of its assets to get off the treadmill. That is the point at which QE becomes printing money.

    WIth overnight rates now poised to remain near zero for the forseeable future, QE is likely to become the Fed’s primary tool for management of monetary policy. I have to disagree with your Goldman Sachs friend, Mr Lando, this is a brave new world we are entering, not just a series of expanded coupon passes.

  • rob

    Help this beginner understand this statement:

    “In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. ”

    How does that force the private sector out of its savings and into cash? I thought savings WERE cash. (?)

  • http://crashthemachine.wordpress.com/ pezhead9000

    So, if the Fed does this is it better to be risk-on or risk-off? or somewhere in-between?

  • http://crashthemachine.wordpress.com/ pezhead9000

    agree!

  • Jon

    Great stuff as usual,TPC. Fascinating and scary all at once!

  • ES

    I agree with Bruce’s view. I feel that there has been an influx insitutional money in the sotck and bond markets since the start of the QE. Where did the money come from ? QE, it would seem

  • Ryan

    Let me get this straight then. The only two ways to increase the money supply is through government deficits and increased borrowing (or decreased savings) by the private/consumer sectors. Hiow else can there be “money printing”?

  • F. Beard

    Hiow else can there be “money printing”? Ryan

    Well, the US Treasury could issue some new legal tender fiat (United States Notes) and pay its bills and debts with them but since every US President since Andrew Jackson who took on the bankers has gotten assassinated, Obama should be careful if he decides to do the right thing.

  • Angry MBA

    I know this is the official reason given by the Fed, but unofficially it is just another mechanism to shore up bank balance sheets, exchanging assets (no not the treasury notes but instead GSE debt which in reality isn’t worth 100c on the dollar). I suspect that the real reason the Fed will pursue QE is that they are expecting more deflation and they want to make sure that banks remain solvent by pumping in money in exchange for less valuable assets.

    That’s a good comment. I would add to that my suspicion (which I cannot prove, but we’ll see if it happens) that the Fed is trying to pump up excess reserves in the larger banks, so that they can absorb (acquire) many of the more questionable smaller banks.

    When most Americans think of the Great Depression, they think of the stock market crash in 1929. When Ben Bernanke thinks of the Great Depression, I presume that he is focusing on the failure of Creditanstalt and the US banking collapse that resulted in the failure of 40% of this country’s banks.

    The key to sustainable recovery is increased money velocity. There isn’t much that the Fed can do about increasing velocity; that’s in Congress’ hands, and they clearly aren’t interested in doing very much.

  • Mike J

    >Since Ben Bernanke initiated his great monetarist gaffe in 2008 there has been almost no sign of a sustainable private sector recovery. Mr. Bernanke’s new form of trickle down economics has surely fixed the banking sector (or at least bought some time), but the recovery ended there. It did not spread to Main Street. We would not even be having this discussion if we were in the midst of a private sector recovery.

    The government stimulus has also been a failure. Government spending has also failed to produce a return to prosperity and a private sector rebound. Krugman, PragCap, et. al., have also used the excuse that it would have worked if it was big enough. What the government hasn’t tried is cutting taxes, cutting regulation and cutting spending. Stop micromanaging the economy by picking winners and rigging the outcome through industrial policy. Give us our free market back!

  • F. Beard

    Give us our free market back! Mike J

    Do you mean go all the way back before 1913 or just return to a form of fascism that profits you? Our government backed banking system is unstable as well as dishonest. It’s the price we pay.

  • gigi

    This is the most cogent analysis I have seen on the web on why QE is a non-event and in words that even laymen could understand.

  • james c

    Banks create money whenever they make a loan.
    Public deficits do not create money:they are financed by bond sales to the non-bank sector.
    QE is a mechanism by which the central bank lends money to the banking system.
    These loans count as reserves and enable the banking system to lend much more money (the banking mutiplier).
    In practice the banking system may not increase its loans accordingly.

  • P Sean

    Dead on response fellas
    SO I have a question for TPC
    Where do the assets in the Feds so called “Asset Swap” originate from?
    I would be very interested in knowing where you believe the Feds assets come from.

  • ObaMao

    Well I think the possible desired effects of QE may turn out to be a dud. Reason being we have Krugys of the world and deficit hawks seeing QE as some kind of panacea.

    That said we’re running out of the ammo… Pork filled & rushed $780 bil stimulus is winding down, interest rate near zero for the foreseeable future and debt time bombs from 2008 deferred via pumping of cheap money from the Central banks, etc. Next in line is QE followed by printing USD like there’s no tomorrow. This $$$ printing may stem the deflation spiral and quickly become the inflation monster triggering the STAGFLATION. And VOILA people will realize it’s all FIAT currencies and collapse of all currencies sans precious metal. Coming sooner than later along with Great Depression II.

  • LVG

    How is it inflationary? If I offer to buy your entire investment portfolio (which gives you cash) and you invest that money in new stocks would you call that inflation? Because if you do you’re totally wrong.

  • LVG

    You’re assuming that net net financial assets are being created. They are not.

  • LVG

    Think of it like a checking and savings account.

  • scharfy

    Certainly, I would agree with TPC’s assessment that QE doesn’t have any effects on actual loan growth when the bottleneck is on the loan demand side.

    Some of the secondary effects, such as what happens to this cash as it is forced onto the banks balance sheets, is unclear to me.

    Wouldn’t they(the Banks) most likely take the cash and buy another asset ?

    Thus isn’t QE a GOVT forcing the banks to sell Treasuries and buy other assets?

    Thus isn’t QE a subsidy to some asset group, somewhere – a de facto compression of risk premia in some asset class in the economy?

    Maybe not inflationary, maybe doesn’t create loan growth, but certainly has some secondary effects….

    This has my QE interest piqued…

  • LVG

    I am fairly certain that TPC is a proponent of tax cuts and has attacked most of the deficit spending that has been implemented so far. He is not a Krugmanite. Correct me if I am wrong TPC.

  • Ed from Orlando

    Great article!
    Additionaly what I would like to hear is what happens if the Fed does nothing, no QE2.
    What is the impact on the economic recovery if they dont do QE?

    A problem I see with Fed policy, past and could be in future…..

    Recently we have seen Greenspan emerge on the talk shows. He stated that stock market equity prices are very important to consumer sentiment. Larger 401Ks make people feel better, spend more and take on debt as they feel better about their future. The Fed has history with inflating housing market valuations with low interest rates for too long a period, to drive GDP growth the past 10 years. This created a great sense of wealth to consumers, drove spending and GDP higher. The Fed always beleive they need to inflate some assets, create sense of wealth, to get the consumer borrowing and spending again to drive GDP growth.
    Whats wrong with doing that again this time? After 2009 stock market crash and 401K assets went into cash, bonds, guarenteed returns. Inflating the stock markets with QE2 will make the banks and investment firms richer, but leave the consumers behind and dealing with higher asset prices (inflation) when they do finaly decide to jump back into the markets (I dont really believe they will soon) it will be top of the next asset bubble ready to pop.
    The Fed will do whatever they think needed to stop deflation, create asset inflation, create wealth affect, drive investment and borrowing. They are not able to inflate home asset prices this time around with just low interest rates. Pushing on a string.
    Its going to take time to heal the debts on everyone balance sheets and grow the economy conservatively year after year towards a healther stable future economy. Quick fixes where Fed creates asset infaltion, which creates bubbles to burts later, just choses winners (in short run financial companies) and losers (us all) in the end.

  • TedH

    Everyone keeps saying they’ll use the cash to buy new assets. Who cares if they do. They’ve merely replaced an asset that was purchased with cash. It makes no net difference. If I sell all my stocks to someone and then go buy new stocks with my “new cash” it’s not like I am injecting all this money into the system. And besides, asset purchases have NO impact on the real economy so who cares if the banks go out and buy a bunch of crap?

  • AWF

    Good Stuff—But

    Who is going to buy them apples?

    And do they have antennae problems?

  • http://www.pragcap.com TPC

    Yes, part of the operation is targeted at cleaning up bank balance sheets. As I said in the piece – that makes some sense when the credit markets are frozen and bank balance sheets are a real concern, but what about now? A lot of these assets (that the Fed would buy) are pretty desirable and high(er) yielding assets. Why take them from the banks at this point in the game? Is it really beneficial? I totally agree with you that this is partially an operation in cleaning bank balance sheets (with the goal that it makes them more likely to lend), but history tells us that this is a failed approach.

  • http://www.pragcap.com TPC

    This is the key question. Everyone thinks the Fed is adding net new financial assets. But they are taking with one hand and giving with the other. The assumption is that they can boost the lending markets ultimately. The facts speak to the contrary.

  • http://www.pragcap.com TPC

    I have not been a proponent of an ever increasing deficit. I have in fact said I am in favor of tax cuts and more EFFICIENT spending. Many of the programs we have implemented have been wasteful and have in fact detracted from the recovery. Unfortunately, we’ve wasted a great deal of our ammo now and there is no fortitude or room for increased deficits, tax cuts or spending. We’re hitting an economic wall. The Fed is basically out of bullets (or at least the effective ones) and the Congress thinks we’re bankrupt.

  • Captain America

    Are the banks even using the cash to buy other assets? I mean let’s think about this logically. So the Fed buys MBS from the big banks. The money will sit in cash (which is where most of the cash is based on the trillion $ in excess reserves) and/or they will use some of this cash to buy the same high yielding assets they sold. What is the net change here? If they don’t increase lending then nothing has really change. It actually is a total non-event.

  • slightly_skeptical

    TPC, what about the theory that this is so the banks can continue to buy treasuries and fund government deficits. The Fed buys treasuries/GSE debt from the banks in exchange for hard cash which they then use to buy treasuries. You can quote modern monetary theory, but the reality is that as of today the government has not and will likely not issue any new money that is not backed up by debt (treasuries). In order to keep the system going someone has to buy those new treasuries. Sure the Fed could simply sit on them and not auction them off, but that would be too obvious for the less aware to see and have the same psychological effect on market participants as if were simply printing money out of thin air. This would cause market participant to flee the dollar and treasuries. I know it’s a subtle point whose net effect is the same (i.e. the fed buys old treasuries/GSE debt by giving the banks hard cash which they in turn buy the new treasuries issued by the treasury and sold by the Fed. It’s circular I know and smoke and mirrors, but if our banks are not buying the new treasuries, then who is? It’s not like they’re issuing a mere 100 Billion per year, we’re talking multiple trillions and as far as the eye can see.

    If you can answer who is buying the bulk of our debt (treasuries) and it’s not the banks then one could dismiss this theory, but if it is our banks, then where are they getting the money from to buy the trillions that are already lined up for the next several years to fund the government deficits? Seems to me the Fed’s balance sheet is the temporary buffer that’s being used to buy some time hoping the economy can start up again and QE is the smoke and mirrors to cover up that reality.

    If the Fed is buying up treasuries from the banks, then why don’t they simply NOT auction off any new treasuries they are being issued by the treasury and just hold onto them? Wouldn’t this have the same theoretical effect (excluding the smoke and mirror effect)?

  • http://currencytradingelliottwave.blogspot.com/ AAP

    I agree with many of the aforementioned comments in regards to the quality of the research in this article.
    The simple fact that QE does not add money to the M3 money supply is a widely overlooked point, which I believe to a great extent debunks the central argument of a hyperinflation advocate. I subscribe to Robert Precter’s monthly Theorist and he has been shouting this from the roofs for quite some time.

    It’s no secret that markets are irrational and it’s participants even more so. What is true and what people perceive to be the truth are two very different things. If Bernanke can fool the markets into believing that he’s got the situation under control – the markets may create the recovery they are anticipating. Fooling speculators into taking major indexes higher, may create a virtuous cycle.

  • http://www.pragcap.com TPC

    Funding our bond purchases is not a concern. The auctions are always well oversubscribed for well known reasons that I have written about in the past: http://pragcap.com/when-will-the-bond-auctions-begin-to-fail

    Besides, banks are holding over a trillion in excess reserves. If this was a “funding” source for the govt there would be no reason to add to this source as it is already exorbitant.

  • dis737

    This is where I think you are wrong. By buying GSE paper (that is worth less than par w/o the gov. guarantee) they are in fact addding “adding net new financial assets.” The treasury is forced to make the paper whole which is forcing the Federal Gov. to create new financial assets.

  • FXBot

    Wow, great piece of work TPC. Bravo. This might be the most important piece of research in market circles these days and my guess is it will go entirely overlooked as the market melts higher (for the wrong reasons) and the economic recovery fails to materialize. The banks win again! The little guy loses. What else is new?

  • Rob

    Monetary policy does not have an immediate impact in the real economy and sometimes provides a big initial headfake. (Both in the real economy and in financial markets.)

    Deflation can turn on a dime into significant inflation (and vice versa) if expectations change.

    Earlier this year mortgage rates rose in anticipation of when the Fed would stop buying MBS, but since then mortgage rates has fallen to new all time lows. Is this due to reduced demand of loans or anticipation of future MBS purchases or both?

    The more people I see lining up in the deflation camp the more I think that we will soon see inflation (or at least a collapse of the bond market). When everyone agrees soon something else will happen.

  • slightly_skeptical

    Max, I agree the Treasury and Fed are both part of the government, but they do have distinctive functions and it’s important to differentiate between them and what each one can do. The Treasury issues treasuries to fund government deficits (TPC may disagree with this but that is today’s reality – money does not get printed out of thin air – may happen in the future as espoused by modern monetary theory proponents, but that’s not happening as of today, all new money issued by the government is backed by treasury debt.) The Fed then exchanges Fed Notes (hard cash if you will – i.e. what you have in your wallet) for those treasuries issued by the Treasury. Whallah the Treasury now has money to fund government deficits and spends that cash. The Fed then runs auctions to sell those treasuries it acquired from the Treasury.

    Now the question I have is who has been buying those treasuries from the Fed of late? Given most countries are broke and running their own deficits, most banks world wide are in bad shape, who then has the cash to buy trillions of treasuries we’re issuing year after year via Fed auctions? I’m theorizing that the ballooning Fed balance sheet holds that answer – and apparently the $2 Trillion they’ve got on there is still not enough, looks like they planning to expand it by an additional $3 Trillion. This would fund our current deficit rate (we’re currently running $1.5 Trillion deficits a year) for another 2 years.

  • slightly_skeptical

    TPC, thanks, I hear what your saying about the auctions being over subscribed, but who’s buying? However that still doesn’t explain where’s the money coming from to buy those treasuries? After all aren’t primary dealers (banks) required to buy even if there is under subscription? Is a failed auction at all possible? Keep in mind that it’s not just our deficits that need funding via treasury debt, who has been buying European issued debt over the last 2 years?

    As for the excess reserves ($1 Trillion), if not for accommodative FASB accounting changes how much excess reserves would the banks really have if any? Why did we need TARP if they were so flush with excess reserves.

    BTW, I’m not in the hyper inflationist camp. Hyper inflation will only happen when the US government decides to issue money that is not backed by government debt as per Zimbabwe, Weimar Republic. I’m firmly in the deflationist camp for now, until they get the economy growing again.

  • http://www.pragcap.com TPC

    SS,

    Most people misinterpret the operation of bond auctions. The Fed auctions bonds to soak up excess reserves. In today’s environment (with a huge amount of excess reserves) the bond auctions are really nothing more than a sideshow that fulfill the congressional accounting mandate. The bond market doesn’t fund our spending. It’s a pure monetary tool. So, what really happens when the govt auctions bonds? Well, first, the treasury spends some amount of money. This money gets deposited in bank accounts and results in reserves. The Fed auctions bonds in order to remove these reserves from the system so they can target the FF rate. So, it’s important to realize that the reserves are there to be spent on bonds as long as the govt is running a deficit. So, there are always bond buyers as long as govt has spent the money. This is vitally important to understand because once you can grasp this concept you realize that funding of government spending is not the bogey here. Inflation and deflation are the bogey in our monetary system. And in today’s environment deflation is the obvious risk. Check the link I posted. I will clarify a lot of what I’ve written above.

  • http://www.pragcap.com TPC

    Btw,

    Nice comment on Zimbabwe and Weimar. You’ve grasped the one MAJOR concept (foreign denominated debt) that almost all of the hyperinflationists fail to recognize. Hyperinflation is really the death of a currency that is due to very rare exogenous events (usually excess foreign denominated debt, a currency peg or some other failure of policy that is really an extension of economic failure).

  • http://www.pragcap.com TPC

    You’re assuming this govt issued paper is worthless (or worth less than par at maturity) which would imply some sort of govt insolvency or lack in their ability to back this paper. That’s a big stretch in my opinion.

  • http://www.pragcap.com TPC

    Deflation and inflation is not a psychological event in the same way that stock prices are influenced by bullishness and bearishness. This is not a case of too many people in the same boat. In fact, I would argue that deflation tends to snowball. If everyone believes in deflation then everyone believes prices will fall further which means they will be hesitant to spend. This is the trap that is deflation. It is what every central banker fears. When deflation becomes as mainstream as you believe we will have likely lost the economic war by that point. Most asset markets tell me that most participants are faithful that the Fed will still be able to inflate us out of this mess.

  • dis737

    What I am saying is the payments to Fannie and Freddie to cover their losses are “net new financial assets” that are being used to cover the guarantees on the GSE paper bought by the Federal Reseerve when they mature. They have already drawn $145B and I have seen estimates as high as another $500B. That capital is covering losses, it is not going to be paid back.

  • boatman

    that piece of line ben is pushing on is hockling…..my buddy’s nephew is still in his house 30 months later w/no payment…..zombie banks ya’ think?

    somewhat sadly,…..looks like i was right about tiger…..really it was human nature i was correct on….

  • Rob

    I don’t see any of this deflation that everyone is talking about. Looking at my normal weekly purchases, most are the same price as they were a year ago, and a few have gone up. Gasoline may be down a bit where I am. Overall, I would estimate that prices are about 2-3% higher than a year ago for the things that I normally buy.

    I think that most of these deflation warnings are coming from the financial industry, which would really, really, like another shot of free liquidity courtesy of Uncle Ben. “Buddy, can you spare a trillion?”

  • boatman

    food and energy were dropped from the CPI to screw the old people on social securuty raises.

    debt-class assets are deflating, consumptive items are going up.

  • Mike J

    Do you mean go all the way back before 1913 or just return to a form of fascism that profits you? F. Beard

    I apologize if I was a bit too insistent on my soapbox this morning but the persistent deterioration of our economy is a consistent disappointment. As for what profits me, I would only say I think we should all want what’s best for the country. There has never been a perfect age of free market liberalism. Even under Ronald Regan we had a Chrysler Bailout and have been throwing good money after bad ever since. I just think net-net we should make rational progress.

  • Mike J

    If a private enterprise miss allocates resources they go bankrupt. This has proven to be an effective incentive and has produced results. As you pointed out the government can’t go bankrupt. They don’t have this incentive toward proper allocation. Additionally, political pressures push them towards goals that are at odds with efficient allocation of resources. In order to maximize efficient allocation of resources we should minimize government spending.

  • ron

    QE may be the greatest nonevent but any future hyperinflation could be the worst event . US worldwide projection of power would fall commensurate with a currency collapse . There is currently no other entity that could adequately compensate ( ie. project enough worldwide power quickly enough ) for a sudden US collapse of power – not even China . Such a collapse would constitute a power vacuum that historians maintain is a major percursor of warfare . Any collapse of the world’s foremost superpower could precipitate WWIII – may God forbid .

  • jt

    possibly this is what one should think about before quoting and debating opinions and not facts!
    http://www.youtube.com/watch?v=zORv8wwiadQ&feature=related

  • jt

    Since you are in support of tax cuts i would like to ask the following questions:
    1) do you believe Bush tax cuts should be extended and how we ll did they work thus far?
    2) what is your view on the http://www.usatoday.com/money/perfi/taxes/2010-05-10-taxes_N.htm
    3) http://www.ritholtz.com/blog/2010/08/tax-base-as-of-gdp/
    4) http://www.ft.com/cms/s/2/1a8a5cb2-9ab2-11df-87e6-00144feab49a.html
    5) Any thought/comments on GINI coefficient http://www.zerohedge.com/article/path-socialist-prosperity-charting-distribution-income-within-countries
    I would appreciate any comments.

  • http://www.pragcap.com TPC

    JT,

    Which are you? Are you a hyperinflationist? Or are you a defaultista? Or something else? I lay my cards on the table each and every day so before you go demanding answers lets see your cards….Thanks.

  • http://www.pragcap.com TPC

    Apparently, there were not enough facts in this piece of research for JT….But in typical fashion he offers not a single counterargument….

  • Mikie

    100% agree with all this. The populist press and the “Gold 5,000″ bugs all love the “printing money” term, yet fail to recognize (because it would debunk their whole thesis) that not 1c of new money has entered the system.
    Further, lets put some perspective on the numbers. 1.5trn$ of new balance sheet at the Fed is the size of 1 Citibank. Coupled with the deleveraging of most banks out there, the Fed is just picking up the slack in the system. A new bank so to speak, as the others get smaller

    The Gold bugs etc will hang onto the “printing money” myth for as long as they can. They will continue to short Tsys and buy Gold. I think its fair to say though, these trades are looking more vulnerable every day. The market is slowly figuring out that the risk of rampant inflation in the mainstream economy is a pipe dream

  • Max

    slightly_skeptical, the Treasury is completely in control of its funding. It can issue 100% short term debt if it wants, and since t-bills are interchangable with bank accounts, this is the same operation as “quantitative easing”.

  • JKAR

    Not quite sure I understand. How is it just a swap of an existing asset for another? When I see charts of the Fed’s balance sheet and a sharp expansion/rise of that value, how is it a swap? It it’s simply an exchange of one asset for another, then the balance sheet shouldn’t “expand” as often claimed by other economists? How does one interpret this issue of balance sheet expansion on the part of the Fed.

    thank you for your answer.

  • jake wood

    i agree with jkar, how can you can it a swap when the end result is the fed’s balance sheet expands? a swap of assets would have no effect on the total balance sheet. It seems obvious to me that the fed is expanding its balance sheet by printing money which it then uses to buy treasuries or whatever. Otherwise please explain where the fed gets the assets to buy the treasuries?

  • jake wood

    how can you call it a swap when the end result is the fed’s balance sheet expands? a swap of assets would have no effect on the total balance sheet. It seems obvious to me that the fed is expanding its balance sheet by printing money which it then uses to buy treasuries or whatever. Otherwise please explain where the fed gets the assets to buy the treasuries?

  • http://www.pragcap.com TPC

    How does the government create money? They just do. These banks used cash to buy bonds at some point from the Fed. So now, they’re just getting cash in exchange from the Fed. The Fed is not adding net new money to the system. Just as in Japan, the only net new money will be due to government spending over private sector debt extinguished. Is that clear?

    Sorry I missed the comment earlier. I don’t see comments when posts have been moved back 24 hours….

  • jake wood

    how does the government create money? they just do. yes i understand it is called a printing press. you may call it electronics blips but there is no difference. there was no money and then there is. it is a powerful position to be in. but then you turn around and say the fed is not adding net new money to the system, that is where you lose me. if the fed has a hundred dollars balance sheet and buys bonds for a hundred dollars and then has a two hundred dollar balance sheet, where did the additional one hundred dollars come from? cetainly looks like new money to me.

  • JKAR

    Thank you TPC and Jake Wood for the comments. It seems I still am confused and side with Jake on the issue. If I understand TPC, the Fed balance sheet must then include the bank balance sheets. But would then not be the Adjusted Monetary Base? And like the Fed balance sheet, the AMB has also expanded if I read the charts correctly. So again, not sure how there can be a swap without the creation of new money. Even Bernanke believes in the printing press.

    Oh well, thanks again.

  • Rob

    I don’t believe that inflation and deflation move quickly back and forth like the stock market, but inflation and deflation are psychological events. You said it yourself. What matters more than even the base money supply is what people expect to happen. The Fed can push on a string all it wants, but if everyone expects deflation the Fed can’t force inflation. Money won’t move, it will just sit there idle.

    In the late 1970s and early 1980s, people expected further inflation even as the Fed was extrordinarily restrictive with the base money supply and interest rates. People still begged to take out loans at 15%-20% interest rates. That would make no sense whatsoever unless inflation continued in the teens which must have been the general expectation. Now demand for loans (at least among credit worthy borrowers) has collapsed even though interest rates are at record lows. The situation turned extremely quickly in 1982 as inflation fell dramatically and interest rates followed. What is to say that we don’t see a dramatic pivot point at some time in the near (1 month to 2 years) future? I bet sometime in the next two years that we see 10Yr yields rise as quickly as tell fell from April to today. 150 basis points in a few months. When the turn comes it won’t likely be a gradual shift, it will be headsnappingly quick. Bonds will collapse and the bears might finally get the stock market crash to new lows that they have been wanting.

    Maybe turning from inflation to deflation is not correctly stated as turning on a dime, maybe it is more like an ocean liner turning in the middle of the night when no one notices except a few lone people who are out watching the stars.

  • Mountaineer

    TPC,

    You’re right, you should be proud of this post. It’s a beautiful example of how an analytical ass-whippin’ should be done. I told you the comments would be interesting, you underestimate how obscene your concepts are to many people. The herd has a lot of momentum. Keep up the great work, the effort and insight are greatly appreciated!

  • http://ae911truth.org I1

    From Wikipedia- “quantitative easing”

    “The term quantitative easing (QE) describes a form of monetary policy used by central banks to increase the supply of money in an economy when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero. A central bank does this by first crediting its own account with money it has created ex nihilo (“out of nothing”).”

    From Investopedia-

    “The major risk of quantitative easing is that although more money is floating around, there is still a fixed amount of goods for sale. This will eventually lead to higher prices or inflation.”

    There it is, plain and simple and not from some sc*mbag goldman trader.

  • http://www.pragcap.com TPC

    Wikipedia? Be careful where you get your financial information from. I can explain to you the exact mechanics of this operation known as QE. The Fed is not adding net new financial assets to the system. They are merely swapping assets with the private sector. You’re double counting the “ex nihilo” money as if it is part of the money supply. It is not. Wikipedia needs to update their definition so that the hyperinflationists can sleep better at night.

  • http://www.pragcap.com TPC

    I am not sure if you saw my answer on the previous post, but there are no net new financial assets being created. The central bank is essentially buying back money that was previously spent into existence. You’re looking at the monetary base as if it is the money supply. No new money is created here. When the treasuries or MBS mature they will go poof! They net to zero. The Fed’s expansion of the balance sheet actually represents money that was previously spent into the private sector. That’s why there has been almost no inflationary impact from this incredible ballooning of the balance sheet.

  • ken

    hey, I would like to confirm my understanding. I’m still rather confused, and im inclined with Jkar and Jake.
    Firstly, when the Fed wants to do quantitative easing, they will increase the liability side of the BS, and the asset side of the BS with Deposits (thus increasing the size of the Fed’s BS). After which, it will use the “newly-created Deposits” to swap for the risky assets that are on the Bank’s BS, thereby reducing the risk on the banks, increasing the bank’s reserves, and finally allowing them to lend more.
    If my understanding is correct, what is the name for the liabilities created on the Fed’s BS?
    What is the monetary base? Isn’t it the amount of US dollar notes printed and floating around in the economy and according to the charts, the monetary base has increased tremendously in 2009 because of the QE.
    Thanks

  • ken

    Adding to my above post. Am I right to say that although the Fed added deposits (essentially Cash) into the Bank’s Balance Sheets, the banks were not able to lend out due to capital reserves requirements. As a result, the Bank reserves were kept on their balance sheet. This resulted in the sudden increase in Adjusted Total Bank Reserves, Monetary Base. Hence, only when the banks are able to lend using the newly created reserves, will inflation happen.

  • Max

    ken, banks lending is limited by the demand for loans. Normally the Fed could cut interest rates to induce people to take on more debt, but this doesn’t work once the rate hits 0%. It’s an unstable situation of self-fulfilling expectations. If people expect inflation, then they will borrow, causing inflation. If people don’t expect inflation, they will hoard cash, and there won’t be inflation.

  • Aldous Huxley

    When the FED conducts QE, it creates dollars that did not exist, and it exchanges them for assets currently held by others. While it may be an asset swap experience for those who sell their junk bonds, and are then holding cash. But for the system itself it is money printing.

    Does the FED take dollars from some other entity, to conduct this asset swap? No. It doesn’t.

    It’s a monetary event. Period.

  • The Prudent Bull

    @TPC and others following this article this is not news. Ben Bernanke, Tim Geithner, and Obama had told this all before and it was scripted like the following:
    Mad Hatter: Would you like a little more tea?
    Alice: Well, I haven’t had any yet, so I can’t very well take more.
    March Hare: Ah, you mean you can’t very well take less.
    Mad Hatter: Yes. You can always take more than nothing.

    Regardless of what they buy, regardless of how many currency swaps they send to the ECB, and regardless of what the CNBC propaganda machine has to say…Deflation is here and will take over the economy. Just keep taking more and more of nothing. Let us just shut up and drink the tea!

  • Jojo

    “The Fed simply electronically swaps an asset with the private sector.”

    Correct, the Fed purchases WORTHLESS mortgages which will eventually be written off. Once written off, this is government DEBT as the asset will have went ‘poof’. Thus, the government has created money out of thin air.

  • http://www.pragcap.com TPC

    That’s simply not a true statement by any means. Most of these mortgage bonds were not worth zero. Many of them were pseudo govt guaranteed and many of the other assets they’ve purchased were govt guaranteed. This gets back into the whole USA solvency issue which is sheer nonsense.

  • Jojo

    My understanding of QE is that it is a SEIZURE of assets.

    You have 3 houses, and 3 100,000 dollar bills in an economy, where each house is worth 100,000.

    The Fed removes 1 house or ASSET from the system, and does not add any new dollar bills as this article states.

    Thus the economy adjusts and suddenly the 2 houses left cost 150,000 each.

    No new money was printed, but the dollars in the system are now worth less in real terms.

  • Jojo

    “We have Ben Bernanke, who is running the Federal Reserve, who does not know what he is doing. The man is taking 400 billion dollars on to the Federal Reserve balance sheets – of dicey loans, bad debt. I mean he is turning the Federal Reserve into a pawn shop. Some day somebody has to pay for this and you know who this somebody is – my little girl, you, me.”

    – Jim Rogers

    Rogers seems to agree with me that they are taking on WORTHLESS assets.

  • jake wood

    TPC said ‘The central bank is essentially buying back money that was previously spent into existence’. I have no idea what that means?
    This much seems clear to me: the fed is buying bonds, the fed must pay something ie cash. Where does the cash come from? Either it already exists in the fed balance sheet in which case there would no expansion of the balance sheet just an exchange of assets as TPC keeps saying or the fed prints up new money which it then uses to buy the bonds which results in a larger balance sheet. It seems to me the latter is what the fed is doing as we can all see the Fed balance continuing to grow. TPC, you seem to speak in riddles to avoid the obvious answer. The FED is printing money.

  • http://www.pragcap.com TPC

    It’s actually quite simple. The Federal govt already created the money that is in the system. This money, which the banks previously used to buy MBS or Treasuries is what the Fed is effectively buying. When the govt wants to buy something from the private sector they just do. They press a button on a computer and buy it. In this case, they are merely swapping an asset out with the private sector. No net new money is actually being added to the system. You’re counting the Fed’s balance sheet as net new money. It is not. You have to think of the private sector as a closed system. If the Fed is just buying an asset from the banks then are they really adding net new money to the system or is it just a swap? It’s just a swap. All the Fed does is alter the quality of the bank balance sheet. Nothing more.

  • http://www.pragcap.com TPC

    Mr. Rogers is assuming that these assets are worthless. As I said above, this gets into the argument over govt solvency because you’d have to effectively convince everyone that Fannie and Freddie are insolvent (which they might be), but that they have run out of money (which is really impossible because they are govt backed).

  • jake wood

    TPC okay you are saying the Fed is outside the system and the assets the fed holds don’t count as part of the system? So assume a $100 system and the Fed buys $50 of bonds and puts $50 of cash in the system ie no change to total assets of the system. Assuming the fed pays fair value for the bonds, i agree it is an asset swap. Assuming that when the bonds mature, the fed collects its $50 and retires the cash, then i see what are you saying the fed cannot effect the total assets in the economy. But if the $50 of bonds default to $25, then hasn’t the fed bailed out the bondholder?
    Also doesn’t the fed action create liquidity in the system and result in asset inflation when the former bond holder looks for another investment for his cash?
    Thanks for your help.

  • http://www.pragcap.com TPC

    That’s essentially correct. And yes, if the Fed bought an asset and it defaulted then the govt would effectively be adding net assets. But as I described below, the Fed is projected to make a profit on these assets so you could actually argue that the Fed is removing profits from the private sector. Plus, I think it’s pretty difficult to argue that these assets are worthless now (considering that much of it is govt guaranteed or pseudo guaranteed).

    I hope that helps and thanks for sticking with me through the explanation. This is confusing stuff.

  • kevin

    To TPC,

    If monetary stimulus is ineffective, and fiscal deficits are already too high (thus, no room for efficient fiscal spending or tax cuts), how is the U.S. going to resolve the negative impacts of disinflation (or deflation) and negative (or very low) real economic growth caused by the private sector deleveraging its debts? Asset prices in general do not have a favorable outlook under such scenario.

    And how far down the road is it before the U.S. private sector balance sheets are repaired?

    Thanks.

  • Andrew

    Hi,

    I am really struggling with the wording of the following:

    >>JJ Lando a bond trader at Goldman Sachs has eloquently described QE:

    “In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”

    Surely this should read ‘the Fed converts privately held treasuries into overnight reserves?’ Ie it makes more liquid an already quite liquid asset – which must have limited impact and yet……there is an impact in providing liquidity.

    Also to say it is an asset swap to buy treasuries with reserves seems a bit odd from the Feds viewpoint. The fed buys the treasuries with its liability.

    It is only an asset swap from the economies point of view.

    If the feds were buying gold with their liabilities would people still say they are not printing money? Even James Bullard describes QE as ‘money printing – if you want’

  • Eryk

    I appreciate that you’re trying to clarify a convoluted monetary transaction, TPC, and I know I’m late to this party, but it would help if you traced the creation of this money from start to finish in detail, so I could be more certain what you’re on about here.

    For starters, this is my current conception of the process:

    The government issues a bond to raise cash, which it then spends back into the economy. Along comes QE, and the Fed buys the bond back with cash that it creates ex nihilo by crediting its own account. At this stage, the banking system has twice as much cash as the value of the bond. Finally, the bond matures and the government uses tax revenue to pay it off. The Fed absorbs this cash just as it emitted it in the QE stage. This leaves the original cash in the banking system that was used to purchase the bond in the first place. Thus no money was created. However for a spell, there was twice as much liquidity in the system. Also, I think I see how QE can actually take profit out of the system since the Fed will remit the interest earned on the bond back to the government, whereas the original holder of the bond would have taken that as profit, no?

    Well, if I

  • Eryk

    I appreciate that you’re trying to clarify a convoluted monetary transaction, TPC, and I know I’m late to this party, but it would help if you traced the creation of this money from start to finish in detail, so I could be more certain what you’re on about here.

    For starters, this is my current conception of the process:

    The government issues a bond to raise cash, which it then spends back into the economy. Along comes QE, and the Fed buys the bond back with cash that it creates ex nihilo by crediting its own account. At this stage, the banking system has twice as much cash as the value of the bond. Finally, the bond matures and the government uses tax revenue to pay it off. The Fed absorbs this cash just as it emitted it in the QE stage. This leaves the original cash in the banking system that was used to purchase the bond in the first place. Thus no money was created. However for a spell, there was twice as much liquidity in the system. Also, I think I see how QE can take profit away from the banking system since the Fed will remit the interest earned on the bond back to the government, whereas the bank would have taken the interest as profit. But that doesn’t affect how much cash is in the system, just who’s holding it (the tax payer vs the bank).

  • Eryk

    Sorry about the accidental submission of an incomplete post. I won’t mind if you delete it. Being able to do that myself would be nice, but I didn’t have cookies enabled yet for this site.

  • Willy2

    Quantitative Easing only helps to push interests rates lower. But once rates are going up across the board even the QE won’t help anymore.