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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Comments

  1. 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”.

  2. 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.

    • 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….

      • 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.

  3. 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?

    • 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.

      • 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.

        • 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.

          • 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.

            • 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.

              • 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.

  4. 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!

  5. 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.

    • 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.

  6. 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

  7. 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.

  8. 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.

  9. 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.

  10. @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!

  11. “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.

    • 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.

      • 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.

  12. “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.

    • 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).

  13. 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.

  14. 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’

  15. 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

    • 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.

  16. 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).

  17. 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.