- Money Creation In the Time of Quantitative Easing or Q.E.
- The Federal Reserve is Living Dangerously With All These Excess Reserves
- Is Quantitative Easing (QE) 4 Stimulative?
- I’m Positive Negative Interest Rates Won’t Work
- The Risks of Quantitative Tightening
Money Creation In the Time of Quantitative Easing or Q.E.
The political season is upon us. And with Thanksgiving just around the corner, complete with turkey, stuffing, and football, you might find yourself in the middle of a heated family debate about politics and money.
One family member who is an Ayn Rand fan and watches Fox News faithfully might start squawking about how the government is printing all this money and sinking us into a big hole. He might argue with another family member, who happens to be a fan of the New York Times columnist and Nobel Prize laureate in economics, Paul Krugman.
Krugman has been adamant since the 2008 financial crisis that the government should be spending more money. This view stems, in part, from a belief that the government, not commercial banks, can boost the amount of cash in the economy.
He is not alone. Many people see money and banking as similar to how the field is idyllically portrayed in the movie, It’s a Wonderful Life. In the film, Jimmy Stewart’s S&L takes in deposits and lends them out to individuals in the community.
In the real world, the opposite happens. Banks create money when they make loans. That is why lending is called “credit creation.” In fact, what separates capitalism from other economic systems is that private debts created by banks circulate as new money.
For example, say a person takes out a $50,000 home equity loan. Here, a bank creates a deposit of $50,000 and credits that person with a loan for the same amount. The customer then spends the money, and a private agreement between the bank and the customer results in new money entering the economy.
The Bank of England, the U.K.’s version of the Federal Reserve, estimates that bank deposits produce 97% of the U.K.’s money. Moreover, the loan-generating function of the private financial institutions described above provides most of those deposits.
So, I should tell my Paul Krugman-loving cousin, aunt, or sister-in-law that banks make money out of thin air? Yes, and most money in the economy was created by the banks’ magic wands, not the government.
And what if your Fox News-loving cousin, uncle, or brother-in-law argues that quantitative easing (QE) is government money printing? The Federal Reserve is the government’s bank, so it can create money. So it has gotten into the money creation business with quantitative easing or QE.
In capitalism before QE, the government’s role in creating new money was limited. Instead, it mostly moved around cash, funded itself by collecting taxes or selling government bonds, and then spent that money back into the economy.
Our government’s primary role was backstopping bank-produced money. That is what happened during the financial crisis in 2008. The banking system froze after a five-year bank money-printing binge that doubled total mortgage debt from $4 to 8 trillion. As a result, healthier banks were unwilling to honor the payments made by customers of weaker banks. So the government had to decide whether to allow the more vulnerable banks to fail, which could have brought down the entire financial system or guarantee the bank money.
So what does this mean for this made-up barbecue beef? Both combatants are right. Government spending is increasing the money supply because the Federal Reserve is printing money to buy back that debt using commercial banks’ deposit-making functions.
When the Federal Reserve buys a bond from a nonbank, the seller’s bank credits them with a deposit. The Federal Reserve then offsets that deposit by providing that bank with equal reserves. That deposit is new money since no one’s bank account gets reduced by the amount.
Sometimes, though, too much bank money flows toward existing assets, and you get the debt but not the dynamism. In the last economic cycle bank debt fueled a housing bubble, and, it seems in this period, bank money helped fuel a stock buyback binge and maybe a stock market bubble.
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted on as individualized investment advice.
Keen, Steve. “Nobody Understands Debt — Including Paul Krugman.” Forbes / Investing, Feb. 10, 2015. http://www.forbes.com/sites/stevekeen/2015/02/10/nobody-understands-debt-including-paul-krugman/
McLeay, Michael, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate. “Money Creation in the Modern Economy.” Bank of England Quarterly Bulletin, 2014, Q1. https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy
WashingtonsBlog. “Bank of England Admits that Loans COME First … and Deposits FOLLOW.” Washington’s Blog, March 20, 2014. http://www.washingtonsblog.com/2014/03/bank-england-admits-loans-come-first-deposits-follow.html
The Federal Reserve is Living Dangerously With All These Excess Reserves
Starting in 2009, the Federal Reserve added a couple trillion dollars of new money to the economy through a quantitative easing program of buying bonds from banks and non-banks. Now the Feds reportedly want to reduce their balance sheet by selling those bonds.
Selling bonds to banks will extinguish excess reserves—a non-event. If, however, non-banks buy those bonds, it will decrease the money supply, which may hurt the economy.
What’s been happening over the past few years
During the period when QE was in effect, the Feds bought a total of $4.5 trillion in bonds from banks and non-banks. Even though the Feds stopped QE in 2014, they continued to buy bonds with any proceeds they had received when a bond had matured.
Remember, when a bond matures, its owner receives payment from the issuer for the bond’s face value. Up until now, the Feds have been reinvesting that money back into the economy.
J.P. Morgan Warns Banks
In a May 8 story, Bloomberg Markets reported on investment bankers at J.P. Morgan hoping to drum up business by confidentially urging small and mid-sizes banks to merge in order to fend off the risks associated with the Feds selling bonds back to the marketplace.[i]
The investment bankers are warning that, when the Feds sell bonds to non-banks, the buyers will pay with bank deposits. Moreover, unlike everyday transactions, in which a seller deposits any proceeds into the bank, this time the Feds will extinguish the money, leaving the banks without the deposits needed to fund loans.
By warning that the shrinking deposits could cause lending to slow, the investment bankers are getting the relationship between lending and deposits wrong: lending creates a deposit, not the other way around. Thus, any risk to mid-sized and small banks is due more to the shrinking of the money supply causing a recession than a lack of deposits to fund loans.
Why Would Anyone Buy Bonds?
This is especially true for non-banks that are sitting on cash they had received from selling bonds to the Feds or to institutions that already bought financial assets with proceeds from bond sales. Why would those non-banks buy bonds now, when the Feds are saying the economy is getting better, and when interest rates are going up? (Remember, bonds do poorly when interest rates go up.)
Furthermore, why would banks want to use their excess reserves to buy bonds when the Feds are forced to pay them more interest each time the Fed fund’s rate is raised? (Currently, banks earn 1% on their roughly $2 trillion of excess reserves.)
Why the Fed Pays Banks Interest
In normal circumstances before the 2008 financial collapse, the Feds did not pay banks interest on reserves. So banks kept only what was required by law, thus making it easier for the Federal Reserve to control interest rates. Now with two trillion of excess reserves, the Fed must pay banks interest on them, if they didn’t banks would lend them to other banks making it impossible for the Fed to influence interest rates.
The second half of this year should be interesting
The Feds seem primed to raise rates again in June. Plus, they seem bent on selling bonds (will see if there are any buyers) to reduce their balance sheets. Each of these moves may destabilize the economy, and both demand investors’ attention.
[i] Monks, Matthew, “JPMorgan Tells Banks to Partner Up as U.S. Deposit Drain Looms,” Bloomberg Markets, May 8, 2017, https://www.bloomberg.com/news/articles/2017-05-08/jpmorgan-tells-banks-to-partner-up-as-u-s-deposit-drain-looms
Is Quantitative Easing (QE) 4 Stimulative?
Beginning in October 2019, the Federal Reserve started buying $60 billion a month of treasury bills, which are short-term government bonds.
Because the bonds are short-lived, the Federal Reserve has been adamant that this new bond-buying program is not QE 4.
One critical point about QE is not what the Fed is buying but from whom they are buying.
When they purchase treasuries from banks, banks get more reserves per non-event; however, when they buy from a non-bank, the Fed receives a bond (an asset) offset with reserves (a liability). Commercial banks get reserves (an asset) offset by a deposit (an obligation).
That bank deposit is no different than what the seller of the bond would get if they took out a new loan. It injects dollars into the economy because nobody’s bank account gets reduced.
In typical business transactions, the purchaser of a bond or any other financial asset sees their bank account drop by the amount paid. Money moves around but is not created, not so with QE. Because the Fed creates new money, nobody sees their bank account fall by the amount of the purchase.
Reserves and Deposits
This connection between reserves and deposits is, in part, why negative interest rates won’t work. Why would banks create deposits that they may have to pay interest on when the reserves received from the central bank to offset the deposit are subject to a negative interest rate?
Here in the U.S., commercial banks make interest on their excess reserves. And if the interest rate is higher than what they are paying to their depositors, QE leads to higher profits.
Does QE Juice the Stock Market?
There is no way to know for sure. Still, when the Fed adds money to the economy by buying bonds from non-banks, the stock market seems to go up. When they subtracted cash from the economy by not reinvesting mortgage payments (quantitative tightening), it went down.
Has the Fed Stumbled upon Continual Economic Growth?
Keep providing money (QE) to the economy by buying assets from nonbanks. As money continues to fund financial assets, labor gets little of it. Does this mean inflation will remain tame? The wealth effect dictates that rising stock prices will result in wealthy investors spending more, causing the economy to grow.
What could possibly go wrong?
I’m Positive Negative Interest Rates Won’t Work
There is much talk in the financial press about ‘negative interest’ rates—which adds yet another oxymoron to a list that includes ‘Great Depression,’ ‘jumbo shrimp,’ and ‘open secret.’
It is a head-scratcher that a person could deposit $1,000 at their bank and get $995 back. Were that true, they might as well have kept their money under the proverbial mattress.
The European Central Bank, Sweden, Denmark, Switzerland, and Japan have all implemented some form of ‘negative interest.’ None of these countries or regions, however, has seen commercial banks charging their customers for depositing money.[i]
Instead, what the financial press is referring to is another desperate, misguided attempt by the Central Banks of these countries to increase bank lending. What they are hoping for is, if they charge banks for depositing money, banks will decide to make more loans to earn more interest rather than leave their money at the Central Bank and watch it deplete from deposit fees.
However, we had seen this scenario before, when the Central Banks of the world instituted quantitative easing. Here in the United States, bank reserves jumped from $46 billion in 2008 to around $2.7 trillion today. During this time, respected economists, journalists, and politicians opined about possible inflation caused by commercial banks lending those recently acquired reserves.[ii]
For example, on January 3, 2013, former Senator, Phil Gramm and Stanford Economist, John Taylor wrote in the Wall Street Journal: “with banks holding excess reserves rather than lending them out–and with velocity at a 50-year low and falling–the inflation rate has stayed close to the Fed’s 2% target.” [iii]
Also, in the Journal that same month reporters Jon Hilsenrath and Kristina Peterson wrote: “One reason the hawks have been wrong about inflation is that the money that the Fed has pumped into the financial system has tended to sit at banks without being lent to customers” [iv]
Inflation never happened, because the theory that reserves multiply into loans—the so-called ‘money multiplier’—is a myth. A vestige of a time when countries were on the gold standard and, theoretically, the amount of gold a Central Bank owned dictated commercial bank lending.
In today’s world, the number of reserves that banks deposit at their Central Bank has almost no bearing on credit creation. Nor can the banking system reduce the total amount reserves by making loans.
Say I borrow $100,000 from Bank A. Along with the loan, Bank A will credit me back with a deposit for $100,000. If, the next day, I move the $100,000 from Bank A to Bank B, I will still have my $100,000 loan with Bank A, but the money will now reside in Bank B.
Bank A will then transfer $100,000 from their reserve account at the Federal Reserve to Bank B’s reserve account. Bank A will have less money earning negative rates; however, Bank B will have an extra $100,000 exposed to negative rates. Thus, making a loan will merely move reserves from one bank’s reserve account to another bank’s reserve account.
I am not one who believes that Central Banks are evil or that we need to audit our own Central Bank—the Federal Reserve. But a central bank penalizing banks for having too many reserves, when it was the Central Bank’s bond purchases (quantitative easing) that had credited the banks with the reserves in the first place, brings to mind a famous quote from a famous but misguided economist, Karl Marx, that history repeats itself “the first time as tragedy [financial crisis], the second time as farce [negative interest rates].”[v]
But if the economy continues to slow, or goes into another recession, and our Central Bank, the Federal Reserve, joins other Central Banks and implements negative interest rates, the ineffectiveness of that policy might create the opening for what Thomas Kuhn, in his famous book The Structure of Scientific Revolutions, called a paradigm shift.[vii] Away from a finance and banking based economy to one built on the blocking and tackling of economic growth: entrepreneurship, education, manufacturing, investment, and infrastructure.
[i] Random, Jana, and Simon Kennedy. “Negative Interest Rate Less Than Zero.” BloombergBusiness, January 29, 2015. http://www.bloombergview.com/quicktake/negative-interest-rates
[ii] Sheard, Paul. “Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves.” Standard & Poor’s Rating Services, August 13, 2013.https://www.kreditopferhilfe.net/docs/S_and_P__Repeat_After_Me_8_14_13.pdf
[iii] Sheard, Paul. “Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves.” Standard & Poor’s Rating Services, August 13, 2013.https://www.kreditopferhilfe.net/docs/S_and_P__Repeat_After_Me_8_14_13.pdf
[iv] Sheard, Paul. “Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves.” Standard & Poor’s Rating Services, August 13, 2013.https://www.kreditopferhilfe.net/docs/S_and_P__Repeat_After_Me_8_14_13.pdf
[v] Marx, Karl. “The Eighteenth Brumaire of Louis Napoleon.” Die Revolution, 1852.
[vi] Woodward, Bob. Maestro: Greenspan’s Fed and the American Boom. New York: Simon & Schuster, 2000.
[vii] Kuhn, Thomas S. The Structure of Scientific Revolutions. Chicago: University of Chicago Pess, 1962.
The Risks of Quantitative Tightening
Quantitative easing (QE) became quantitative tightening (QT) in October 2018. That was when the number of treasuries and mortgage-backed securities (MBS) not being reinvested ($50 billion per month) by the Federal Reserve was close to the level of maturing treasury bonds and mortgage payments from homeowners.
QT is similar to what would happen if somebody who was paying your bills suddenly stopped doing so and started to reduce your bank account by the total amount of bills previously paid.
Before that, QE remained in effect as the Fed continued to purchase new treasury bonds with the proceeds from maturing bonds. The reinvestment of maturing treasuries into new ones was, in many ways, more stimulative than the original QE, because this time the Fed could use the proceeds from maturing bonds to purchase new government debt directly.
Regarding mortgage-backed securities, the Fed has barely reduced its $1.7 trillion of them, reducing them by only 5% over the past 12 months. However, that reduction ramped up in October, when the Fed stopped buying new MBSs.
Since switching to QT, the Dow Jones Industrial Average has been down 16%, the S&P 500 has dropped 18%, and the NASDAQ has fallen 22%.
Why not just stop QT, then?
The Fed might do that. After current Fed Chair Jay Powell pooh-poohed that idea, the stock market tanked. A few days later, New York Fed President John Williams, in an attempt to clean-up Powell’s remarks, said the Fed could stop QT in 2019 if the situation warranted that action.
Stopping it would make the U.S. more likely to evolve into a Japanese type of economy in which, to generate economic growth, the government’s bank must create money to buy the government’s debt.
Right now, Japan’s Central Bank owns almost $4.24 trillion in Japanese government bonds – a ratio of 100% to the gross domestic product (GDP). When that happens, the economy stops being capitalistic, where banks create the public’s money supply, and morphs into a zombie-like economic system, whereby the government’s central bank funds the government with government-generated money.