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QE2 and "Money Printing"

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May 12, 2011 – Comments (15)

My position has been (contrary to many other published thoughts) that QE was not in fact "money printing" in the sense of how it is normally defined, which goes like: the Fed printed billions of dollars out of nowhere and exploded the monetary base and that this added a slew of new dollars to the system and is therefore inevitably inflationary.

Did the Fed print new dollars out of nowhere: Yes.

But in doing so the Fed used those newly printed dollars to buy Treasury bonds in the Open Market. The Fed created a new dollar (asset for the market, liability for the Fed) out of thin air. But then didn't dump them on the market (free money that was given away), it bought Treasury bonds and removed those bonds from the market. So you can see that it was nothing more than a swap from the markets perspective. No new net financial assets were created.

And technically a deflationary swap since the dollars don't pay interest, and the Treasury bonds did. Interest bearing assets were removed from the system and replaced with non interest bearing assets.

Did the monetary base explode (M0 and reserve balances)? Yes.

... So what?

Like I have explored and demonstrated in the past (see links below) and as have many people that understand the banking system, banks are not reserve constrained. The money multiplier model is a myth. When a bank wants to lend, it simply lends. It tries to find reserves after the fact. Either on the open market or at the Discount window. Since the Fed controls the discount window, there is always a source of reserves. The only thing that changes in this case is the "price" of reserves (the interest rate that they will fetch on the interbank lending network). This is the overnight rate that the Fed manages. Either buy buying or selling Treasury bonds in its portfolio (which either adds or drains reserves respectively).

Since there is a large excess of reserves in the system right now, all it means is that short term interest rates will be low for a very long period of time. Because a healthy bank doesn't want excess reserves (reserves are not lent out), they are just an asset that pays 25bp. They would much rather buy a Treasury bond with it, since it pays interest. This is why there is an interbank market for lending reserve, because when there is a deficit of reserves, the short term interest rate gets bid and is repsonded to by the Fed. Because there is a large surplus of reserves, there is no competition for them and the interest rate will then remain low.

As I stated in my last detailed posts on QE, the only thing that it encouraged was a long of speculation. See (Follow Up: QE is not Inflationary, Thoughts on Risk Asset Instability - http://caps.fool.com/Blogs/follow-up-qe-is-not/533092) and (One of the smartest comments I have read yet regarding Quantitative Easing - http://marketthoughtsandanalysis.blogspot.com/2011/02/one......).

It is no secret or wonder than margin debt (leverage, not an inflationary phenomena) has exploded: http://caps.fool.com/Blogs/more-margin-debt-please-no/579298. It is this speculative mentality regarding the misunderstading of QE rather than 'money printing' that has sustained this rally across nearly every asset class for the last several months.

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QE2: Captblogain, your ship is sinking
Warren Mosler

http://moslereconomics.com/2011/05/12/qe2-captblogain-your-ship-is-sinking

So imagine the corn crop report comes out and it surprises on the upside at up 30%
What happens? The price of corn probably starts to fall. Commercial buyers back off, farmers rush to hedge, and, overall, players of all ilks try to reduce positions, get short, etc.

A few weeks later it’s further confirmed that the farmers are producing a massive bumper crop.

What happens? The same adjustments continue.

But what if that crop report was wrong? What if, in actual fact, there had been a crop failure? And market participants never do get that information?

What happens? Prices go down for a while as described above, but at some point they reverse, as sellers dry up, and as consumption overtakes actual supply price work their way higher, and then accelerate higher, even if no one ever actually figures out there was a crop failure.

QE is, in fact, a ‘crop failure’ for the dollar. The Fed’s shifting of securities out of the economy and replacing them with clearing balances removes interest income. And the lower rates from Fed policy also reduces interest paid to the economy by the US Treasury, which is a net payer of interest.

But the global markets mistakenly believed QE was producing a bumper crop for the dollar. They all believed, and some to the of panic, that the Fed was ‘printing money’ and flooding the world with dollars.

So what happened? The tripped overthemselves to rid them selves of dollars in every possible manner. Buying gold, silver, and the other commodities, buying stocks, selling dollars for most every other currency, selling tsy securities, etc. etc. etc. in what was, in most ways, all the same trade.

This went on for months, continually reinforced by the pervasive rhetoric that QE was ‘money printing’, and that the Fed was playing with fire and risking hyperinflation, with the US on the verge of suddenly/instantly becoming the next Greece and getting its funding cut off.

Not to mention Congress with it’s deficit reduction phobia.

So what’s happening now? While everyone still believes QE is a bumper crop phenomena, QE (and 0 rate policy in general) is none the less an ongoing crop failure, continuously removing $US net financial assets from the economy.

And so now that the speculators and portfolio shifters have run up prices of all they tripped over each other to buy, the anticipated growth in spending power-underlying aggregate demand growth needed to support those prices- isn’t there. And, to throw more water on the fire, the higher prices triggered supply side repsonse that have increased net supply along with a bit of ‘demand destruction’ as well.

Last week I suggested that higher crude prices were the last thing holding down the dollar, and that as crude started to fall I suggested its was all starting to reverse.

It’s now looking like it’s underway in earnest.

15 Comments – Post Your Own

#1) On May 12, 2011 at 11:31 AM, mtf00l (44.16) wrote:

I appreciate you article and blogging in general.

If you haven't realized yet, I'm a skeptic.  Until we are on the Federal Reserve board or on the equivalent of the Treasury board we will have no idea how it works, what they're doing or what the plans are.

Other than that great blogging!

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#2) On May 12, 2011 at 2:25 PM, binve (< 20) wrote:

Thanks mtf :)

>> If you haven't realized yet, I'm a skeptic.  Until we are on the Federal Reserve board or on the equivalent of the Treasury board we will have no idea how it works, what they're doing or what the plans are.

Fair enough.

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#3) On May 12, 2011 at 6:43 PM, rfaramir (29.51) wrote:

At least you admit this much, now:

"Did the Fed print new dollars out of nowhere: Yes." and

"Did the monetary base explode (M0 and reserve balances)? Yes." and

"the only thing that it encouraged was a long of speculation."

If speculation on margin is happening, that IS lending, isn't it? With reserves skyrocketing, the potential for an explosion in the money supply becomes a near certainty. Fractional reserve lending of those excess reserves can result in 9 * 1.4Trillion in new money supply. As you say, the "banks are not reserve constrained" right now. This is because they are not lending out those reserves, for fear of losing their capital on bad bets. Now that interest rates are so low and unemployment is so high, how many "good bets" are out there for new capital investment? Not many. They're scared spitless, or at least loanless. So they content themselves with 0.25% free money, for now. Once that fear subsides, look out.

And Bernanke won't be able to reign in the expansion like he thinks he can ("in 15 minutes"). What's he going to do, sell Treasuries to soak up liquidity at the very moment that the dollar looks like it is succumbing to hyperinflation? If he sells, China sells, Japan sells, the world drops the dollar as their reserve currency. He's done for.

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#4) On May 12, 2011 at 6:48 PM, rd80 (98.55) wrote:

But then didn't dump them on the market (free money that was given away), it bought Treasury bonds and removed those bonds from the market.

But the new money created by the Fed did get to the market either through being spent/distributed by the gov't after selling the bonds or by leaving dollars in the system that otherwise would have gone to buy the bonds that the Fed purchased.

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#5) On May 12, 2011 at 7:09 PM, binve (< 20) wrote:

rfaramir,

>>At least you admit this much, now:

??? I never denied it.

>>If speculation on margin is happening, that IS lending, isn't it?

Yeah, in the same way a bookie lends money to a gambling addict betting on the ponies. But the kind of lending that the Fed wants (increases in commerical loans, mortgages, small business loans, etc.) is not happing.

My point was, and still is, that nearly all of the activity since QE2 started has been speculative in nature.

It is not businesses taking out lines of credit to expand business, it is not people feeling like it time to refinance. And I am not saying they should. The last thing we need is a new credit expansion cycle.

The premise that that QE was somehow good for the economy is wrong,

The premise the QE is leading sustainable inflation expectations or hyperinflation, in the face a continued balance sheet recession is also wrong.

rd80 ,

That is the whole point. The new dollars got sold for bonds on the Open Market. There are no new net financial assets. The only thing that happened was that bonds were swapped for dollars.

So did QE give any more ammunition to the market to make more loans (because now they have more reserves)? No. If the bank wanted to make a loan before QE2, they would make the loan and they would get the required reserves after making that loan either by borrowing reserves from other banks, borrowing reserves from the Fed at the discount window, or selling Treasuries from their own portfolio in exchange for reserves.

Nothing has taken place that has enabled activity that couldn't take place before, and no new net financial assets were added to the system.

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#6) On May 12, 2011 at 7:37 PM, fhrgfrdd (< 20) wrote:


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#7) On May 13, 2011 at 1:21 AM, whereaminow (42.34) wrote:

Interesting read and discussion. Thanks binve!

David in Qatar

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#8) On May 13, 2011 at 8:30 AM, binve (< 20) wrote:

Thanks David!

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#9) On May 13, 2011 at 10:28 AM, rfaramir (29.51) wrote:

"The premise that that QE was somehow good for the economy is wrong"
Good, so we agree here.


“The premise the QE is leading sustainable inflation expectations or hyperinflation, in the face a continued balance sheet recession is also wrong.”
With that proviso, we can agree, but when the “balance sheet recession” is over, what then? Then the excess reserves explode into our money supply. But I agree, it won’t be immediately.


“the whole point. The new dollars got sold for bonds on the Open Market. There are no new net financial assets. The only thing that happened was that bonds were swapped for dollars."
Here’s where you’re wrong. If *I* swapped some bank’s bonds for *my* cash, the net effect is nil. I become less liquid, the bank becomes more liquid. Maybe the bank is more prone to speculation than I, but I suspect not, given my CAPS picks in commodities. :-)


But if the *Fed* ‘swaps’ cash for the bank’s bonds, the Fed has just created new net money in the economy. It doesn’t have a vault full of already-printed bills that it sends to the bank. It makes an accounting entry, creating the money electronically, and then hands it over in return for the bonds. The bank gets more liquid, and the Fed gets some government bonds for *free*. True, the Fed holds onto the bonds, so you might want to argue that they aren’t really “in the economy” the way the bank’s new cash is, but that ignores the fact that the bank’s bonds weren’t really “in the economy” either, they were stuck among the bank’s assets, which is exactly why they are more liquid after the ‘swap’. The bonds being held are not the issue, they are pretty much the same whether the bank or the Fed holds them (except that the Fed returns a large proportion of the interest they earn back to the Treasury, which ends up giving more coercive power to government, a bad thing). The ‘cash’ is where the difference is, unless you agree to let me counterfeit like the Fed, in which case it would be the same. But until then, please stop denying that the Fed creates the money used in the swap.


I’ll agree that that new money is currently sitting in the banks’ account with the Fed as excess reserves (mostly), so they aren’t *currently* contributing much to price inflation. But they are a weapon of financial mass destruction waiting to go off once banks start lending.

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#10) On May 13, 2011 at 10:31 AM, rfaramir (29.51) wrote:

Sorry, my last "please stop denying" should have been aimed at "No new net financial assets were created," not at "that the Fed creates the money used in the swap," since you DO admit that.

 

Those newly created dollars ARE a "new net financial asset." 

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#11) On May 13, 2011 at 11:23 AM, TMFAleph1 (96.14) wrote:

@rfaramir

Now that interest rates are so low and unemployment is so high, how many "good bets" are out there for new capital investment?

All other things equal, lower interest rates makes capital investment projects more attractive (higher NPV), not less.

And Bernanke won't be able to reign in the expansion like he thinks he can ("in 15 minutes"). What's he going to do, sell Treasuries to soak up liquidity at the very moment that the dollar looks like it is succumbing to hyperinflation? If he sells, China sells, Japan sells, the world drops the dollar as their reserve currency. He's done for.

The Fed removing money from the system by selling Treasuries doesn't mean the end of the dollar as a reserve currency. Where are all of China's and Japan's excess reserves going to go? The euro? The yen? IMF Special Drawing Rights? I don't think so. Furthermore, there are other mechanisms for reining in inflation, including increasing banks' reserve requirements or raising short-term rates.

As to whether Bernanke will get the timing right, I share your skpeticism regarding his confidence.

Alex Dumortier

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#12) On May 13, 2011 at 11:38 AM, binve (< 20) wrote:

rfaramir,

With that proviso, we can agree, but when the “balance sheet recession” is over, what then? Then the excess reserves explode into our money supply. But I agree, it won’t be immediately.

Excess reserves do not explode into the money supply. The money multipler model is demonstrably incorrect. There are many nations who have no reserve requirements at all. I discuss this at length here http://caps.fool.com/Blogs/follow-up-qe-is-not/533092.

A credit boom can happen regardless of the size of excess reserves. It is driven by demand not by supply.

This is why monetary policy has been specacularly ineffective during this crisis.

But if the *Fed* ‘swaps’ cash for the bank’s bonds, the Fed has just created new net money in the economy.

This is where you are wrong.

You can't look at any entity in the economy in isolation. The Fed does not simply print money and dump it on the open market. It prints money to manage the level of reserves, and can only buy something that exists already in exchange for those reserves. This is the crux of Open Market operations and I am suprised by how few people seem to understand this concept.

Here is the proper way to look at it: Assume for a moment that the Government via the Tresury is in a blanance position (that is they are spending exactly the same amount that they are taxing), then at any point in time the amount of reserves + the amount of outstanding Treasury debt is a fixed quantity. Lets call this quantity NFA. This means that all enities in the economy including the Fed can only manipulate the composition of the NFA, not the overall amount. 

So lets further assume some starting point, again where the Treasury is not issuing new debt their position is neutral, where the Fed holds half of the outstanding Treasury debt on its balance sheet.

Then what this means that the rest of the non-government sector hold the other half of the Treasuries and reserves the same amount of reserves. (50% of the NFA held by the public is reserves, and other 50% is treasuries). The Fed can then "print money" and buy up the other half the Treasuries from the non-governemnt sector. So now in this case the Fed holds 100% of the Treasuries on its balance sheet and the non-govermnent sector holds only reserves equal in amount to the NFA.

It is obvious that from the non-govenment sectors point of view that the only thing that happened was a swap. The have no more purchasing power (NFA) then they did before the Fed bought up the rest of the Treasuries.

But!! you say, But what about all the Treasuries on the Fed's balance sheet!! .... So what? Do you know what happens to all the interest the Fed collects on holding the Treasuries?  ... They give it back to the Treasury.  The Treasury pays the Fed to hold Treasuries and then the Fed gives it back at the end of the year. The Fed and the Treasury have always operated like two halves of the same balance sheet and it is because of holdovers from the old monetary system that we tend to think of them as distinct enties. That distinction does far more harm than good and we should end the Fed and merge it with the Treasury: http://caps.fool.com/Blogs/the-us-treasury-and-the/452537

So lets return back to my example. Lets start again with the fact that the Fed holds 50% of the Treasuries and the non-goverment sector holds the other 50% and an equal amount of reserves. Now instead of the Fed buying all the Treasuries, lets say the non-government sector wishes to sell all its reserves and buy the rest of the treasuries. Assuming that is consistent with the Fed's interest rate policy (which it wouldn't be), then the non-goverment sector has 100% of the Treasuries and no reserves. The Fed's blanace sheet is then neutral (it doesn't could holding reserves, because it can create them as necessary for when the public desires them).

Again, the public has absoultely the same amount of NFA that it did before the swap.

So between the two cases, the Fed had either 100% of the Treasuries as an asset and the same amount of reserves as a liability. Or it was balanced.

You can see that the Fed "printing money" is not some arbitary action that it can undetake. It doesn't simply print money and hand it to the public. It must buy something that already exists in exchange for the money that it printed. This is why from the non-goverment sector's perspective, Open Market Operations (OMO) by the Fed is always an asset swap

The Treasury is the only entity within our system that can change the net financial assets in the system. It is the only entity which can create an asset (it credits bank accounts directly) without generating a corresponding liability. The Fed can't. For the Fed to buy an asset (like a Treasury, MBS, etc.) it must issue a liability (Federal Reserve Notes = Dollars).

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#13) On May 13, 2011 at 11:48 AM, binve (< 20) wrote:

Correction:

Here is the proper way to look at it: Assume for a moment that the Government via the Tresury is in a blanance position (that is they are spending exactly the same amount that they are taxing), then at any point in time the amount of reserves + the amount of outstanding Treasury debt is a fixed quantity. Lets call this quantity NFA.

Should be

Here is the proper way to look at it: Assume for a moment that the Government via the Tresury is in a blanance position (that is they are spending exactly the same amount that they are taxing), then at any point in time the amount of reserves + the amount of outstanding Treasury debt held by the non-government sector is a fixed quantity. Lets call this quantity NFA.

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#14) On May 13, 2011 at 2:55 PM, rfaramir (29.51) wrote:

 

The supply of land on earth I haven't bought yet plus the supply of money I possess is a constant, too. I buy some land with some of the money, and a mere 'swap' happens. But this is not interesting.

 

What may be interesting is if I am a counterfeiter purchasing real resources with my new paper. It is interesting to all other users of that paper because I am diluting the purchasing power of their paper.

Give me power equal to the Federal Reserve to create money and I'll be happy. Either by letting me print, too, or taking away its ability to do so. (Only the second option is rational or moral.)

 

"It must buy something that already exists in exchange for the money that it printed."

Helicopter Ben himself disagrees with you on this. He claims the power to print a bunch of 100 dollar bills and throw them out of a helicopter to all and sundry below. No exchange needed.

 

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#15) On May 13, 2011 at 10:19 PM, mtf00l (44.16) wrote:

rfaramir,

I like the way you think.  That said I'm still not convinced anyone really knows what the game is.  Only time will tell.

Let me know when you spark up your press, I'll help load the paper! =D

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