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QE2 and the Liquidity "Black Hole"

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April 12, 2011 – Comments (20)

Another good post by TPC. I perfomed a similar set of analysis here (Follow Up: QE is not Inflationary, Thoughts on Risk Asset Instability - http://caps.fool.com/Blogs/follow-up-qe-is-not/533092) and here (One of the smartest comments I have read yet regarding Quantitative Easing - http://marketthoughtsandanalysis.blogspot.com/2011/02/one-of-smartest-comments-i-have-read.html) several months ago and came to the same conclusions

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QE2 AND THE LIQUIDITY “BLACK HOLE”
12 April 2011 by Cullen Roche

http://pragcap.com/qe2-and-the-liquidity-black-hole

I’ve been harping on this for months now and it looks like the message is getting across just in time.  Yes, just in time for the end of QE2.  As I mentioned over 6 months ago, QE2 is a monetary non-event.  It adds not one penny of extra liquidity or money to the banking system.  And it looks like Wall Street is finally beginning to realize this (as the evidence now clearly shows).  This note from Deutsche Bank describes (in retrospect), what I discussed back in August 2010 (courtesy of FT Alphaville):

“The $2 trillion in purchases have literally gone down a black hole.  Required reserves haven’t been required to increase and the Fed reserve  add has literally simply been hoarded as cash. Excess reserves at the  Fed have subsequently soared by the same. In short, QE has been a  spectacular disappointment in its impact on bank lending, whether via  whole loans or securities. It was as if the banks conducted the  very sterilization of QE that many thought perhaps the Fed should do to  “contain” inflation expectations.

Risky security prices have risen since QE but not Treasuries, the main  instrument of QE2. Yet banks’ balance sheets have gone sideways. Effectively investors have marked asset prices higher and circumvented  the banks. It is as if the first purchase by the Fed from an investor  simply triggered a series of deposit for security switches through the  investor base with banks never making an additional loan. This is consistent with a greater concern for risky asset post QE2 end, than Treasuries. The  danger for investors is that they confuse the result of higher asset  prices as reflecting excess liquidity rather than “irrational”  exuberance given that actual liquidity (as broadly defined by the  banking system) hasn’t gone up at all.

For all the worries about the end of QE2, the  focus should be on how we came about the “risk on” trade and elevated  asset prices. It was not through revitalized bank lending. There is no  banking system that is standing on its own two feet and propelling  growth forward. It remains like a herd of deer in the headlights – ready  to hand the cash straight back to the Fed when asked for. If risky  asset prices were elevated because of the expectation of a kick start  from the banks, they are at risk of falling. Treasuries are  immune because no one could buy them as the Fed purchased them. There is  no call on loans that funded Treasury positions through QE2. Moreover  if the banks slowed the pace of deleveraging (deposit destruction)  because of the safety of their cash hoard, there is a risk that they may  become even more recalcitrant.”

I should add that there does appear to be an increase in lending in one area – the borrowing of funds for purposes of speculative investments! Other than that, this note sounds all too familiar.  Never in the history of markets has there been a program more misguided or misunderstood….


20 Comments – Post Your Own

#1) On April 12, 2011 at 3:34 PM, mtf00l (49.94) wrote:

I think it's what we don't know that would surprise us.  The Fed routinely "missplaces" money.

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#2) On April 18, 2011 at 11:40 PM, checklist34 (99.73) wrote:

Binve, i have had the weirdest experience of the last 5 years of my life. 

I have recently had a series of thoughts about how monetary spazzes and economic spizzes work, and I have just one question and no idea who else to ask...

if you aren't around or if you don't know, I'll maybe start a thread on it. 

I ask you because an old thread of yours, which I can't find, titles something like "QE2 is deflationary" or something leads me to believe you may be on the same train of thought.  I probably didn't htoroughly read that thread or associated links or replies because in general i'm not a huge fan, or wasn't anyway, of that kind of discussion.

Here are my questions

1.  If I said to you that for all practical purposes the government debt isn't debt but money created

2.  if I said to you that the only apparent purpose that I can see for the government issuing debt is a) old habits from olden days long gone, b) to provide some yield on the currency and possibly increase demand for it that way c) to provide a savings rate...  simply put:  the purpose of issuing those bonds is to provide a savings rate on cash, not because they are actually necessary

3.  if i said to you that the net effect of QE2 was to cancel some interest payments.  because payments that would have gone to whatever non-us-government party now just went to the government itself (hence canceled) therefore in essence QE2 reduces the amount of dollars floating around out there

4.  if I said - and I think I mean this dude - that "fractional reserve banking" doesn't actually create money.  I know i've posted that it does, I know its widely thought that it does...  I know that.  But face it if you're a bank and I borrow 100k from you, you magically create that 100k, yes, but now I owe you 100k so the net amount of moeny in the system hasn't actually changed

5.  if i said - I know, I know, i'm going to get shot at again - that the national debt is probably actually the money supply, and the federal deficit is literally the amount of new dollars they intend to create this year and

6.  if i said that the federal reserve doesn't actually have the ability, as far as I can tell, to create dollars or "print money"... but rather CONGRESS does, by running deficits

7.  if I said that congress creating more dollars via running deficits wouldn't be inflationary if a corresponding increase in national productivity (or something like that) occured ...

8.  if I said that for the private sector to save any money in a country where a trade deficit exists, the government is going to have to run a deficit.  for a closed country with no outside trade partners government deficit = private savings or something like that

9.  for all practial purposes inflation is created not by the creation of more dollars or anything like that, but by the ratio of dollars to total output (or something like that).  so dollars created (i.e., deficit spending by congress) spent on freebies and slop create more inflation that dollars spent on roads and schools and stuff...

10.  governments can and should create money and should run big deficits when in a situation like most of the world right now, they should just work hard to control inflation

11.  governments should practically never run surpluses unless the country has a trade surplus maybe or inflation is wildly high

12.   the euro isn't a fiat currency

13.  the above apply to true fiat currency governments and stuff

Excuse for a moment my ... oft-touted contempt for reading the ideas of others, and I realize how ridiculous that must sound, but there is a reason for it and its served me well.

And do me one favor, if you can...

because I think I want to read some of the work of others if...

Is there any school of monetary and academic thought those things are consistent with?   

Because I am convinced of all of the above, after a couple of weeks of thinking, and I want to debate the point with people who may think similarly or critique or argue one point...

Can you toss a poor boy a dime?

 

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#3) On April 18, 2011 at 11:43 PM, checklist34 (99.73) wrote:

and PS:  if you give 2 craps...

close those leveraged bear ETFs on a substantial downdraft.

our debate over whether we go bcak anywhere near (no is my view, yes is yours) the march 2009 lows won't make any difference to whether they ever go green.  They will never be green in 2018, even at S&P 500.  

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#4) On April 19, 2011 at 9:21 AM, binve (< 20) wrote:

checklist,

hey man, I missed your comments earlier. I will read them now and give some thought and answers. sorry for the delay!

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#5) On April 19, 2011 at 9:25 AM, binve (< 20) wrote:

I am going to answer each point as I come across it, so that I don't have one massive comment :)

>>I ask you because an old thread of yours, which I can't find, titles something like "QE2 is deflationary" or something leads me to believe you may be on the same train of thought.  I probably didn't htoroughly read that thread or associated links or replies because in general i'm not a huge fan, or wasn't anyway, of that kind of discussion.

Yep! The two links at the very top of the post say basically this message. The first one in particular was a fairly rigorous study be me investigating a number of these issues. I provide a lot of cross-references to where I found the information.

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#6) On April 19, 2011 at 9:52 AM, binve (< 20) wrote:

>>1.  If I said to you that for all practical purposes the government debt isn't debt but money created

It's not actually either one.

Here is the brief history: Back in the days of the Gold Standard, when the US Gov wanted to run a deficit (to pay for wars, etc.), it would have to issue bonds. That is because under the Gold Standard, each dollar in existence had to be back by a cetain amount of Gold. So the debt could be held by the non-governemnt sector (either US citizens or foreign countries) or it could be held by the Federal Reserve. This is where the term 'debt monetization' comes from, because the Fed would literally monetize (convert into newly issued dollars) the debt that was issued by the government.

But in 1971, all of that changed. When the Gold window was closed, the US Dollar became 100% fiat. 

It is not commodity backed, and it is not a convertible currency.

So what is a dollar? What is 'money' in a fiat currency system?

It is a tax credit. That is the most accurate description of what a dollar is.

They way dollars exits today is because the US Government spends them in existence. Net dollars are created by Federal Government spending and dollars are destroyed by Federal Governement taxation. Fiat money is a tax credit.

Within the banking system, dollars are also created (loans which create deposits) but so are liabilities on bank balance sheet (for every bank the gets a deposit because of a loan, another bank is liable for that money). All assets and liabilities within the banking system net to zero. The banking system does not create net new dollars. The only entity that does is the US Gov via the US Treasury.

So getting back to bonds.

Back in the Gold Standard days and in the Constiution, any net government spending (deficit spending) must be financed by bond issuance. In this case, the word finance is true. Under a Gold Standard, the US Government did need to finance its spending.

Today, under in a fiat currency system, that is an anachronism. In fact it is dangerous, because people still labor under a false assumption. 

The US Gov is soverign issuer of US Dollars. It can never 'run out' of dollars. It does not need to 'finance' any spending. Taxes and bonds do not 'fund' the governement.  This is why the term 'debt monetization' no longer has any applicability.

The US Gov must issue bonds based on Constiutional mandate for any spending in excess of taxation. But it is a holdover, it does 'fund' anything anymore. The only role of bonds monetarily today is as a reserve drain. (When banks buy bonds, it soaks up reserves, allowing short term interest rates to rise. The Fed targets short term rates [the Fed funds rate] via OMO to ensure the demand for reserves exists at it target rate. Today we have ZIRP => Fed funds rate is 0-25 bp, which is that same level at which reserves pay interest. This is the manifestation of QE2, the Fed is buying treasury issuance [bonds] so that the banks can't buy them with excess reserves. It wants excess reserves in the system to that short term interest rates stay low. Since it is denying an intrest bearing claim [Treasury bonds] from the banking system and forcing them to hold reserves [essentially cash] it is in fact slightly deflationary).

So what is a bond now? 

A US Treasury bond is a savings account at the Federal Reserve. That's it.

It is not a 'financing' instrument. It is not 'debt' per se. It is a liability of the US Government (just as cash/dollars is), but it is a liability which the US Gov will always be able to pay. It is issuer of the US Dollar and Treasury bonds issue interest in US Dollars => the USG will never be unable to pay the interest.

So thinking of Treasury bonds as 'debt' in our fiat currency system is highly misleading, and will cause you to think about things in the wrong conceptual framework.

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#7) On April 19, 2011 at 9:54 AM, binve (< 20) wrote:

>>2.  if I said to you that the only apparent purpose that I can see for the government issuing debt is a) old habits from olden days long gone, b) to provide some yield on the currency and possibly increase demand for it that way c) to provide a savings rate...  simply put:  the purpose of issuing those bonds is to provide a savings rate on cash, not because they are actually necessary

100% agreed, like I stated in my answer to question 1 above.

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#8) On April 19, 2011 at 9:56 AM, binve (< 20) wrote:

>>3.  if i said to you that the net effect of QE2 was to cancel some interest payments.  because payments that would have gone to whatever non-us-government party now just went to the government itself (hence canceled) therefore in essence QE2 reduces the amount of dollars floating around out there

Exactly. I went through that exact train of thought here: http://caps.fool.com/Blogs/follow-up-qe-is-not/533092..

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#9) On April 19, 2011 at 9:57 AM, binve (< 20) wrote:

>>4.  if I said - and I think I mean this dude - that "fractional reserve banking" doesn't actually create money.  I know i've posted that it does, I know its widely thought that it does...  I know that.  But face it if you're a bank and I borrow 100k from you, you magically create that 100k, yes, but now I owe you 100k so the net amount of moeny in the system hasn't actually changed

Completely agreed!! See the link in comment #8 or my answer in comment #6.

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#10) On April 19, 2011 at 10:45 AM, binve (< 20) wrote:

>>5.  if i said - I know, I know, i'm going to get shot at again - that the national debt is probably actually the money supply, and the federal deficit is literally the amount of new dollars they intend to create this year and

I think that is very close to being a true statement. There are a few details that are missing. 

First, the term 'money supply' is another confusing anachronism. And most people don't agree on which measure to use, and even more people don't agree on what it means.

For example, if you use a 'narrow' measure (such as MZM or M0), then you will be counting only demand deposits and bank reserves. But as we just talked about in the previous points above, and building of bank reserves doesn't mean that more money gets into circulation (does not necessarily increase the money supply). There are still some who believe in the Money Multiplier, but I show it is a failed model in the link in comment #8.

So what if you use a 'wide' measure of money like M3? That is not a good measure because it accounts for a lot of debt instruments that are not liquid and really are not good money substitutes. So while I think it is better than MZM, M0, or M1, it is still not a very good measure.

But let's talk about the debt in a slightly different way. 

The total sum US Government debt is nothing more than the accumlated net savings of the non-government sector.

... That's all it is.

This can be further broken down into the savings of the private US sector and a deficit in the Current Account (Net Exports).

In order to understand this / see this relationship, you need to think about the macroeconomy in terms of sectoral balances. 

First, we define GDP from the perspective of 'sources'

GDP = C + I + G + (X-M)

C = Private consumption
I = Private investment
G = Government Spending
(X-M) = Net exports - Net Imports

Next we define GDP from the perspective of 'uses'

GDP = C + S + T

C = Private consumption
S = Private savings
T = Government Taxes

Equate the two

C + I + G + (X-M) = GDP =  C + S + T

=>  C + I + G + (X-M)  =  C + S + T
=>   I + G + (X-M)  =  S + T (Canel C, on both sides)

Now rearrage into a more useful form:

(G-T) = (S-I) - (X-M)

The is the macroeconomic sectoral balance. What this says is the Net government spending (G-T, which is spending minus taxation) equals Net private savings (S-I, which is savings minus money spent on investment) minus net exports (X-M, exports minus imports, or the current account).

So when the government spends money, it has to go somewhere. It either goes into the private sector and is either saved or spend, or it goes to the foreign sector.

If we run a few scenarios:

If X-M is positive (more exports than imports) and S-I is negative (the private sector is investing more than it is saving) then the governement is in surplus (G-T is less than zero, which means it taxes more than it spends).

If X-M is negative (more imports than exports) and S-I is positive (the private sector is saving more than it is spending) then the government is in deficit (G-T is greater than zero, which means it spends more than it taxes).

The first sceanario describes Germany today, the second scenario describes the US today. 

Governemnt Surpluses or even a balanced budget is not necessarily a good goal by itself, it must always be compared to the state of the rest of the macroeconomy. 

If the private sector needs to save (because it is deleveraging for example) and the there is a current account deficit, then the government needs to run a deficit. If it doesn't then then the private sector has no way of getting the money it needs to save (because the governent is simulatenously either the net source of money (adding) or the net sink of money (draining) depending on its policy stance (whether it wants to be in surplus or deficit)).

The opposite is true also. Lets say the economy is humming along. We are at full employment, the private sector is investing heavily in the economy and the we have a current account surplus (more exports than imports). If the goverenment tried to run a deficit in this case, then there would be much more money available than the non-government sector actually needs and that money would chase the resources that are already fully utilized (economy is running at capacity = full employment) and inflation (and potentially massive inflation) would ensue.

So this is why a government policy stance on either surpluses or deficits is not universally good or bad. It depends completely on what the other two major sectors are doing.

Back to the orginal question:

The background I just described gives us a way to look at the 'national debt' and 'budget deficit' in a different light. The debt is just the accumulation of previous budget deficits. It is not a 'burden' that is left to our children (like I said above, the USG will always be able to service interest payments). It says that the net stance of economic policy is that the US is a net importer and that the private sector is a net saver of dollars.

There can be a lot of discussion and debate as to why that is the case, but once we understand the sectoral balance, we can start piecing that argument together.

And so policy stances regarding the National debt must be viewed in the context of sectoral balances.

When people talk about 'running a surplus now so that we can spend later', they are talking gibberish. That is not the way are system works. The US Government will always maintain the ability to spend. Running either a surplus or a deficit has no bearing whatsoever on the ability of the US Gov to buy any resource denominated in US Dollars.

 

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#11) On April 19, 2011 at 11:11 AM, binve (< 20) wrote:

>>6.  if i said that the federal reserve doesn't actually have the ability, as far as I can tell, to create dollars or "print money"... but rather CONGRESS does, by running deficits

100% agreed!

That is the point I was trying to make in the post in comment #8. 

People ascribe far too much power and influence to the Fed than it actually has. People think that monetary policy is all powerful and that fiscal policy plays a supporting role, whereas the opposite is true. 

What was the bigger factor in the housing bubble: Low interest rates or lax lending standards?

It is the second, not the first. Most people don't seem to get that.

I do think the Fed is an incompetent organization. But I don't ascribe more influence to them then they acutally have.

I do think there would be so much more transparancy if the Fed and Treasury were simply merged. They are in effect already (the Fed / Treasury / Primary Dealers all coordinate bond auctions. This is why they are never underscribed by design).

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#12) On April 19, 2011 at 11:14 AM, binve (< 20) wrote:

>>7.  if I said that congress creating more dollars via running deficits wouldn't be inflationary if a corresponding increase in national productivity (or something like that) occured ...

Exactly, that is precisely what I talk about in comment #10

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#13) On April 19, 2011 at 11:15 AM, binve (< 20) wrote:

>>8.  if I said that for the private sector to save any money in a country where a trade deficit exists, the government is going to have to run a deficit.  for a closed country with no outside trade partners government deficit = private savings or something like that

Yep, it all goes back to sectoral balances (comment #10)

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#14) On April 19, 2011 at 11:19 AM, binve (< 20) wrote:

>>9.  for all practial purposes inflation is created not by the creation of more dollars or anything like that, but by the ratio of dollars to total output (or something like that).  so dollars created (i.e., deficit spending by congress) spent on freebies and slop create more inflation that dollars spent on roads and schools and stuff...

Yep, like I say in comment #10, whether a budget deficit will be inflationary or not highly depends on what the other two sectors in the macroeconomy are doing. 

No single sector of the macroeconomy can be evaluated independently of eachother.

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#15) On April 19, 2011 at 11:26 AM, binve (< 20) wrote:

>>10.  governments can and should create money and should run big deficits when in a situation like most of the world right now, they should just work hard to control inflation,

Agreed. This is why targeted spending (not just indisicriminate spending) makes sense here. Defecit spending right now should be 'jobs-rich'. If we wanted to spend money now to say: implement a natural gas infrastructure to transition off oil, or develop/promote an alternative energy, etc. Something that gives tremendous long term national benefit and creates jobs at the same time...

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#16) On April 19, 2011 at 11:31 AM, binve (< 20) wrote:

>>11.  governments should practically never run surpluses unless the country has a trade surplus maybe or inflation is wildly high

 Yep, I touch on this in comment #10 . 

By definition, the entire world cannot run either a trade suplus or a trade deficit. There must be some mixture among economies of both. There are also advantages and drawbacks to both.

IMO the best scenario is that if every country ran a zero current account deficit and imported what they are deficient in (and what others are good at producing) balanced by exporting what they are good at producing. It would be much more fair and much more stable.

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#17) On April 19, 2011 at 11:41 AM, binve (< 20) wrote:

>>12.   the euro isn't a fiat currency

This actually is a false statement

But it gets at the point of the thought thread here.

The euro is a fiat currency. However, the ECB controls it, not any one nation.

The proper analogy is this:

The US Government is sovereign issuer of the US Dollar, as a results it can never 'run out' of US Dollars.

The US States and citizens of the US are currency users. They must finance their spending since they cannot create currency. As such, these entities can default / go bankrupt.

For the EU, it goes like:

The European Central Bank is sovereign issuer of the Euro, as a results it can never 'run out' of Euros.

The EU member countries and citizens of the EU countires are currency users. They must finance their spending since they cannot create currency. As such, these entities can default / go bankrupt.

 

So the point to take away here is that in terms of the currency paradigm, Eurozone countries are like the US States with respect to the Federal Government. They have no monetary soverignty.

 

..

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#18) On April 19, 2011 at 11:42 AM, binve (< 20) wrote:

>>13.  the above apply to true fiat currency governments and stuff

Yep

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#19) On April 19, 2011 at 11:53 AM, binve (< 20) wrote:

>>And do me one favor, if you can... because I think I want to read some of the work of others if... Is there any school of monetary and academic thought those things are consistent with? Because I am convinced of all of the above, after a couple of weeks of thinking, and I want to debate the point with people who may think similarly or critique or argue one point... Can you toss a poor boy a dime?

Sure!

This last post was a very good example of that: http://caps.fool.com/Blogs/an-excellent-conversation/571286. It is a lengthy read, but a good one. 

Especially read the conversation between David and I at the bottom (comments #12 through #15).

For a good list of MMT resources, go here (http://pragcap.com/resources/understanding-modern-monetary-system). This is a very good post and has a list of more references/blogs at the end.

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#20) On April 19, 2011 at 11:54 AM, binve (< 20) wrote:

>>and PS:  if you give 2 craps... close those leveraged bear ETFs on a substantial downdraft. our debate over whether we go bcak anywhere near (no is my view, yes is yours) the march 2009 lows won't make any difference to whether they ever go green.  They will never be green in 2018, even at S&P 500.  

Completely agreed. That has been my plan for the last couple of months. I am just waiting for the next downdraft.

I should have closed them a year ago last April, but I was being stubborn / stupid. :)

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