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How Quantitative Easing Really Works

If you want an accurate explanation of quantitative easing, here it is. I am going to describe the basic mechanics and the transmission mechanism to the rest of the economy. To the degree there is official documentation on the mechanics, I will refer to it here in order to use the Fed’s own voice in describing QE. Let’s start with the mechanics.

The Mechanics of QE

In March of 2010, the Fed described QE this way in a paper written by Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack on the New York Fed’s website:

Since December 2008, the Federal Reserve’s traditional policy instrument, the target federal funds rate, has been effectively at its lower bound of zero. In order to further ease the stance of monetary policy as the economic outlook deteriorated, the Federal Reserve purchased substantial quantities of assets with medium and long maturities. In this paper, we explain how these purchases were implemented and discuss the mechanisms through which they can affect the economy.

So quantitative easing is simply large scale asset purchases (LSAP) by the central bank. The central bank is permitted by law to purchase a wide range of assets including but not limited to Treasury securities, mortgage-backed securities, or municipal bonds (see Blanchflower: The Fed Should Buy Munis And Monetize State Debt). Before the first round of quantitative easing, the Federal Reserve’s asset base consisted mostly of Treasury securities. However, as bond market liquidity dried up, the Fed stepped in and purchased a panoply of assets in the first round of quantitative easing including many mortgage-backed securities.

Brian Sack remarked in December 2009:

The Fed is currently in the process of purchasing nearly $1.75 trillion of Treasury, agency, and agency mortgage-backed securities through the LSAP programs. We have already completed our purchases of Treasury securities, totaling $300 billion. And our purchases of agency securities and mortgage-backed securities (MBS) are well advanced. Indeed, we have completed purchases of $155 billion of agency debt securities to date, out of a target level of $175 billion, and of just over $1 trillion of MBS, out of a target level of $1.25 trillion.

The second round of quantitative easing was concentrated on purchases of Treasury securities. While the Fed had about $800 billion in assets in mid-2007, the first round of QE swelled this to $2.25 trillion by December 2009. The Fed’s asset base is now moving toward $3 trillion.

In the March 2010 paper, the NY Fed goes on to say:

We present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.

But this is a subjective conclusion. The purpose of the paper is to provide the intellectual underpinnings to defend the Fed’s large scale asset purchases. Therefore, one should view the mechanics presented as objective and the conclusions as subjective. For example, In Sack’s December 2009 speech, he said:

The LSAPs were not aimed at supplying liquidity to financial institutions or at reducing systemic risk. Instead, they were intended to support economic activity by keeping longer-term private interest rates lower than they would otherwise be.

A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel. [EMPHASIS ADDED]

Sack is telling us that the Fed did not intend to perform a lender of last resort role, a legitimate Fed function. Rather, the Fed’s intention was to artificially supress risk premia to support economic activity. This is important to remember.

The money used to purchase these assets is created specifically for the transactions. That is to say the money did not previously exist before the transactions. This fact is what is behind the view that the Fed is ‘printing money’, a term Ben Bernanke, the Fed Chair also used when describing QE in 2009 (see Jon Stewart: The Big Bank Theory).

The Fed uses permanent open market operations (POMO) to conduct its large scale asset purchases. The Fed explains POMO this way:

The purchase or sale of Treasury securities on an outright basis adds or drains reserves available in the banking system. Such transactions are arranged on a routine basis to offset other changes in the Federal Reserve’s balance sheet in conjunction with efforts to maintain conditions in the market for reserves consistent with the federal funds target rate set by the Federal Open Market Committee (FOMC).

On March 18, 2009, the FOMC announced a longer-dated Treasury purchase program with a different operating goal, to help improve conditions in private credit markets.

On August 10, 2010, the FOMC directed the Open Market Trading Desk at the Federal Reserve Bank of New York to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.

On November 3, 2010, the FOMC decided to expand the Federal Reserve’s holdings of securities in the SOMA to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Note, August 2010 was when the Fed started QE2. November 2010 was when QE2 was first announced as the Fed decided to expand its balance sheet.

That’s the mechanics.

Transmission Mechanism

How QE actually works is the more subjective part of quantitative easing. Brian Sack told us in 2009 that the Fed was not performing its role as lender of last resort but rather it was ‘manipulating’ risk premia in order to lower long term interest rates to boost the real economy. I use the term ‘manipulate’ rather deliberately as I believe QE introduces a distortion into the markets by making price signals difficult to read for investors and businesses alike. The Fed is attempting to lower interest rates artificially. By that, I mean it is not saying that risk premia are elevated because of liquidity since Mr. Sack has already told us it is not performing a lender of last resort role. The Fed is trying to supress risk premia dictated by market forces through its own activity.

Now, in fairness to the Fed, this is exactly what it does with short-term interest rates by setting the Fed Funds rate. However, with short-term rates at zero percent and the economy still not firing on all cylinders, the Fed is telling us short-term rates at zero percent is not enough stimulus. It wants long-term interest rates to be lower than the market-determined rate as well. Clearly, this is a massive attempt at central planning and is, thus, likely to have unintended consequences like excess leverage and speculation.

You can read Ben Bernanke’s views on the QE2 transmission mechanism in my post “The government has a printing press to produce U.S. dollars at essentially no cost“. I take a benign approach to Bernanke’s comments there. However, Marshall is less flattering in “Amateur Hour at the Federal Reserve“. But, go back to QE1 and read Marshall’s piece “Bernanke doesn’t understand the basic economics of central banking” from December 2009. I think this got to the heart of the matter when Marshall told us loans create reserves and warned that QE would have nearly no impact on lending – which proved true.

The loan desk of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit (a zero net financial asset transaction).

Bernanke often speaks as if he believes reserves create loans.

Update 14 Mar 2011: I should point out that:

If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:

  • refuse to issue new reserves and cause a credit crunch;
  • create new reserves; or
  • relax the reserve ratio.

Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.

-“The Roving Cavaliers of Credit” – Steve Keen’s DebtWatch

I prefer Janet Yellen, the Fed Vice Chair, and the way she recently explained how QE is transmitted to the real economy. She writes:

Some General Observations

It is important to recognize at the outset that conventional and unconventional monetary policy actions bear many similarities. Forward guidance concerning the path of the federal funds rate, for example, is explicitly intended to influence market expectations concerning the future trajectory of shorter-term interest rates and thereby affect longer-term interest rates. That said, standard monetary policy actions also typically alter not just current short-term rates, but the anticipated path of short-term rates as well, influencing longer-term rates through the identical channel. In fact, central bankers have long recognized that this “expectations channel” operates most effectively when the public understands how policymakers expect economic conditions and monetary policy to evolve over time, and how the central bank would respond to any changes in the outlook.

The transmission channels through which longer-term securities purchases and conventional monetary policy affect economic conditions are also quite similar, though not identical. In particular, central bank purchases of longer-term securities work through a portfolio balance channel to depress term premiums and longer-term interest rates. The theoretical rationale for the view that longer-term yields should be directly linked to the outstanding quantity of longer-term assets in the hands of the public dates back at least to the 1950s.(2)

Each of these policy tools tends to generate spillovers to other financial markets, such as boosting stock prices and putting moderate downward pressure on the foreign exchange value of the dollar. My reading of the evidence, which I will briefly review, is that both unconventional policy tools–the use of forward guidance and the purchases of longer-term securities–have proven effective in easing financial conditions and hence have helped mitigate the constraint associated with the zero lower bound on the federal funds rate.

-Unconventional Monetary Policy and Central Bank Communications

What she is discussing is something called the expectations theory of interest rates.

It works like this: “long-term interest rates can be expressed as a series of short-term interest rates, such that if you know long-term rates, you can calculate expected future short-term interest rates. This is important because it tells you what people believe the Federal Reserve is likely to do with interest rates in the future.”

The Fed telegraphs how short-term rates will or will not be affected by the real economy and expectations shift accordingly. Therefore, to the degree the Fed is successful in getting long-term interest rates to move, it is because it has adjusted those expectations. That’s how it works.

The reason this is true is market arbitrage. Any market participant could go out into the market and purchases zero coupon treasury strips as an arbitrage against long-term Treasury yield mispricing if long-term rates did not reflect the path of future expected short rates. Let me repeat that: if long-term rates don’t reflect the expected path of short-term rates, you have a sure fire arbitrage opportunity. If the Fed is destined to keep rates at zero percent for the next five years and I am sure of it, but the yield on five-year Treasuries doesn’t reflect this, all I have to do to make money is buy the five-year and sell Treasury strips and leverage that trade up in the Repo market. Isn’t that what some investment banks are doing right now – ploughing their POMO acquired money into a leveraged bet on Treasuries? That is exactly what happened after the first jobless recovery in 1992-1994 before Greenspan caused a huge bear market in Treasuries by raising rates.

I don’t want to gloss over the discussion about risk premia. Clearly, Yellen and Sack are saying they are trying to change private portfolio preferences independent of future rate rises. Meaning that the risk premia for holding long-dated paper is suppressed. And analogously, I assume the risk premium for holding risk assets is suppressed. This is a manipulation of price signals and will create a misallocation of resources.

Look, quantitative easing is an asset swap. The Fed creates electronic credits and swaps them with existing financial assets. If the Fed is buying government paper, it is essentially trading one government liability for another, swapping a demand deposit electronic credit for a longer-dated government asset.

“From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”

So QE2 Is Equivalent to Issuing Treasury Bills. In actual fact, all QE2 does is drain the real economy of interest income by swapping an interest-bearing government liability for a non-interest bearing government liability. This decreases aggregate demand in the economy. So the real economy effects of QE are to slightly lower aggregate demand. This is offset by changing interest rate expectations, which alter private portfolio preferences, and lower risk premia, leading to credit growth, leverage and speculation, forces which should pump up the real economy. The Fed had intended to lower interest rates via the lowered risk premia. To date, the Fed has lowered risk premia. But this has also provided the tinder for speculation and leverage. Moreover, the Fed has also raised inflation expectations to boot, causing interest rates to rise and working at cross-purposes with the lowered risk premia. Thus, QE2 has only been successful insofar as it has increased business credit and raised asset prices. In my view, QE2 has been a bust as it adds volatility to the system and will have negative unintended consequences down the line.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

27 Comments

  1. Spencer Bradley Hall says:

    IORs are the FUNCTIONAL EQUIVALENT of required reserves, not short term T-bills. T-bills are settled upon maturity, or are liquidated at a discount. IORs sport a “floating”, overnight, remuneration rate (currently consonant with the 1 year “Daily Treasury Yield Curve Rate”).

    I.e., the policy rate “floats” (like an adjustable rate mortgage), via a series of either, cascading, or stair-stepping, interest rate pegs. I.e., as with ARMs, a “note is periodically adjusted based on a variety of indices”.

    Similarly, “Among the most common indices (for ARMs), are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).” – Wikipedia

    The remuneration rate is a monetary policy “tool”, it is the Central Bank’s target rate’s “floor” (a hypothetical policy otherwise known as the “Friedman rule”).

    I.e., IORs are not just an asset swap. IORs are assets defined by economists to be outside-of-the properties normally assigned to the money aggregates. I.e., IORs are a credit control device. IORs absorb bank deposits (offsetting the expansion of the FED’s balance sheet on the asset side, e.g., QE2), as well as impound consumer & corporate savings, and induce dis-intermediation among the non-banks. IORs increase the cost of loan-funds (mortgage rates), ceteris paribus. IORs increase the capitalization rate on company earnings.

    IORs are bank earning assets. IORs are investments. IORs are riskless, guaranteed, & are a hedge against higher interest rates (i.e., promise even higher, & safer returns as the economy expands).

    IORs eliminate the motivation of the banks to lend within the short-end segment of the yield curve. IORs are the bank’s primary liquidity reserves (clearing balances) – despite the day-light credit backstop, borrowing FED funds, etc. (i.e., both FED-WIRE & contractual clearing balances have declined conterminously).

    As Dr. Richard Anderson (V.P. St Louis FED), states: “Remember that “excess reserves” is an accounting concept, not a physical item. The physical item (asset) is deposits at Fed Res Banks. These deposits may be used to satisfy statutory reserve requirements; any “excess” deposits are labeled as “excess reserves.” This terminology dates from the 1920s, and I find it obsolete.”

    Those who point to the “monetary base” which is not now, nor has ever been, a base for the expansion of new money & credit, are the: “could have, would have, should have” dinosaurs.

    • Spencer, thanks for the IOR comments but this is about QE. There is nothing in this article about interest on reserves. That isn’t a relevant issue here.

  2. Spencer Bradley Hall says:

    IORs are the FUNCTIONAL EQUIVALENT of required reserves, not short term T-bills. T-bills are settled upon maturity, or are liquidated at a discount. IORs sport a “floating”, overnight, remuneration rate (currently consonant with the 1 year “Daily Treasury Yield Curve Rate”).

    I.e., the policy rate “floats” (like an adjustable rate mortgage), via a series of either, cascading, or stair-stepping, interest rate pegs. I.e., as with ARMs, a “note is periodically adjusted based on a variety of indices”.

    Similarly, “Among the most common indices (for ARMs), are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).” – Wikipedia

    The remuneration rate is a monetary policy “tool”, it is the Central Bank’s target rate’s “floor” (a hypothetical policy otherwise known as the “Friedman rule”).

    I.e., IORs are not just an asset swap. IORs are assets defined by economists to be outside-of-the properties normally assigned to the money aggregates. I.e., IORs are a credit control device. IORs absorb bank deposits (offsetting the expansion of the FED’s balance sheet on the asset side, e.g., QE2), as well as impound consumer & corporate savings, and induce dis-intermediation among the non-banks. IORs increase the cost of loan-funds (mortgage rates), ceteris paribus. IORs increase the capitalization rate on company earnings.

    IORs are bank earning assets. IORs are investments. IORs are riskless, guaranteed, & are a hedge against higher interest rates (i.e., promise even higher, & safer returns as the economy expands).

    IORs eliminate the motivation of the banks to lend within the short-end segment of the yield curve. IORs are the bank’s primary liquidity reserves (clearing balances) – despite the day-light credit backstop, borrowing FED funds, etc. (i.e., both FED-WIRE & contractual clearing balances have declined conterminously).

    As Dr. Richard Anderson (V.P. St Louis FED), states: “Remember that “excess reserves” is an accounting concept, not a physical item. The physical item (asset) is deposits at Fed Res Banks. These deposits may be used to satisfy statutory reserve requirements; any “excess” deposits are labeled as “excess reserves.” This terminology dates from the 1920s, and I find it obsolete.”

    Those who point to the “monetary base” which is not now, nor has ever been, a base for the expansion of new money & credit, are the: “could have, would have, should have” dinosaurs.

    • Spencer, thanks for the IOR comments but this is about QE. There is nothing in this article about interest on reserves. That isn’t a relevant issue here.

  3. Karen says:

    “Look, quantitative easing is an asset swap. The Fed creates electronic credits and swaps them with existing financial assets. If the Fed is buying government paper, it is essentially trading one government liability for another, swapping a demand deposit electronic credit for a longer-dated government asset.”

    I don’t agree. As I understand it, the QE occurs when the Fed creates the electronic credits, not when it swaps them for Treasuries or whatever else. If the Fed had bought government paper with already-existing assets that it had somehow acquired from someone else, that would be a simple asset swap with no QE. The Fed’s swap of Treasuries (that were already on its books) for MBS earlier in the financial crisis did not involve any QE.

    There is a fundamental difference between Fed-created electronic credits and debt instruments like government bonds, corporate bonds, or promissory notes – i.e., loans.

    Loans don’t really create new money, they only transfer it temporarily from one party to another. If the borrower defaults, then the transfer becomes permanent instead of temporary, and the loan becomes akin to a gift, but again there is no extra money brought into the world to alter the currency supply in a way that changes the fair value of a dollar. Even fractional-reserve banking does not really create new money, only the illusion of it*.

    But when the Fed creates electronic credits out of thin air, it is increasing the supply of dollars without an offsetting increase in real goods or services. This reduces the fair value of every existing dollar – stealing, in real-wealth terms, from existing holders of that currency and from those who continue to accept the currency at its old (no longer fair) market value. QE is, when you get right down to it, a lot like counterfeiting but without the jail time.

    To avoid a run on the currency, large-scale currency creation is nowadays accompanied by promises that the extra currency will be collected up again and destroyed “when it’s no longer needed.” If and when that happens, holders of the currency are theoretically made whole again, though only to the extent that they haven’t changed their currency holdings during that time.

    But all too often throughout history, those promises are not kept. And a government that deficit-spends even in good times doesn’t inspire the greatest of confidence.

    * – The Fed rather cryptically says it adjusts currency quantities on an ongoing basis “to meet demand.” If that means it creates more of its electronic credits all the time to accommodate increases in lending by the fractional-reserve banking system, then I am technically correct that fractional-reserve banking itself does not create new money but it does automatically trigger QE by the Fed so in that sense it does increase the money supply.

    So, where am I wrong?

    • Karen,

      You are confused as to what has occurred and the terminology used. As I indicated above quantitative easing is the large scale asset purchases conducted by the Fed. The electronic credits it creates are created specifically to carry out the POMO asset purchases.

      Additionally, the Fed has not swapped Treasuries for MBS. POMO is a swap of credit at the Fed for existing assets. It is not an asset for asset exchange but an injection of high powered money into the reserve system.

      Also, from the government’s perspective there is no functional difference between any government liability except the terms of the obligation. A federal reserve note is akin to a demand deposit at a normal bank while a Treasury bonds is akin to a corporate bond.

      And yes loans create reserves. I suggest you read Steve Keen’s article about the Roving Cavaliers. I will provide some links at another opportunity.

      The overall point is that the monetary system does not operate the way basic economics textbooks present it with a money multiplier. This is a relic of the gold standard which is not applicable to a fiat money system. Read yesterday’s post on MMT for pointers.

    • OK, I am in front of a computer and can answer with links. Karen, I come from an Austrian perspective. So what you have written makes sense to me. But it is inaccurate as it is applicable to a gold standard that no longer exists. I suggest you read the links in this post for the background information. I provided them to aid in developing the arguments here that I have previously presented in other posts. For the quickest data dump, read the following post from yesterday:

      http://www.creditwritedowns.com/2011/03/more-thoughts-on-out-of-control-deficit-spending.html

      You can also look at any of the posts with this tag:

      http://www.creditwritedowns.com/tag/modern-monetary-theory/

      The most important factor in the change from gold standard to fiat currency has to do with the money multiplier. The lack of a money multiplier and the creation of reserves from loans means that QE results in a pileup of excess reserves because those reserves do not create loans.

      See Steve Keen’s piece called the Roving Cavaliers of Credit. it is very wide read.

      http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

      Here’s the part to pay attention to:

      Every macroeconomics textbook has an explanation of how credit money is created by the system of fractional banking that goes something like this:
      Banks are required to retain a certain percentage of any deposit as a reserve, known as the “reserve requirement”; for simplicity, let’s say this fraction is 10%.
      When customer Sue deposits say 100 newly printed government $10 notes at her bank, it is then obliged to hang on to ten of them—or $100—but it is allowed to lend out the rest.
      The bank then lends $900 to its customer Fred, who then deposits it in his bank—which is now required to hang on to 9 of the bills—or $90—and can lend out the rest. It then lends $810 to its customer Kim….

      This model of how banks create credit is simple, easy to understand (this version omits the fact that the public holds some of the cash in its own pockets rather than depositing it all in the banks; this detail is easily catered for and is part of the standard model taught to economists),… and completely inadequate as an explanation of the actual data on money and debt…

      Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.

      • Karen says:

        I have seen that same explanation of fractional reserve banking… but this process creates only credit, not new money. It gives $900 of Sue’s money temporarily to Fred, but that means as long as Fred has it Sue can’t use it. Even with fractional-reserve banking, the idea is still that two people cannot use the same money at the same time. So the lending can’t create a permanent alteration in the relationship between money and other goods and services.

        “Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.”

        But if “base money” includes both Sue’s $1000 and Fred’s $900 (and Jane’s $810 etc.), it isn’t actually a correct measure of money, when by money we mean the commodity that is used as a commonly accepted medium of exchange in terms of which we conceptualize the value of all other goods and services.

        Unlike the Fed, Sue’s bank is not allowed to create money to pay Sue if Fred doesn’t make good. It has to take a loss and pay Sue out of its own profits. The U.S. Treasury is also not allowed to create money – that privilege is granted by law exclusively to the Federal Reserve.

        When the Fed conjures up a lot of dollars out of thin air, it is changing the relationship between our common medium of exchange (the commodity called dollars) and all other goods and services. Until it collects those added dollars back and retires them, everything that was worth one dollar before is afterwards correctly worth more than one dollar. [Caveat: because modern economies create more and more wealth over time, it is appropriate - and stabilizing - for the quantity of money to grow in tandem. There may be unfairness in the details of how the new currency is introduced into circulation, but its creation keeps prices stable and is thus a good thing.] Because money is a commodity that follows the law of supply and demand, large-scale creation of money that is not justified by increased real wealth IS inflationary. Inertia and ignorance tend to delay the effects, but eventually the economy adjusts to the new reality and prices go up.

        Dollars are NOT just another debt instrument comparable to U.S. Treasury bonds. Dollars are units of our common medium of exchange. Treasury bonds promise to pay the holder dollars later in exchange for dollars now; dollars do not promise to pay their holders Treasury bonds later in exchange for Treasury bonds now.

        That’s my take on it.

        • Karen, you are living in a gold standard world that no longer exists. Let me give you an example. You write:

          “When the Fed conjures up a lot of dollars out of thin air, it is changing the relationship between our common medium of exchange (the commodity called dollars) and all other goods and services. Until it collects those added dollars back and retires them, everything that was worth one dollar before is afterwards correctly worth more than one dollar.”

          That’s how I learned economics. However, it doesn’t work that way with fiat money. Credit is what is important. If in your example, no one lends Sue’s $1000, Sue’s $1000 doesn’t become Fred’s $900 (and Jane’s $810 etc.). That’s what I am trying to make clear and what you seem to be missing.

          The reserves created by QE do not have a transmission mechanism into dollars or credit unless banks lend the new reserves because credit decisions are made independent of the reserves in the system. This is what Keen’s example demonstrates. The monetary base (M1) does not expand in concert with the reserves in the system.

          Since 2008, this is exactly what has happened. The Fed has created a gazillion excess and reserves and M1 has not responded. This means that QE does not create credit inflation because the ‘money multiplier’ shrinks when the economy is at or near debt deflation. I would argue it creates asset price inflation instead as it’s objective is manipulation risk premia.

          Additionally, from the government’s perspective, dollars ARE just another debt instrument comparable to U.S. Treasury bonds. They are a liability to be repaid with more of the same fiat money. The only difference between Treasuries and dollars/electronic credits is the interest used to entice the holder to forgo a dollar today for a dollar tomorrow. However, from the government’s perspective, each liability – treasuries or dollars – can be repaid via a simple electronic keystroke. That is what separates fiat money from money backed by something tangible.

          Do I like this? No. I don’t like fiat money. Government will always attempt to debase money unless they have some sort of tangible anchor. But you have to understand that fiat money is different to money backed by a tangible asset.

          • Karen says:

            “Additionally, from the government’s perspective, dollars ARE just another debt instrument comparable to U.S. Treasury bonds.”

            I don’t see that at all. On my dollar bills it says, “this note is legal tender for all debts, public and private.” That’s not a promise, that’s a decree.

            A dollar in the hands of the government is just the same as a dollar in the hands of you or me – it’s a commodity we can trade for pretty much anything else.

            It’s my understanding that our fiat money system is just like a gold standard system in which the central bank (the Fed) has the only gold mine in the world*, and that gold mine is capable of rates of production that are limited only by the Fed’s imagination and will.

            Other banks are constrained to treating dollars the same way they would gold coins in a gold-coin money system. They can lend gold coins to Fred and Jane, but if they misjudge things and can’t pay Sue and JC Penney when asked, they have to persuade someone else to lend them enough gold coins or renege on their promises to Sue and JC Penney. (JC Penney is where Fred spent his $900 loan; why on earth would Fred borrow money just so he can put it in the bank!)

            The US Treasury and you and me are also required to treat dollars just as we would gold coins. When the government issues a bond, the purchaser must fork over the purchase price now, and in return the government will pay him his money back with interest over time. If the government spends the money but then can’t collect enough in taxes to pay as promised, it can’t just reach into its magic gold mine. It CAN ask the Fed to reach into the gold mine and lend it new gold coins, and if the Fed agrees, that both delays the government’s day of reckoning and reduces the real value of the debts owed by everyone who owes those gold coins to someone else (including the government).

            (* – other central banks also have exclusive mines, but Japan’s turns out silver and the Japanese use silver as their money, the ECB turns out platinum and the EU uses platinum as its money, etc., etc.)

        • One more thing, Karen: I agree with you when you say “because modern economies create more and more wealth over time, it is appropriate – and stabilizing – for the quantity of money to grow in tandem. There may be unfairness in the details of how the new currency is introduced into circulation, but its creation keeps prices stable and is thus a good thing”.

          Just because the Fed’s printing money isn’t immediately felt on consumer pries doesn’t mean it isn’t inflationary. Of course it is. The question is about transmission mechanism. As I said above, right now the excess reserves are piling up. But those assets are sitting on bank balance sheets and they are loath to earn nothing on them. The asset price inflation and resultant mis-allocation of capital we are seeing that comes from it are very much Fed-induced phenomena.

          So I agree with your underlying message that expanding reserves in the system exponentially is a bad thing, leads to (asset price and eventually consumer price) inflation, and distorts the allocation of capital in the economy. All around, QE is so bad, it does make you think that this experiment with fiat money will end badly:

          http://www.creditwritedowns.com/2009/04/the-age-of-the-fiat-currency-a-38-year-experiment.html

  4. Karen says:

    “Look, quantitative easing is an asset swap. The Fed creates electronic credits and swaps them with existing financial assets. If the Fed is buying government paper, it is essentially trading one government liability for another, swapping a demand deposit electronic credit for a longer-dated government asset.”

    I don’t agree. As I understand it, the QE occurs when the Fed creates the electronic credits, not when it swaps them for Treasuries or whatever else. If the Fed had bought government paper with already-existing assets that it had somehow acquired from someone else, that would be a simple asset swap with no QE. The Fed’s swap of Treasuries (that were already on its books) for MBS earlier in the financial crisis did not involve any QE.

    There is a fundamental difference between Fed-created electronic credits and debt instruments like government bonds, corporate bonds, or promissory notes – i.e., loans.

    Loans don’t really create new money, they only transfer it temporarily from one party to another. If the borrower defaults, then the transfer becomes permanent instead of temporary, and the loan becomes akin to a gift, but again there is no extra money brought into the world to alter the currency supply in a way that changes the fair value of a dollar. Even fractional-reserve banking does not really create new money, only the illusion of it*.

    But when the Fed creates electronic credits out of thin air, it is increasing the supply of dollars without an offsetting increase in real goods or services. This reduces the fair value of every existing dollar – stealing, in real-wealth terms, from existing holders of that currency and from those who continue to accept the currency at its old (no longer fair) market value. QE is, when you get right down to it, a lot like counterfeiting but without the jail time.

    To avoid a run on the currency, large-scale currency creation is nowadays accompanied by promises that the extra currency will be collected up again and destroyed “when it’s no longer needed.” If and when that happens, holders of the currency are theoretically made whole again, though only to the extent that they haven’t changed their currency holdings during that time.

    But all too often throughout history, those promises are not kept. And a government that deficit-spends even in good times doesn’t inspire the greatest of confidence.

    * – The Fed rather cryptically says it adjusts currency quantities on an ongoing basis “to meet demand.” If that means it creates more of its electronic credits all the time to accommodate increases in lending by the fractional-reserve banking system, then I am technically correct that fractional-reserve banking itself does not create new money but it does automatically trigger QE by the Fed so in that sense it does increase the money supply.

    So, where am I wrong?

    • Karen,

      You are confused as to what has occurred and the terminology used. As I indicated above quantitative easing is the large scale asset purchases conducted by the Fed. The electronic credits it creates are created specifically to carry out the POMO asset purchases.

      Additionally, the Fed has not swapped Treasuries for MBS. POMO is a swap of credit at the Fed for existing assets. It is not an asset for asset exchange but an injection of high powered money into the reserve system.

      Also, from the government’s perspective there is no functional difference between any government liability except the terms of the obligation. A federal reserve note is akin to a demand deposit at a normal bank while a Treasury bonds is akin to a corporate bond.

      And yes loans create reserves. I suggest you read Steve Keen’s article about the Roving Cavaliers. I will provide some links at another opportunity.

      The overall point is that the monetary system does not operate the way basic economics textbooks present it with a money multiplier. This is a relic of the gold standard which is not applicable to a fiat money system. Read yesterday’s post on MMT for pointers.

    • OK, I am in front of a computer and can answer with links. Karen, I come from an Austrian perspective. So what you have written makes sense to me. But it is inaccurate as it is applicable to a gold standard that no longer exists. I suggest you read the links in this post for the background information. I provided them to aid in developing the arguments here that I have previously presented in other posts. For the quickest data dump, read the following post from yesterday:

      http://www.creditwritedowns.com/2011/03/more-thoughts-on-out-of-control-deficit-spending.html

      You can also look at any of the posts with this tag:

      http://www.creditwritedowns.com/tag/modern-monetary-theory/

      The most important factor in the change from gold standard to fiat currency has to do with the money multiplier. The lack of a money multiplier and the creation of reserves from loans means that QE results in a pileup of excess reserves because those reserves do not create loans.

      See Steve Keen’s piece called the Roving Cavaliers of Credit. it is very wide read.

      http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

      Here’s the part to pay attention to:

      Every macroeconomics textbook has an explanation of how credit money is created by the system of fractional banking that goes something like this:
      Banks are required to retain a certain percentage of any deposit as a reserve, known as the “reserve requirement”; for simplicity, let’s say this fraction is 10%.
      When customer Sue deposits say 100 newly printed government $10 notes at her bank, it is then obliged to hang on to ten of them—or $100—but it is allowed to lend out the rest.
      The bank then lends $900 to its customer Fred, who then deposits it in his bank—which is now required to hang on to 9 of the bills—or $90—and can lend out the rest. It then lends $810 to its customer Kim….

      This model of how banks create credit is simple, easy to understand (this version omits the fact that the public holds some of the cash in its own pockets rather than depositing it all in the banks; this detail is easily catered for and is part of the standard model taught to economists),… and completely inadequate as an explanation of the actual data on money and debt…

      Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.

      • Karen says:

        I have seen that same explanation of fractional reserve banking… but this process creates only credit, not new money. It gives $900 of Sue’s money temporarily to Fred, but that means as long as Fred has it Sue can’t use it. Even with fractional-reserve banking, the idea is still that two people cannot use the same money at the same time. So the lending can’t create a permanent alteration in the relationship between money and other goods and services.

        “Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.”

        But if “base money” includes both Sue’s $1000 and Fred’s $900 (and Jane’s $810 etc.), it isn’t actually a correct measure of money, when by money we mean the commodity that is used as a commonly accepted medium of exchange in terms of which we conceptualize the value of all other goods and services.

        Unlike the Fed, Sue’s bank is not allowed to create money to pay Sue if Fred doesn’t make good. It has to take a loss and pay Sue out of its own profits. The U.S. Treasury is also not allowed to create money – that privilege is granted by law exclusively to the Federal Reserve.

        When the Fed conjures up a lot of dollars out of thin air, it is changing the relationship between our common medium of exchange (the commodity called dollars) and all other goods and services. Until it collects those added dollars back and retires them, everything that was worth one dollar before is afterwards correctly worth more than one dollar. [Caveat: because modern economies create more and more wealth over time, it is appropriate - and stabilizing - for the quantity of money to grow in tandem. There may be unfairness in the details of how the new currency is introduced into circulation, but its creation keeps prices stable and is thus a good thing.] Because money is a commodity that follows the law of supply and demand, large-scale creation of money that is not justified by increased real wealth IS inflationary. Inertia and ignorance tend to delay the effects, but eventually the economy adjusts to the new reality and prices go up.

        Dollars are NOT just another debt instrument comparable to U.S. Treasury bonds. Dollars are units of our common medium of exchange. Treasury bonds promise to pay the holder dollars later in exchange for dollars now; dollars do not promise to pay their holders Treasury bonds later in exchange for Treasury bonds now.

        That’s my take on it.

        • Karen, you are living in a gold standard world that no longer exists. Let me give you an example. You write:

          “When the Fed conjures up a lot of dollars out of thin air, it is changing the relationship between our common medium of exchange (the commodity called dollars) and all other goods and services. Until it collects those added dollars back and retires them, everything that was worth one dollar before is afterwards correctly worth more than one dollar.”

          That’s how I learned economics. However, it doesn’t work that way with fiat money. Credit is what is important. If in your example, no one lends Sue’s $1000, Sue’s $1000 doesn’t become Fred’s $900 (and Jane’s $810 etc.). That’s what I am trying to make clear and what you seem to be missing.

          The reserves created by QE do not have a transmission mechanism into dollars or credit unless banks lend the new reserves because credit decisions are made independent of the reserves in the system. This is what Keen’s example demonstrates. The monetary base (M1) does not expand in concert with the reserves in the system.

          Since 2008, this is exactly what has happened. The Fed has created a gazillion excess and reserves and M1 has not responded. This means that QE does not create credit inflation because the ‘money multiplier’ shrinks when the economy is at or near debt deflation. I would argue it creates asset price inflation instead as it’s objective is manipulation risk premia.

          Additionally, from the government’s perspective, dollars ARE just another debt instrument comparable to U.S. Treasury bonds. They are a liability to be repaid with more of the same fiat money. The only difference between Treasuries and dollars/electronic credits is the interest used to entice the holder to forgo a dollar today for a dollar tomorrow. However, from the government’s perspective, each liability – treasuries or dollars – can be repaid via a simple electronic keystroke. That is what separates fiat money from money backed by something tangible.

          Do I like this? No. I don’t like fiat money. Government will always attempt to debase money unless they have some sort of tangible anchor. But you have to understand that fiat money is different to money backed by a tangible asset.

          • Karen says:

            “Additionally, from the government’s perspective, dollars ARE just another debt instrument comparable to U.S. Treasury bonds.”

            I don’t see that at all. On my dollar bills it says, “this note is legal tender for all debts, public and private.” That’s not a promise, that’s a decree.

            A dollar in the hands of the government is just the same as a dollar in the hands of you or me – it’s a commodity we can trade for pretty much anything else.

            It’s my understanding that our fiat money system is just like a gold standard system in which the central bank (the Fed) has the only gold mine in the world*, and that gold mine is capable of rates of production that are limited only by the Fed’s imagination and will.

            Other banks are constrained to treating dollars the same way they would gold coins in a gold-coin money system. They can lend gold coins to Fred and Jane, but if they misjudge things and can’t pay Sue and JC Penney when asked, they have to persuade someone else to lend them enough gold coins or renege on their promises to Sue and JC Penney. (JC Penney is where Fred spent his $900 loan; why on earth would Fred borrow money just so he can put it in the bank!)

            The US Treasury and you and me are also required to treat dollars just as we would gold coins. When the government issues a bond, the purchaser must fork over the purchase price now, and in return the government will pay him his money back with interest over time. If the government spends the money but then can’t collect enough in taxes to pay as promised, it can’t just reach into its magic gold mine. It CAN ask the Fed to reach into the gold mine and lend it new gold coins, and if the Fed agrees, that both delays the government’s day of reckoning and reduces the real value of the debts owed by everyone who owes those gold coins to someone else (including the government).

            (* – other central banks also have exclusive mines, but Japan’s turns out silver and the Japanese use silver as their money, the ECB turns out platinum and the EU uses platinum as its money, etc., etc.)

        • One more thing, Karen: I agree with you when you say “because modern economies create more and more wealth over time, it is appropriate – and stabilizing – for the quantity of money to grow in tandem. There may be unfairness in the details of how the new currency is introduced into circulation, but its creation keeps prices stable and is thus a good thing”.

          Just because the Fed’s printing money isn’t immediately felt on consumer pries doesn’t mean it isn’t inflationary. Of course it is. The question is about transmission mechanism. As I said above, right now the excess reserves are piling up. But those assets are sitting on bank balance sheets and they are loath to earn nothing on them. The asset price inflation and resultant mis-allocation of capital we are seeing that comes from it are very much Fed-induced phenomena.

          So I agree with your underlying message that expanding reserves in the system exponentially is a bad thing, leads to (asset price and eventually consumer price) inflation, and distorts the allocation of capital in the economy. All around, QE is so bad, it does make you think that this experiment with fiat money will end badly:

          http://www.creditwritedowns.com/2009/04/the-age-of-the-fiat-currency-a-38-year-experiment.html

  5. Spencer Bradley Hall says:

    OK. But where (in the commercial banking system), does the FRBNY’s “trading desk” credit the PDs when conducting their POMO purchases & reinvestment of Treasurys? OMO’s under the FRBNY’s “FED POINTs” explains it thus: “This structure works because the primary dealers have accounts at clearing banks…”. Or if not directly deposited, do the PDs (indirectly deposit), thru routine practice in their correspondent account relationship with their commercial bank, have credits transfered, or swept, to the CB’s IBDD account?

    So, in my mind at least, QE2 is all about IORs. Inter-bank demand deposits (IBDDs), are owned by the member commercial banks; they are bank legal reserves and can be converted dollar-for-dollar into Federal Reserve Notes. The volume of FRBIBDDs is almost exclusively related to the volume of Reserve Bank credit. When Federal Reserve Banks expand credit, for example by buying U.S. obligations, the balance sheets of the Banks reflect an increase in earning assets, and an equal increase in IBDD liabilities, i.e., costless legal reserves (in the case of QE2 intially IORs).

    Open market operations should be divided into 2 separate classes (1) purchases from, & sales to, the commercial banks; & (2) purchases from, and sales to, others than banks:

    A purchasing operation of the first type (QE2), involves the Federal Reserve Banks acquiring (+) U.S. Obligations on its asset side, & (+) inter-bank demand deposits on its liability side. On the “T-Account” for the Commercial Banks, the member banks then lose (+) U.S. Obligations, but acquire (+) Reserves.

    Note that transactions between the Federal Reserve & the commercial banks directly affect the volume of bank reserves, without bringing about any change in the money supply. There is simply an alteration in the assets of the commercial banks; the banks’ reserves (and excess reserves) were increased by exactly the amount the government securities portfolio was decreased.

    However, purchases and sales between the Reserve banks & non-bank investors directly affect both bank reserves, and the money supply. A purchasing transaction between the Federal Reserve Banks, once again, increases (+) U.S. Obligations on its asset side & (+) demand deposits on its liability side. But now on the “T-Account” for the Commercial Banks, the member banks acquire (+) Reserves, as well as (+) demand deposits.

    It is assumed that the proceeds from the sale of this security to the non-bank public, was deposited (credited) to the owner’s commercial bank account. The excess reserves of the bank were increased by a lesser amount than the reserves were increased, since the expansion in Reserve bank credit caused an equal increase in the commercial banks’ deposit liabilities (for transaction accounts).

    This is why market players say it is just an asset swap – bonds for stocks (even though the demand for loan-funds is diminished because the Treasury securities have been taken off the market, & placed in the System Open Market Account, while the supply of loan-funds is being increased, by crediting the bond holder’s accounts) – which, other things being equal, lowers interest rates in the short-run.

  6. Spencer Bradley Hall says:

    OK. But where (in the commercial banking system), does the FRBNY’s “trading desk” credit the PDs when conducting their POMO purchases & reinvestment of Treasurys? OMO’s under the FRBNY’s “FED POINTs” explains it thus: “This structure works because the primary dealers have accounts at clearing banks…”. Or if not directly deposited, do the PDs (indirectly deposit), thru routine practice in their correspondent account relationship with their commercial bank, have credits transfered, or swept, to the CB’s IBDD account?

    So, in my mind at least, QE2 is all about IORs. Inter-bank demand deposits (IBDDs), are owned by the member commercial banks; they are bank legal reserves and can be converted dollar-for-dollar into Federal Reserve Notes. The volume of FRBIBDDs is almost exclusively related to the volume of Reserve Bank credit. When Federal Reserve Banks expand credit, for example by buying U.S. obligations, the balance sheets of the Banks reflect an increase in earning assets, and an equal increase in IBDD liabilities, i.e., costless legal reserves (in the case of QE2 intially IORs).

    Open market operations should be divided into 2 separate classes (1) purchases from, & sales to, the commercial banks; & (2) purchases from, and sales to, others than banks:

    A purchasing operation of the first type (QE2), involves the Federal Reserve Banks acquiring (+) U.S. Obligations on its asset side, & (+) inter-bank demand deposits on its liability side. On the “T-Account” for the Commercial Banks, the member banks then lose (+) U.S. Obligations, but acquire (+) Reserves.

    Note that transactions between the Federal Reserve & the commercial banks directly affect the volume of bank reserves, without bringing about any change in the money supply. There is simply an alteration in the assets of the commercial banks; the banks’ reserves (and excess reserves) were increased by exactly the amount the government securities portfolio was decreased.

    However, purchases and sales between the Reserve banks & non-bank investors directly affect both bank reserves, and the money supply. A purchasing transaction between the Federal Reserve Banks, once again, increases (+) U.S. Obligations on its asset side & (+) demand deposits on its liability side. But now on the “T-Account” for the Commercial Banks, the member banks acquire (+) Reserves, as well as (+) demand deposits.

    It is assumed that the proceeds from the sale of this security to the non-bank public, was deposited (credited) to the owner’s commercial bank account. The excess reserves of the bank were increased by a lesser amount than the reserves were increased, since the expansion in Reserve bank credit caused an equal increase in the commercial banks’ deposit liabilities (for transaction accounts).

    This is why market players say it is just an asset swap – bonds for stocks (even though the demand for loan-funds is diminished because the Treasury securities have been taken off the market, & placed in the System Open Market Account, while the supply of loan-funds is being increased, by crediting the bond holder’s accounts) – which, other things being equal, lowers interest rates in the short-run.