Why Quantitative Easing Isn't Printing Money

House · May 31, 2013

From the author of the article Gold Rallied for Years on 'Misunderstanding' (discussed on SS here)

The title of a recent article I wrote for CNBC.com was " How Gold Rallied for Years on a 'Misunderstanding,' " but it's obvious from the comments I received that I did not clear up these misunderstandings.

So I'd like to explain in a bit more detail why quantitative easing (QE) is not printing money and why bank reserves aren't money.

Let's take a look at the balance sheets of the actors involved. Here's what the T-accounts for the balance sheets of each institution, showing the assets on the left and the liabilities on the right, look like before quantitative easing:

As you can see, Bank ABC's assets consist of 50 reserves at the central bank, 50 loans and 40 bonds. The central bank's balance sheet has assets of 70 T-bonds and T-bills, but against liabilities of 50 in reserves (the aforementioned reserves of the banks) plus 20 of notes and coins in circulation-what we usually call money. The Treasury has assets of 110 and liabilities of 110, namely the T-bonds and T-bills that the banks and the central bank hold.

Now, the central bank embarks on quantitative easing. It buys up all the bonds that Bank ABC holds. What do the balance sheets look like now?

Bank ABC has only shuffled the composition of its portfolio around. It's exchanged bonds for reserves in what is no more than an asset swap. There is no increase in the size of its balance sheet.

The central bank's balance sheet, on the other hand, grows substantially. On the asset side it gains 40 bonds and on the liability side, reserves increase by the same amount. Note though that there is no change in cash in the hands of the public-what we know as money.

The whole operation leaves the Treasury's balance sheet unchanged. No new bonds are issued, no revenues received.

So we can see that while the central bank's balance sheet does expand, the only impact in the private sector is to change the composition of the banks' balance sheets, exchanging bonds for reserves. The total assets of the private sector don't change. Hence no money is being created any more than, say, if someone sold their stocks and put the money into bonds.

Now, some people will argue that reserves are money. But let me explain why I don't think reserves are money.

What is money? Money has three functions: a medium of exchange, a store of value and a unit of account. Bank reserves are a store of value; they may be a unit of account; but they are definitely not a medium of exchange.

Only financial institutions can hold reserves at the central bank. You can't go into a store and buy a loaf of bread with bank reserves, as you can with, say, a dollar bill or a checking account at a your local bank. Reserves just sit there. Although they do earn interest, that doesn't mean they are money. You can rent out your house and get an income stream from that, too, but that doesn't make your house money.

Finally, one should also look at the intentions of the economic actors holding the bonds in the first place. As Nomura Research Institute Chief Economist Richard Koo points out, the banks, bond dealers or whoever held those bonds in the first place held them as a store of value, not as a medium of exchange. When the Fed buys the bonds away from them, they are apt to replace them with another store of value, such as stocks, rather than a medium of exchange. The money simply goes from one asset to another and does not contribute to expenditure that boosts growth and, ultimately, inflation.

Of course there is likely to be some leakage. Some of the reserves exchanged in the sale may be cashed in for money. There is also the "wealth effect" as the value of these stores of value rise, but that is not creating money, just inducing freer spending of the money that exists.

The process would be inflationary if the banking system were to use those reserves to increase their loans. This is the fundamental concern of those who fear that QE is going to cause inflation or hyperinflation, and it is not unreasonable.

However, this is putting the cart before the horse, particularly during a balance sheet recession, which why I said the purchases of gold were based on a misunderstanding.

As the Bank for International Settlements (BIS) put it: "In fact, the level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly."

The proof that QE is not inflationary can be seen in Japan. Japan ran a QE regime from 2001 to 2006, and yet is still in deflation. The reason their QE didn't work is because even with interest rates at zero, nobody wanted to borrow. There was no demand for loans. Bank lending started falling on a year-on-year basis in November 1998 and was consistently negative until September 2005. Until the banks start to lend out the reserves, no money is created and no inflationary pressures build. Q .E .D (quod erat demonstrandum).
Click to expand...

CNBC

Emanance · May 31, 2013

So the banks are forced to hold these QE 'Reserves' on their balance sheets to finance loans...I think not. QE 'reserves' are valued in US dollars and have to grow in value for the bank at a rate greater than inflation plus their running cost, or the bank is going backwards & bankrupt. Hence their under performing balance sheets turn toxic in a 'balance sheet recession'. Looking at the Dow Jones Industrial Average and until recently Japan's Nikkei 225 it's easy to see where these QE funds are really going.

So using the Nikkei 225 as an example because of it's recent moves, we can assume that up until recently the volume of positive trading that sent it on it's bull run came from QE reserves held by the banks who need this money to perform. This increase of the Nikkei 225 also attracted a lot of new capital from regular people & businesses using non QE money, who are scared shitless of leaving it in the bank because of the intentional debasement of the Yen (inflation). Then during it's recent moves downward I think it's reasonable to assume the majority of profit taking would of more likely be done by these same bank's seasoned investment professionals. Leaving the small fry holding the losses. Just like one massive pump & dump, transfer of wealth.

Next question is; What do the banks of japan do with the QE money now?
Can't put it (back) in shares while they are going south.
Can't put it in Japanese Bonds or it will send the government bankrupt.

Where is this QE money going? Like do they give it back?

willrocks · May 31, 2013

Thanks for making the the important parts bold. Couldn't stand reading through all that s#!t after a few beers.

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