The following article can be found at http://www.businessinsider.com/a-deep-dive-into-the-mechanics-of-a-qe-transaction-2010-11?utm_medium=email&utm_campaign=BI_Select_110910_ Personal&utm_source=Triggermail&utm_term=Business+ Insider+Select Who here is able to refute this sophisitcated claim from BusinessInsider Magazine that QE does notincrease the money supply? I (and I am sure many others) would love Austrian insights on this argument.
Thank you!
Quote: "A Deep Dive Into The Mechanics Of A QE Transaction Some people want you to believe that the Fed just injected the economy and stock market full of money that will now result in an economic boom and much higher prices in most assets. That’s simply not true. Here’s the actual mechanics behind QE. Before we begin, it’s important that investors understand exactly what “cash” is. “Cash” is simply a very liquid liability of the U.S. government. You can call it “cash”, Federal Reserve notes, whatever. But it is a liability of the U.S. government. Just like a 13 week treasury bill. What is the major distinction between “cash” and bills? Just the duration and amount of interest the two pay. Think of one like a checking account and the other like a savings account. This is a crucial point that I think a lot of us are having trouble wrapping our heads around. In school we are taught that “cash” is its own unique asset class. But that’s not really true. “Cash” as it sits in your bank account is really just a very very liquid government liability. What is the difference between your checking and savings account? Do you classify them both as “cash”? Do you consider your savings accounts a slightly less liquid interest bearing form of the same thing a checking account is? What is a treasury note account? It is a savings account with the government. So now you have to ask yourself why you think cash is so much different than a treasury note? What is the difference between your ETrade cash earning 0.1% and that t note earning 0.2%? NOTHING except the interest rate and the duration. You can’t use your 13 week bill to pay your taxes tomorrow, but that doesn’t mean it isn’t a slightly less liquid form of the exact same thing that we all refer to as “cash”. They are both govt liabilities and assets of yours. When you own a t note you really just traded your “cash” for a slightly less liquid form of the same exact thing. If the Fed buys those t notes from you they give you back your cash minus the interest rate. That’s all there is to it. No change in the money supply. No change in anything except the rate of interest you were earning. If the government removes t notes then all they’re doing is altering the term structure of their liabilities. They’re not changing the AMOUNT of liabilities. The other day, Ben Bernanke explained that he is not adding any new cash to the system via QE: “Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.” This is very important because millions of investors are betting on the inflationary impact of QE. But again, as Mr. Bernanke said there is no reason to believe that QE is inflationary. Why? Because they are not adding net new financial assets to the private sector. The assets already existed! They are merely swapping reserves for bonds. They are giving the banks a checking account instead of a savings account. What does this mean? If Bank A owned a 1.2% 5 year note and they sell that note to the Fed they receive reserves earnings 0.25%. Their savings account was changed to a checking account. What changed? Nothing. Just the duration and rate of the paper. The number of assets in the system is the exact same. You can see this description in the following diagram (via Alea): chart As you can see the net financial assets are UNCHANGED. They are merely changing the composition of the bank balance sheet. The logical question that most people ask is: “where did the Fed get the money to buy the bonds?” They didn’t get it from anywhere. It truly is ex nihilo. But it is not new money being injected into the private sector. It is merely being swapped with something that was already spent into existence. Therefore, you’ll often hear that banks have new money to put to work. That’s not true. They had a 0.2% piece of paper that was already put to work and can be exchanged in markets for whatever they please. There is not “more firepower” in the market following QE. All that the Fed altered was the duration of the U.S. government’s liabilities. The Fed took on an asset (treasurys) and also accounted for a new liability (the reserves). But this transaction did not change the net financial assets in the system. The point here is that from an operational perspective the Fed is not really altering the money supply. There might be some slight market change in the bonds the Fed purchases, but this is offset by the fact that the private sector is losing interest income they would have otherwise earned. For instance, in QE1 the Fed removed $1.2T in assets from the private sector. Much of this was high yield paper. We know the Fed turned over ~$50B to the U.S. treasury (its “profits”) from QE1. What did the banks get in return? They got a checking account at the Fed earning 0.25% or roughly $2.5B over the course of QE1. So the private sector LOST ~$47.5B in interest income it would have otherwise earned. So, now you must be asking yourself why the heck they’re even doing this to begin with. Well, QE supposedly changes the term structure of the bond market. Fewer 5 year notes should lower interest rates and entice borrowing, generate lending, make other assets more attractive, etc. If you sell your bonds to the Fed and receive low interest bearing cash you might want to rebalance your portfolio. Mr. Bernanke is hoping you will reach out on the risk curve and buy equities or corporate debt. But the price you purchase those securities at will depend entirely on their fundamentals and the price that you and the seller agree upon. If you run out and bid up risk assets just because you think the Fed is “printing money” then you’re making a mistake. If you run out and buy stocks even though their fundamentals have not changed you are making a mistake. This is probably best seen in the price of commodities presently where investors are hyperventilating over the “printed money” and buying up hard assets. For instance, coffee prices are up 70% since QE started yet Howard Schultz, the CEO of Starbucks says the fundamentals have not changed at all in the last two months. He claims the speculators are to blame (thank you for that Ben Bernanke!). Inefficient market at work in real-time? Sure looks that way and we can thank the Fed for causing the bubbly situation in commodities. They’re advocating undue speculation, causing severe market distortions, driving down the dollar and rewarding speculators for further financializing this economy. The Fed has caused this mass hysteria over a minor interest rate decline. In short, there is not more cash in the system following QE. There is not more “firepower” with which to purchase equities. Hopefully, the above description makes that very clear. This was most obvious in Japan where QE caused a brief 17% rally in equities as speculators leveraged up, jammed prices and then later realized that the slightly lower yields hadn’t really changed anything. What happened next? Their equity market fell 40%+ over the next two years. QE was a great big “non-event”. All it did was manipulate markets temporarily and cause a huge amount of confusion."
I'll take a stab here:
Before we begin, it’s important that investors understand exactly what “cash” is. “Cash” is simply a very liquid liability of the U.S. government. This may have been true when you could take cash into some govt place and get gold or silver in return. But now "Cash" is simply the USA saying "IOU NOTHING". You can call it “cash”, Federal Reserve notes, whatever. But it is a liability of the U.S. government. From Investopedia: "What Does Liability Mean? A company's legal debts or obligations that arise during the course of business operations. Liabilities are settled over time through the transfer of economic benefits including money, goods or services. Investopedia explains Liability Recorded on the balance sheet (right side), liabilities include loans, accounts payable, mortgages, deferred revenues and accrued expenses. Liabilities are a vital aspect of a company's operations because they are used to finance operations and pay for large expansions. They can also make transactions between businesses more efficient. For example, the outstanding money that a company owes to its suppliers would be considered a liability. Outside of accounting and finance this term simply refers to any money or service that is currently owed to another party. One form of liability, for example, would be the property taxes that a homeowner owes to the municipal government." And here is Businessdictionary.com "liability Definitions (3) 1. General: Claim against the assets, or legal obligations of a person or organization, arising out of past or current transactions or actions. Liabilities require mandatory transfer of assets, or provision of services, at specified dates or in determinable future. 2. Accounting: Accounts and wages payable, accrued rent and taxes, trade debt, and short and long-term loans. Owners' equity also is termed a liability because it is an obligation of the firm to its owners. Liabilities are entered on the right hand-side of the page in a double-entry bookkeeping system. Read more: http://www.businessdictionary.com/definition/liability.html#ixzz14yHU3Wwv In other words, by any use of the English language as we know it, a liability means I have to GIVE YOU SOMETHING. What does "“cash”, Federal Reserve notes, whatever" obligate the US govt to give me, the holder of that piece of paper? Nothing. So we have a sophistry from the very start of this article. Just like a 13 week treasury bill. What is the major distinction between “cash” and bills? Just the duration and amount of interest the two pay. Think of one like a checking account and the other like a savings account. That's like saying a married woman and a widow are both married. One has one husband the other has zero husbands. The duration of cash is "never" and the amount of interest is "zero".
This may have been true when you could take cash into some govt place and get gold or silver in return. But now "Cash" is simply the USA saying "IOU NOTHING".
You can call it “cash”, Federal Reserve notes, whatever. But it is a liability of the U.S. government.
From Investopedia:
Definitions (3)
1. General: Claim against the assets, or legal obligations of a person or organization, arising out of past or current transactions or actions. Liabilities require mandatory transfer of assets, or provision of services, at specified dates or in determinable future.
2. Accounting: Accounts and wages payable, accrued rent and taxes, trade debt, and short and long-term loans. Owners' equity also is termed a liability because it is an obligation of the firm to its owners. Liabilities are entered on the right hand-side of the page in a double-entry bookkeeping system.
Read more: http://www.businessdictionary.com/definition/liability.html#ixzz14yHU3Wwv
Just like a 13 week treasury bill. What is the major distinction between “cash” and bills? Just the duration and amount of interest the two pay. Think of one like a checking account and the other like a savings account.
That's like saying a married woman and a widow are both married. One has one husband the other has zero husbands. The duration of cash is "never" and the amount of interest is "zero".
. If the Fed buys those t notes from you they give you back your cash minus the interest rate. That’s all there is to it. No change in the money supply. No change in anything except the rate of interest you were earning. If the government removes t notes then all they’re doing is altering the term structure of their liabilities. They’re not changing the AMOUNT of liabilities.
There are two major errors here.
1. Let us ask ourselves. Why does the govt sell T notes in the first place? Why not just keep them? Why promise to pay interest [which is what a T note is] in exchange for cash? They are both liabilities [according to the silliness of the author]. Why promise to give someone interest in exchange for a liablility that was not giving him any interest?
The answer, of course, that Cash something you can actually use in real life. You know, buy stuff with. But you cannot buy things with a T note. So printing T notes will not let the govt spend spend spend. Someone has to be willing to take those T notes off the govts hands and give the govt cash for them, which the govt can then spend spend spend.
So that of course exchanging T notes for cash will give the govt the ability to spend more, causing inflation. That's the whole point of this excercise in the first place.
Now, this huge flaw in the authors silly argument would exist even if the govt was selling these T notes to Japan or China. Those countries may have decided to not spend those dollars they have, or spend them outside the USA [since the dollar is used for exchanges between all countries when buying certain things, like oil]. But now all those dollars are going to be spent in the USA by the US govt.
No matter who is the junkie supplying the govt with its fix of cash, there is going to be more govt spending, meaning the private sector [=you and me and businesses that produce things and hire people for productive jobs] will have less. After all, there is only so much steel, so much wheat, so much anything. Whatever the govt takes for itself means less for us. Think of the Soviet Union taking the cows from the peasants to give to "the people". The peasants have no milk anymore; the govt has it all. That's what's happening when the govt manages to sell a T note.
Not to mention that the govt has to then repay that note, plus interest. But rest assured it has already spent the money it got from selling that T note, and right away. And it hasn't spent it in investing in some productive fashion that will make sure it makes the money back with interest, thus able to pay off it's debt and make a profit besides. That may be how a business uses money it borrows, but it's laughable to think the govt does that ever. So how will it repay those loans? Ultimately, by making you and me pay for it.
OK, that's the first major error in this absurd article's attempt at assuring us everything is perfectly all right. On to the next major flaw:
2. Even if we ignore the first major flaw, and pretend that T notes and cash are more or less the same thing, and that buying T notes is merely exchanging one liability for another, quantitative easing is still hugely inflationary and is nothing more than printing money.
We can best understand this with the following story: A counterfieter prints money in his basement, 600 billion dollars worth. The next day he goes on a shopping binge, buying like a drunken sailor. The cops arrest him for for the crime of printing money as he is buying a new yacht with the money he printed yesterday.
"But I wasn't printing money when I bought that yacht, officer. I was merely exchanging existing money for a yacht."
The author is making exactly the same argument as our counterfieter. Let's look at what wikipedia has to say about QE:
"A central bank implements quantitative easing by first crediting its own account with money it creates ex nihilo ("out of nothing").[2]
[=the counterfieter prints the money]
...The central bank then purchases financial assets, including government bonds, agency debt, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. [= he buys a yacht] "
The author didn't bother with the first step. He just said that the second step creates no new money.
The other day, Ben Bernanke explained that he is not adding any new cash to the system via QE: “Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.”
Poor Ben. When things go bad, and they will, his friends will sell him out. He is lying now for them, as he has in the past.
Here is a fuller quote of this little gem:
"“If you think of the Fed’s balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves in the banking system.
[=we print money]
Now, what these reserves are is essentially deposits that commercial banks hold with the Fed,
[= and we give it to commercial banks]
so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing.
[= we have printed the money and given it to our pals, but they have not yet bought any yachts. For now it is in their wallets].
What’s happening is that banks are holding more and more reserves with the Fed.”
[=we printed money and gave it to them, but they have not yet spent it. But they will. That's why we gave it to them in the first place, this time.
Last time we gave them printed money in exchange for all the worthless mortgages they held. The point of the excercise was to save the banks from bankruptcy. Of course the little guy had to suffer because of this when his money lost purchasing power, but that's life.
This time the govt will get the money when it sells T notes, because nobody else wants their T notes anymore. Of course the little guy will suffer because of this when his money loses even more purchasing power, but that's life. Ask not what your country etc. ]
. For instance, in QE1 the Fed removed $1.2T in assets from the private sector. Much of this was high yield paper. We know the Fed turned over ~$50B to the U.S. treasury (its “profits”) from QE1. What did the banks get in return? They got a checking account at the Fed earning 0.25% or roughly $2.5B over the course of QE1. So the private sector LOST ~$47.5B in interest income it would have otherwise earned.
Boy, did we trick those stupid banks! They got 2.5 billion when they could have gotten 50 billion. Makes you wonder why they were yelling and screaming that this had to be done to save the whole world from financial ruin. I guess they realized that unless they lose 47.5 billion the world will come to an end. So, like good patriots, the coughed up the 47.5 billion to save the world. And they are going to keep on losing 47.5 billion every year for 24 years till that 1.2 trillion is paid in full [not to mention the loss of huge interest on that 1.2 trillion.] And they did it for us, for you and me and everyone all over the world. I salute them.
That's the author's explanation of what happened. I've heard another. That "high yield paper" is very risky. They may have repaid 50 billion this time, but they are never going to repay the full 1.2 trillion. Meaning the banks dumped worthless papers on the Fed, that no one else was willing to buy. And the Fed paid for it with newly printed money.
OK, I tire.
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It's easy to refute an argument if you first misrepresent it. William Keizer
The loans the banks would recieve on the discount window from the Fed are temporal and would be undone as soon as the Fed raises the rates (now at 0.75% if I recall correctly). The money that the Fed has injected with QE2 will stay in the economy (because the Fed is not going to sell those bonds). They are very different things.
It's comforting to know that writers stake their professional reputations writing this stuff; it just HAS to be right. Right?
I suppose that the rise in prices the entire 20th century and the first decade of this one is just a temporary condition. Once people realize that no new notes exist, prices will be bid down again.
Thank goodness the banks get around to using their reserves during times of crisis by which the market is made more liquid. Thank goodness the Fed is there to oversee this process.
I think what the article does is lend credibility to Peter Schiff's belief that the real purpose behind QE2 is to prop up government securities now that China and other nations are showing hesitance.
This article seems to be confusing the government with the Federal Reserve. Although the FR is influenced by the government they still are not the same entity:
Lets say a Bank buys $1M of T-bonds. Then the government uses that $1M to buy a tank. Then the Federal Reserve buys that $1M bond from the bank. So the tank company has $1M and the bank has $1M. Now the government owes the Federal Reserve $1M. Where will the government get the $1M?
What the article doesn't mention is how the government will pay its debts when debt is increasing. Not to mention what about all the interest the government and the Federal Reserve have to pay on reserves, etc. Where will that money come from?
"In a modern democracy, no matter whom you vote for, the government always gets elected" -Christopher Westley
I think I can debunk the notion quite simply:
The writer of the article pre-supposes that one day the FED will unwind its balance sheet - either selling off the Treasuries to the public or letting them mature. That's his mistake.
I, for one, believe there is a zero percent (yes, zero) chance that the FED will ever unwind its (ever growing) balance sheet. I don't think the fiscal conditions of the United States economy or dollar will ever allow it again. Ever. Do you think the conditions will ever be ok for the FED to dump several trillion worth of bonds? (If you remember the assets from QE1 were supposed to be unwound over time - but now that money has been diverted into Treasuries.) So the assets the FED currently owns will be rolled-over and over and over forever.
The good news is that this debt has already been effectively monetized - so it's not owed by taxpayers anymore. The bad news is it is inflationary as HELL.
Thank you all very much for the time and work answering to this article!