Understanding the consequences of quantitative easing

Lately, there has been a lot of talks about Quantitative Easing, the Fed’s purchase of assets, as a way to fight disinflation or deflation. People talk about it as the Fed printing money, and the media and the population conveys images of Weimar-style wheelbarrows of cash and Zimbabwe. This has fueled an accelerated frenzy in all asset classes, equities, bonds, commodities, including Gold prices, which have reached ($1380/oz).

My take is that this frenzy is essentially based on a misunderstanding by most people of how the U.S. monetary system actually works. QE itself isn’t inflationary at all. What is inflationary is expectation of inflation. But because people believe it is inflationary, it can excite speculation, and in turns, generate inflation, if enough people believe it, particularly those creditworthy enough to get in debt.

Inflation is the result of too much purchasing power increasing at a faster rate than goods and services available to purchase. Deflation is the reverse: purchasing power decreasing faster than products and services available to purchase.

This purchasing power is composed of bank money and paper/coins, bank money being the lion’s share of purchasing power. This purchasing power is bank “created”. The bank takes promises of people on one hand, and gives credit to these promises in exchange for interest and collateral, so that they become acceptable by other people. Because some of this bank money is convertible on demand in paper or transferable on demand to other financial institution, people have the illusion that bank holds their money and actually transfers it. This is not the case. Holding an account at a bank with a positive balance is like holding a different currency than your Fed reserve notes. It’s pegged to the USD i.e. it’s convertible 1:1 for Fed reserve notes, but it’s not the same. The only true USD are the Fed reserve notes and their electronic version, the reserves, held by the Federal Reserve Banks. These Fed reserves are the banks’ currency: this is how they settle debts between one another.┬áNo one but banks and the Federal government use the Fed reserves.

So, in a nutshell, because most economic agents are not banks and they use bank money to pay, not reserves, only if bank “created” money increases relative to goods/services production is there a risk of inflation. Another way to say is that reserves have not effect until they are “transformed” into bank money. I’m using quotes again here, because there is no actual transformation, it’s just two sides of a balance sheet.

If we agree on this, let’s see what QE is and what effects it may have. When the Fed buys $1T of assets for Fed reserves, whether private (mortgage-backed securities) or public (Treasury Notes), what the Fed does is does is enter the following accounting entry:

  • they record a new reserves as liability, on the account of the bank they purchased from.
  • they record the purchased assets as assets.

So technically, the bank ends up with an excess of Fed reserves, which they are forced to seek yield from, which some people say they can lend to borrowers, which is inflationary.

Actually, this assumes that creditworthy entities are willing to borrow. Let’s assume 3 types of entities: households, goods/services producing companies, speculators, Government.

  • If creditworthy households do not anticipate asset prices to increase, or have just been spooked by the housing crisis or worse lost they home, they are unlikely to borrow against such assets. If households are unwilling to borrow or if banks feel that they are not creditworthy enough, then no new bank money here.
  • Companies will only borrow if they can invest in productive capacity to satisfy a need they identify.
  • The increased liquidity at banks may end up in the hands of speculators. Problem is: speculators do not consume anything so they don’t really represent real demand. To make money, they need to buy low and then they need to sell to someone who actually values the asset for longer than a few microseconds or even days. It is possible to have commodity prices exploding then crashing just based on speculation, but not actual demand (ex. oil in 2008)
  • The government can borrow money, but in practice the government (in the US) isn’t constrained to borrow to spend. They spend first, then borrow. So the government, represented by Congress, must be willing to spend. This requires political agreement.

Given this, how can we have a sustainable creation of bank money (hence inflationary) scenario:

  • households as an aggregate decide to take on more debt. Not likely in my opinion for the next few years.
  • companies seeing that household are not taking on more debt do not borrow (or borrow but to invest abroad).
  • speculators bid each other rapidly, which creates an asset speculation frenzy. Some households or companies who actually need these assets feel that they are missing and decide to buy and hold. To me, this is possible but unlikely given the current lack of confidence by retail investors in financial markets.
  • last, the government, is unlikely to spend or reduces taxes if there is a gridlock, which seems to be the case at the moment.

In conclusion, it is my belief that QE is more likely to not spur inflation in the coming months. I believe it will indirectly contribute to inflation after a new crisis prompts the Government to go on a new huge spending program. New government spending combined with QE does equal new money, but not QE without expansion of credit.

This is not an investment advice.

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