Cullen Roche, founder of the Pragmatic Capitalism blog, and “Opinion Leader” at the finance & investing site Seeking Alpha, wrote a piece called On the Myth of Exploding U.S. Money Supply at Seeking Alpha in which he maintains that Quantitative Easing is just a switching between different liabilities and is not affecting the money supply at all. He refers to an article he wrote entitled UNDERSTANDING THE MECHANICS OF A QE TRANSACTION in which he maintains that the Fed buying Treasuries is similar to someone moving money from a savings account to a checking account.
I believe Robert Blumen has already dealt with the fallacies of the QE piece in his recent Mises daily. The confusion seems to stem from mistaking highly liquid treasury bonds with prices denominated in cash with the actual specie money used to purchase them. If bond dealers could actually use these liabilities to buy groceries then this would be a different matter altogether, but this is not the case. Unsurprisingly, as Blumen notes, the confusion probably stems from the fact that “liability” money does exist due to the fact that fiduciary media created by the FRB system is readily accepted as an equivalent media of exchange to specie money in payments. But just because some money can be a liability does not imply the reverse, that all liabilities can be considered money or media of exchange as opposed to capital assets.
First, from the owner of a T-note’s perspective, having a note and having the equivalent cash are not the same thing. With the latter, they are free to spend, with the former they are not. A note is not money; it’s a promise to pay.
Second, as the example in the article shows, after the Fed buys a note from a bank, their reserves increase. This increase in reserves allows the bank to lend more money, since loans are limited by the amount of available reserves. Each loan a bank makes results in the creation of new money. In fact, most money creation in the US is done by banks, not the Fed.
Note that banks don’t always hold the Treasuries. However, the net effect is the same, since a private owner of a note would likely deposit the proceeds from selling it into a bank.
BTW, the above mechanism is exactly how the Fed manages interest rates with the FOMC – higher bank reserves allow banks to lend more; a larger supply of credit means interest rates go down.
Having said that, the total money supply can go down during QE. However, that’s not because the Fed isn’t creating more money; it’s because money is being destroyed at a faster rate than the supply is being increased.
Tasman: “Second, as the example in the article shows, after the Fed buys a note from a bank, their reserves increase. This increase in reserves allows the bank to lend more money, since loans are limited by the amount of available reserves.”
So the banks’ reserves must be in cash money vs. Treasuries?
If so, that’s a pretty succinct proof of the flaw in his reasoning.
Reserves must either be on deposit in a member bank’s account at the Fed (similar to what you and I might think of as a checking account), or they can be held as vault cash. Treasury securities and other forms of debt are specifically excluded, because reserves are what forms the foundation or “backing” of debt.
Thanks it makes sense, of course, but insurance companies can use various assets, including bonds as part of their required reserves.
Interesting, though, in the sense that Federal Reserve Notes are themselves debt liabilities as I understand it. That would in essence be a backing of debt with yet more debt.
Bank reserves can be created two ways. First, by the Fed buying Treasuries through the FOMC. Currency is then created on demand when banks ask the Fed to exchange some of the funds they have on deposit with the Fed. The accounting transaction is something like crediting the bank’s account for the amount of the requested currency, and debiting an “FRNs in circulation” account.
On the bank side, though, let’s say that a bank creates new money for a loan, and the borrower withdraws it and spends it. The final recipient then deposits those funds back into the banking system. When they do, those funds become bank reserves. In fact, the money doesn’t technically have to be spent for it to become reserves; it just has to stay in the banking system. This is why, although banks are limited to creating new money for a single loan to 90% of their reserves, they can actually end up creating 9 times their reserves – because newly borrowed (created) money becomes reserves.