The Meaning(lessness) of Money — Why “Quantitative Easing” Won’t Do What People Think it Will Do
There has been much talk, of late, about the ineffectiveness of conventional monetary policy — i.e., lowering the target for the overnight interest rate to incite borrowing and hence economic expansion — and the need for monetary authorities to consider something more dramatic, like so-called “quantitative easing” — the active buying of government debt and other securities in the open market ostensibly to “increase the supply of money” in the economy with a goal of (a) greasing the wheels of finance; and (b) creating inflation expectations.
Trouble is that quantitative easing is more or less meaningless in a modern monetary economy (its major price impact is meaningful however and is discussed below).  As I suggested in a previous post, banks are not constrained by the supply of government money in their lending activity since the Bank of Canada always stands ready to accommodate the growth in privately-created credit money. If it didn’t, the Bank of Canada would be unable to hit its target for the overnight rate which remains, even in today’s crisis, the main monetary policy tool.
Let’s walk through an example. Suppose the Bank of Canada is targeting a 0.5% overnight interest rate. Suppose further that for whatever reason, the Bank decides to engage in “quantitative easing” and goes out and buys $1 billion worth of government treasuries on the open market. What happens?
1. The banking system as a whole is suddenly in a surplus position on the Large Value Transfer System (LVTS), which is where large overnight transactions are settled;
2. Individual banks with a negative LVTS balance will find more than enough positive balances (held by other banks) to settle their overnight obligations.
3. The overnight rate will drift well below the Bank of Canada’s target.
4. Seeing this, and wanting to maintain it’s target at 0.5%, the Bank of Canada will have to transfer $1 billion of government deposits from the private banks onto its books to neutralize its initial purchase (or use Sale and Repurchase Agreements -SRAs). In other words, the Bank will do what it normally does and target a zero balance (actually a small surplus) in the LVTS.
So if open market operations must be neutralized to hit an overnight target, why would the Bank of Canada even bother to make these purchases? Two reasons, neither of which have anything to do with “the money multiplier” or the “quantity theory of money.”
First, the Bank of Canada may want to “make a market” in a given asset class, i.e., assure some liquidity to a seized-up market (ABCP anyone?). Second, it may want to signal a desired direction for bond prices and yields — by bidding on (say) government of Canada debt, the Bank increases demand to that debt/asset class and effectively drives up prices and yields down.
Is any of this inflationary? Again, certainly not through any money multiplier relationship or quantity theory relationship but only through the normal, indirect method of dropping the cost of credit (yields) and thereby increasing the incentives to borrow. But that’s what the Bank of Canada always does — it is a self-confessed “quantity taker” and “price setter.”
And what happens if the BoC purchases debt when it’s overnight target is zero percent (coming soon to an economy near you)? Not much. The bank system will simply have a perpetual LVTS surplus and overnight bids will drift towards the Bank’s new target of, yes, zero. Will this compel the banks to lend more money? Maybe, but only if they think that their borrowers are going to be able to repay them, i.e., are creditworthy. And that’s no different than at any other time.
There’s no magic here. Just a lot of misunderstanding in the popular press and among far too many economists — and even central bankers — who ought to know better.
Interesting post Arun. It helps me understand BoC thinking.
Some questions (and genuine questions, not intended as snarky criticisms, but reflecting my own ambivalence):
1. At the back of your mind, there is some model of how the financial system works in a modern economy. And according to that model, “quantitative easing” would have no (or negligible) effect. But if that model of how a financial system works (or ought to work), were correct, would we be having this financial crisis? In particular, one aspect of the crisis seems to me to be a liquidity crisis, where the most liquid assets are the ones with the greatest demand, highest prices, and lowest yields. It is not just risk, it’s liquidity. For example, “off the run” bonds, which are less liquid than “on the run” bonds, but have the same risk, trade at higher yields.
2. You implicitly invoke a sort of “Law of Reflux” to assert that the whole $1 billion would return as BoC reserves. Or would need to return in order to keep the overnight rate constant. Why would it necessarily be the whole $1 billion?
3. If quantitative easing does not work because the BoC acts as a price maker and quantity taker (and I can never decide how much that is a description of the BoC’s current operating procedures and how much it has become so deeply ingrained into the thinking of those at the BoC that they view it as just the way the world must be), what changes to the operating procedure at the BoC would be required for quantitative easing to work?
All I can think of for now, but I may come back with more.
Hi Nick,
Thank you for your constructive comments. Apologies if I sounded a bit snarky at the end of that post — blogging tends to bring that out in people and try as I might to resist (because I find it distasteful and counterproductive), I sometimes sucomb. Work in progress as they say.
To your comments.
(1) Good point — For anyone with cash-flow constraints going forward — real or perceived — liquidity is king. To whit, everyone faces some level of cash-flow constraint because of outstanding debt, working capital or day-to-day life obligations. Add to that the state of expectations — i.e., crummy, and you get a liquidity crunch, with no one wanting to be the sucker who steps into the breach to lend money to someone who isn’t going to be around in 6 months. So on-the-run bonds and other kings of liquidity rule. And that’s why I see this ultimately as a demand-side problem — you’ve got to change the state of expectations and to do that, you’ve got to create some demand that shows up on the bottom line, i.e., GDP, rising income, profits, and so on. I think we may already be seeing some of that. From what I hear, the banks — for example — are not fully subscribing to the federal government’s IMP program, which is of course good news. We may never see $125 billion.
(2) On the reflux — I’m a reflux guy on the private banking system (shout out to Thomas Tooke!) but I wouldn’t use the term wrt to the central bank’s monetary operations. The only reason the Bank would reverse auction GoC deposits would be to maintain a target for the overnight rate above zero. Does it have to be the full amount of the initial injection? If we throw in a ceteris paribus, I would have to say “yes.” And all the ceteris paribus does is allow us to assume the Bank has done its job and otherwise created a zero settlement balance position so that the $1 billion mucks things up and has to be removed.
(3) On the matter of getting quantitative easing to work. Two things — my discussions with BoC personnel on the trading floor and elsewhere supports the view that the BoC is a price setter; quantity taker. Certainly, their literature supports that interpretation. And just as an aside, Post Keynesians have been saying this for a long time, way before anyone at the Bank would even venture forth that opinion (don’t know if you’re familiar with the old Post Keynesian “horizontalist versus verticalist debate but that’s it in a nutshell — the horizontalists won).
Finally, and this opinion, again, is informed by my post Keynesian perspective, I don’t think quantitative easing can achieve anything other than price effects (with one extreme exception, see below) so I don’t think you can make it work in the way that everyone seems to want it to. Banks and other loan originators have the capacity to create as much credit money as they want. It’s the absence of credit-worthy borrowers that’s the problem, which leads us straight back to the state of expectations, demand-side considerations and the pro-cyclical nature of what banks consider to be credit-worthy borrowers — see anything by Hyman Minsky on this topic. Even if you’re in a zero overnight environment and the Bank is actively buying stuff, banks aren’t necessarily going to extend any more loans just because they have all sorts of no-cost settlement balances — they still have to worry about default risk and the prospect of writing down a lot of bad loans that puts their capital ratios at risk.
That said, I suppose that we could imagine a situation where the BoC goes out and buys a lot of dodgy GM debt, CanWest debt, or some such. I just don’t see that as a practical alternative for the obvious public policy reasons that the Bank would be taking a stake or claim in non-bank companies (I think they’re legislatively limited on this but I’d need to check). It would also mean that the central bank would become a competitor of sorts to the private sector. I’m not necessarily opposed to that idea – paraphrasing Joan Robinson (I think – bad memory here!), banking is too important to leave to bankers – but it’s a big step nonetheless. In any case, the last time the Bank got actively involved in a bailout was with the Canadian Northern and Northland banks and that created all sorts of headaches for the bank.
Okay. Hope that clarifies a bit my thinking.
Thanks Arun: After writing that comment (especially point 1), and thinking about it a bit, I realised I would have to try to put my money where my mouth is, so to speak, and try to write down a model where an increase in the money supply did work, even though nominal interest rates were at zero. Here is the result: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/03/imperfect-financial-markets-and-quantitative-easing.html
I’m not happy with the model (it’s not really even a model, just a sketch of one), but it seems to sort of work.
Still in two minds about the whole question. I can see things through your eyes, I think, but another side of me says “this can’t be right, there’s obvious signs of failure and illiquidity, that more liquidity really ought to help, and we ought to figure out some way to try it, and that fiscal policy, though it might help, is not really getting to the root of the problem”.
Anyway, I’m still thinking.
Thanks.
does anybody have any opinion on how quantity easing supports a monetary policy and how it would support a keynesian theory.
im writing a paper for college and struggling to debate it from both sides
Mr. Oldersmith, it would probably help if you just cut through all the jargon and only thought about what our money supply is. I apologize if this sounds condescending.
Every penny of our currency in existence is in fact debt. Money only comes into existence when a bank creates credit by extending credit to a customer. That customer spends the credit and that credit eventually winds up in a bank account as a deposit. The deposit can only exist because the debt exists. Debt can only be reduced by removing credit (deposits) and the two cancel each other out (like matter and anti-matter). Repaying debt reduces the money supply.
Because the credit created is always less than the debt owed (interest) the only way to pay interest is to create more credit (make more loans). A country as a whole can never get out of debt in this system without complete and utter bankrupty. To avoid bankruptcy the system must create credit fast enough to pay off the previous principle+interest payments in addition to purchasing our new outputs. Basically we use one credit card to pay off another then use another to pay off that one – on and on and on.
At the end of 2006 Canada had about 1.8 trillion credits (people think of them as dollars but they’re actually just credits). The total debt owed for that credit was about three trillion. If we were to hand over every penny in existence we would still owe far, far more. George Carlin was not joking when he said “They OWN you”.
When credit is not created fast enough we have a recession or, if its bad enough, a depression. The way into a “economic downturn” is the raising of interest rates and tightening of loan qualifications to slow credit creation. The only way out is to accelerate credit creation. Slowing credit creation is easy as pie, speeding it up again can be a completely different story.
First, to speed up credit creation requires the population to go further into debt. If the population doesn’t borrow enough the debt based economy cannot recover. If the public stops borrowing altogether, the entire system implodes and the entire money supply disappears, leaving only interest debt and no credit masquarading as money.
Second, banks have to be willing to loan. It doesn’t matter Jane Q Public wants to take out a mortgage for a new house if no bank will (or can) create the credit necessary. In order to create credit a bank must have assets exceeding their liabilities. At the present time many of these assets aren’t worth the electrons that record them in computer memory (not that they were actually worth anything in the first place – they all derive their “value” from bank created credits). The only true asset in our economic system is government debt. Government bonds are money, pure and simple – the only actual money in our system. In fact all the credit that exists is “backed” by government debt. This is why Harper/Obama/etc want to run deficits – to provide the capital that makes “quantatative easing” possible.
Third, The Central bank has to allow credit creation. Interest rates and “open market” operations make credit cheap or expensive, scarce or plentiful. If either of the first two conditions are missing then anything the central bank does to increase the credit creation rate is akin to pushing on a string, it doesn’t go anywhere.
As for Keynes, he said that in economic hard times governments should spend. In reality he meant governments should borrow to increase the banking system’s capital position. Remember that a billion in government bonds means 20 billion or more in new credit. Its not the infrastructure projects that get the economy going, its the glut of new credit that the new debt allows. The new jobs for infrastructure are handy and do serve as a bit of a stimulus but without the corresponding explosion of new credit, it accomplishes nothing.
For the last several years it has not been the general public spending credit that has run our economy. Its been the paper economy – all the little pieces of paper that people keep borrowing to buy in hopes of selling for even more. This system isn’t possible without a steady inflation of the money supply (there simply isn’t enough money). Companies are no longer really relevent – its the price of that piece of paper we call stocks. Even the stock market has become a bit player compared to derivities (all the off track betting that isn’t regulated because they aren’t trading stocks, securities etc, they just betting on where prices will go).
The current economic crisis isn’t because some poor schmuks aren’t making their house payments. Its because the central banks started tightening credit to create a recession and suddenly these off-track betters found they weren’t able to sell their little pieces of paper for enough money. In an effort to not lose their shirts at the track some started to try and collect what was “backing” the bits of paper and found that just wasn’t possible. With the unavialbility of new credit and the news that their pieces of paper had values FAR less than the vastly inflated amount that speculation paid for with credit came panic. The gamblers can’t pay their bookies and the bookies can’t pay off the winners. Thats why Harper/Obama/etc paid out huge sums to “rescue” the banks. Problem is that the derivitives market is something like 10 times the entire world’s GDP and these stimulus packages are far less than a drop in a bucket compared to that.
In the UK the BoE (Central Bank) is buying Government bonds from non-banks – i.e. pension funds and life companies. I believe that they are targeting non-banks so as to ensure that there is an increase in cash resources. I guess that these non-bank institutions will then use the cash resulting from the sale of bonds to invest in other assets such as short-term money market loans or equities. What are your thoughts on this one?
James
Hi All
Cheers Pat to a very informative comment. Clears up a few questions in my mind.
Some of the linkages along the value chain that your outline above are undoubtedly still quite a bit murky, and from you comment have a quite nasty smell that could still make what we are witesssing now, seem like a joke.
I guess the bottom will be felt when the selected few herd at whats left of the the fast drying watering hole believes that the clouds above could actually bring rain again. i.e. when the prevailing trust in the system is turned around. this I guess would mean the fundamentals are transformed back into concrete, i.e. the values of specific assets backing up a good lot of derivatives and other financial vehicles are restored.
As we stated on this blog somewhere back a couple months ago and reiterated y you, the seeming route by Obama/Harper, etc, is purely a ruse that in reality is a meager attempt at restoring confidence, but in actual fact will never come close to matching any level of detoxification that would be required.
Plain and simple, to make the necessary amount of anti-matter is just plain too costly. So if after a couple kicks at the detox clinic of Obama, and we still have no wayward course of trust instilled in values, what then.
Simply throwing hundreds of billions of dollars at such many multi trillion dollar problems just does not have the leverage – that leads one to conclude that this is just a waste.
Or is there a chance that somehow the credit crowd can be swayed with such levers of fiction.
I do believe in monsters- sometimes. Only the ones I can’t see, and hopefully they can build this one. Where is Dr. Frankenstein when you need him. ( or maybe Speilberg)
A believable monster is needed!
At least that is what I think you are saying. Right?
paul
James,
Thanks for the question. I must confess that I haven’t followed the BOE’s “quantitative easing” actions in any great detail — other than what I’ve read and discussed in a subsequent blog post — but if they are in fact buying bonds back from the insurance cos and other (traditionally) non-deposit institutions, then clearly this improves their cash positions and their ability to meet cash-flow requirements.
I think it’s important to keep in mind, as Warren Mosler and his crew always insists, that these quantitative easing operations amount to an asset swap — the insurance companies and pension funds are swapping a long-term highly liquid asset (govt debt) for a short-term highly liquid asset bearing no interest payment, presumably because they have pressing cash-flow needs.
Indeed, I’m not sure why they would use these newly-acquired highly liquid, non-interest bearing assets (i.e., the reserves or cash) to turn around and buy longer-dated debt assets (money market funds) with probably a worse liquidity profile than the original asset (govt bonds). For the same reason, I’m not sure why they would use their new cash to buy equity — that doesn’t seem very prudent either.
Which brings me back to the original intuition, namely that the reason they would sell that debt to the government would be to meet some immediate cash-flow needs
— insurance payouts (who knows what they’ve insured of late — maybe AIG type liabilities?
or
— pension payouts … pensions clearly don’t want to meet their cash-flow needs by dumping equity or other (non govt) debt assets at a loss and thereby damage the fund’s long-term solvency.
Just my guesses here. If you have any additional insight, let me know.
Cheers
Arun
Oops – a typo in my above comment
“At the end of 2006 Canada had about 1.8 trillion credits”
Was supposed to read
“At the end of 2006 Canada had about 1.08 trillion credits”
Just a quick follow up. Yes okay so I was a being a bit humorous at the end of my comment above.
However, there is a key question that requires an answer. Will the current crisis end with some rational policy implementation such as attempting to detoxify assets in the US and Global markets. Which, according to Pat’s comment given the proportions is an unrealistic deleveraging goal.
Given that, are these bank bail-outs that are ongoing globally merely a psychological multi-hundred billion dollar experiment. (or given the AIG executives actions recently, a nice way to pay out bonuses)
(Sorry for straying a bit, but given that Quantitative easing is being considered, I thought I would throw in the current detoxification strategy. I am sure there will be an array of tools throw into the economic hurricane)
Seemingly the banks in Canada announced today they starting to turn down some of the government funding to help lubricate credit markets. Suggesting in the popular press that we are approaching somekind of recovery phase.
http://business.theglobeandmail.com/servlet/story/RTGAM.20090317.wrbanks17/BNStory/Business/home
“Or is there a chance that somehow the credit crowd can be swayed with such levers of fiction.
I do believe in monsters- sometimes. Only the ones I can’t see, and hopefully they can build this one. Where is Dr. Frankenstein when you need him. ( or maybe Speilberg)”
Actually, the money powers will do (and likely are doing) everything possible to pull out of this fairly quickly. The last thing they want is the general public educating itself about how our economic system actually works. They will realize how the system is designed to suck wealth from the general public and blow it into the hands of the wealthy few.
The only reason we’ve gotten this bad is the money powers got too greedy just as they did in the 1920s. The great depression made the general public notice that fractional reserve banking is the biggest con-job in history. As a result there was a real threat of revolution (FDR refers to it in several speeches) and the banking system had severe limits placed upon it. The financial system was split into four “pillars”, Banking, Stock Market, Insurance, and Mortgages. With banks cut off from using the large amounts of capital used by the other three pillars the credit creation ability had very little power to boom and bust the economy. Without the booms and busts the profitability of banking and the ultimate insider trading profits shriveled up. If they don’t get credit rolling soon they may just wake the sleeping giant.
Of course there is the added complication of debt load. The interest rate threshold required to create a recession has dropped each time the central banks have created them. The first one took 20%, the second around 16% (although I think the two were just one long recession), the next around 12%, then 10%, and this time 8%. As the banking system loads us up with debt the interest rate that breaks us gets lower. If we don’t implode this time around then the next recession (around 2014-2016 as a rough guess) will probably do it. Can people (and businesses) carry enough new debt to allow one more boom bust manipulation? Thats the question.
If you want to be able to flawlessly predict a recession within a six month window (I called this one for the US back in the summer of 2006 as being noticed in late 2007 to eary 2008) do the following.
1) Go to the St. Louis Federal Reserve Economic Research site http://research.stlouisfed.org/fred2/
2) Click on “Interest Rates”
3) Click on “Prime Bank Loan Rate”
4) Click on “MPrime” (monthly average prime rate)
A graph showing interest rates back to the 1940s will appear along with gray bars showing the offical recessions. Notice how every recession was preceeded by an interest rate hike. Now look below the graph and:
5) Click on “Customize with FRED Graph”
6) In the textbox above the graph labelled “Add Series” type “UNRATE” (no quotes) and hit enter.
7) Notice how every hike in unemployment rates was preceeded by an interest rate hike.
8) Notice how these interest rate hikes always happen when unemployment appoaches 5.5%
9) Note the time period between the start of an interest rate hike and the start of the official recession.
10) Note the average time period between unemployment starting to rise and the start of the official recession.
To make accurate predictions of what the economy will do and when:
1) Watch the unemployment rate. When it approaches 5.5% you know interest rates are about to climb (how far before 5.5% depends on the velocity of the increase in employment)
2) When the interest rate starts to go up plot the average time between interest hikes and recessions on a calendar
3) When the unemployment starts to go up plot the average time between unemployment hikes and the start of the official recession on a calendar (not much risk here)
Wait for the recession then collect on all those bets you made with your friends about when the next recession will hit. Oh, Canada is roughly 6 months behind the US – so factor that in.
Watching interest rates is a bit risky. Clinton managed to delay a recession mostly be deregulating and creating the conditions for this crisis. Watching unemployment hikes is as reliable as sunrise.
You can get the Canadian data from Statistics Canada and see the same thing but: it costs money, it doesn’t go nearly as far back as the American data, and it can be exceptionally difficult to find the data you want. Our Bankers are slicker than the US Bankers.