QE- Follow the Money Trail

30 March 2016 (inspired by a question posed by my new friend Bob)

A common myth surrounding Quantitative Easing (QE) was that the central banks physically printed cash and fed it to the banks to lend out. This is not quite how it worked in reality. 

First things first. What problem was QE trying to fix?

One of the fall-out problems of the Global Financial Crisis was the reduction in money supply as banks stopped lending money and people started to repay their loans or in the case of non-recourse loans in the USA simply walked away from their debts. The level of defaults led to much more stringent credit worthiness policies and led to a sharp decline in lending. 

The money supply equation M4 is calculated as the sum total of money plus credit. The credit part of the equation is created through  banks lending money through the fractional reserve banking multiplier which effectively has 10 times the punching power of money printed by the Government. 

The problem is when debt starts to be repaid it contracts the money supply at a 10 to 1 ratio as well. In essence the repayment of debt equates to money in the system being destroyed.

Less money supply = less demand for goods and services which leads to recessions and even possible deflation or economic collapse.

The traditional Keynesian theory is that Government should step in with tax cuts and/or more spending (which did happen - think of cycle ways, roading and other NZ Government funded programmes that kicked off in 2008 through to now) to fill the gap in consumer demand and keep an economy ticking along. 

Milton Friedman (an American Nobel prize winning economist) had proposed an alternative theory before he died in 2006 - helicopter money. The theory goes that instead of focussing on demand side economics as Keynes proposed a Central Bank should step in to increase the supply of money. More money supply equals more demand for goods and services. He suggested that the Great Depression was caused by an ordinary financial shock but that its seriousness and duration were directly attributable to a sustained decrease in the money supply.

The same logic can be applied to an alcoholic. To avoid a hangover prescribe more alcohol.

To avoid people over-complicating the method of increasing the money supply and clouding his simple idea he used the analogy of "dropping money out of a helicopter". 

Ben Bernanke was also a student of the cause and effect of the Great Depression. In his solution to the Global Financial Crisis he implemented a form of helicopter money called Quantitative Easing in addition to the usual cutting of interest rates. The solution implemented by the US Government was a fiscal stimulus along the Keynesian thinking where Government steps in to spend when consumers won't. And so the rest of the world followed this lead of a two pronged attack on the GFC with both monetary policy and fiscal policy being used to varying degrees. 

How was QE implemented?

QE as it was implemented was not really a process of printing cash and giving it to the population to spend. It was far more subtle than that. As corporate and personal debt was being repaid in quick fashion during the GFC the money supply was shrinking and liquidity was in short supply. Sir Mervyn King (Governor of the Bank of England) stated in October 2012 that a 

"damaged banking system means that today banks aren't creating enough money. We have to do it for them."

The central banks that implemented QE did it by purchasing financial assets in the market (usually Government bonds in England or, in the case of the US, Treasury Bills) and paying for these items by creating new central bank reserves (essentially bringing money into existence out of nothing).  Remember, the relationship between central banks and trading banks is a closed loop or better still think of it as a wagon wheel with the central bank as the hub and each spoke representing a trading bank. The QE method only works if the trading bank accepts the increased reserves issued by the central bank. Trading banks seized the offer of accepting the new central bank reserves as real money due to their nature of being zero-risk to the trading bank and the cash deposits representing real money to the account holders who sold their financial assets to the central bank.

Here's an example:
Bank of England purchases British Government Bonds in the marketplace for say £100,000,000. It pays for them by agreeing with the trading banks to increase the central bank reserves and agrees to pay these banks a small interest rate in return for holding more reserves than they would otherwise be required to hold. The trading banks are holding a risk-free asset that is interest bearing which enables them to offset the liability of the trading banks being the deposit monies held by the sellers of the British Government Bonds. 

If the £100,000,000 had simply stayed put in the trading banks these banks would have lent it out to borrowers and the credit creation cycle and money supply multiplier magic of fractional reserve banking would have worked. But it didn't stay in the bank. So where did it go?

Follow the Money

The sellers of the Government Bonds were essentially institutional investors, pension funds etc who went looking for a yield better than the banks could offer. Remember that bank interest rates were falling at the time due to Central Banks lowering them to pump confidence into borrowers. As you will see shortly these two strategies work against one another. 

These investors knew that with increased money supply and lower interest rates there would be a run for yield. They ran for the share markets and bond markets. Here lies the answer as to why QE didn't work in pumping the money multiplier through bank lending - deposit holders withdrew their money at the same rate as the Central Bank were creating it and reinvested into the share markets. It made the share market soar. It even saw companies look to invest their surplus cash in buying back there own shares (what better investment is there than buying back your own shares). 

In reality only a small fraction of the QE money went into the general economy at large and even then it was only to the most credit-worthy or institutional customers. Some of these borrowers were also companies that bought back there own shares. The rest of the borrowing found its way into the property market. Again, speculative investments not productive investments. 

It would be interesting to know how Friedman would have viewed the bastardisation of his theory when put into practice. Friedman surely contemplated a tax cut regime or other direct stimulus that put the spending power in the hands of the public. 

Where are we at with QE now?

The European Central Bank voted earlier this month to increase it's ongoing 'expanded asset purchase programme' (lets just call it QE) from €60bn per month to a whopping €80bn per month.


Federal Reserve chair Janet Yellen this morning (30 March 2016 NZ time) delivered her first speech since announcing that interest rates would remain unchanged earlier this month. In her speech to the Economic Club of New York she intimated that the planned path of rate hikes will likely be slower than initially projected last December. She has in the past stated that the Fed would not hesitate to utilise tools previously employed to combat the GFC - namely interest rate cuts (although they have nearly an empty tank for this currently) and of course more QE.

It will be interesting to see if the Fed apply pressure for the Government to utilise fiscal measures for the next round of helicopter money in terms of tax cuts. Given promises being made on the primary candidates election campaigns running at present I wouldn't hold my breath for assistance in this regard.

One thing is for certain, any hint of QE will see money flow to the speculative investments once again as evidenced by the impact of Yellen's speech - the share market immediately soared, US dollar devalued against other currencies and once again the mob rushed in to purchase risky assets chasing that slightly higher yield. 

When will we learn?

© 2016