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March 14, 2014 § Leave a comment

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The Bank of England’s Quarterly Review contains a detailed description of how money creation works in the UK’s fiat money economy…

And it is controversial. It rejects conventional theories of bank lending and money creation (my emphasis):

“The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”

To be sure, numerous papers from many eminent researchers and august institutions (including the Fed, the IMF, the ECB and the Bank for International Settlements) have cast doubt upon conventional theory as an adequate explanation of money creation in a modern fiat money system. But to my knowledge this is the first time that a central bank has presented an explanation of money creation that so comprehensively departs from conventional orthodoxy…

It is of course difficult for mainstream economists to accept that the theory they have believed and taught for so many years – and upon which many models of the economy depend – is simply inadequate.  read more

PHOTOGRAPH: Katie West

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December 20, 2013 § Leave a comment

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… when you think about money it is at least a good idea to take into account that the definition you use might need to include government bonds. They are a central part of the transaction infrastructure of the U.S. economy.

And if you include government bonds as money, then you’ll see there is very little money creation going in QE. Trading bond-money for reserve-money shifts the components of the money supply but does not necessarily increase it. (If the Fed is paying a premium for the bonds, or the Fed’s buying drives the market for the bonds up, there probably is some marginal increase in the money supply.) Of course, this might have important effects but the effect cannot be explained as simply as the standard monetarist narrative would have it.

So why not consider government bonds money? Here’s how Sumner recently responded in the comment section on his blog:

And I do not consider money and bonds to be close substitutes. When I go shopping I do not agonize about whether to bring cash or T-bills to the grocery store. And bonds pay interest, cash does not. Even reserves paid no interest until 2008, when the Fed shot itself in the foot with IOR.

Frankly, I don’t know what the grocery store insertion accomplishes here. My local grocery store won’t accept bills in denominations larger than $50. Are $100 bills not money? Is the balance of my bank account not money because I have to write a check or go to an ATM to settle a transaction at my grocery store? Is all available consumer credit card indebtedness money because it could be used in grocery stores? The grocery store test is both under-inclusive and over-inclusive.

More importantly, Sumner begs the question: are bonds money? It’s not whether money and bonds are close substitutes but whether, when it comes to figuring out whether QE is inflationary, bonds and reserves are close substitutes and should both count as money. And with both bonds and reserves paying a bit of interest these days, and both being transactional currencies considered both safe and liquid, it seems that they are.

The upside of counting bonds in the relevant money supply is that it explains why the QE-driven enormous expansion of the Fed’s balance sheet—that is, the growth of base money—hasn’t been very inflationary. You don’t have to make up phantom, Occam’s Razor violating concepts such as “demand for reserves,” to explain this. You just notice that QE doesn’t grow the money supply by very much.  read more

PHOTOGRAPH: Andrew Shapter

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May 15, 2013 § Leave a comment

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This morning I saw a very nice quiz concocted by a financial markets guy. I don’t want to get him in trouble so will borrow heavily from him but without attribution. If you can get this right, then you know why Quantitative Easing One, Two, and Three is a big bunch of baloney.

Consider the following thought experiment. These are the scenarios; what is the expected result of each?

A. The Treasury decides that it will fund itself 30% more in Overnight Bills and reduce bond issuance across the curve.

B. The Fed announces it will increase QE by 30% (it will remit the net income of this activity back to the Treasury).

C. Congress announces a new tax on all passive income from USTreasuries, to holders both at home and abroad (ie Central Banks), for all new-issue USTreasuries. The tax will be equal to 30% of the return in excess of the fed funds rate.

D. Treas Secty Lew pre-announces that we will ‘selectively default’ and apply a haircut of 30% on all future Treasury coupon payments of new issues in excess of fed funds rate.

What will be the likely effects of each policy? Don’t peek!

OK here is what the markets guy (rightly) says:

Here’s what’s funny. Most intelligent market participants will say things like:

A. Stocks down a few percent on fear of US debt downgrade. Economy slightly weaker or unchanged.

B. Stocks up 5-10% and economy grows another 1% for 1-2 yrs; monetary stimulus.

C. Stocks down 5-10% on tax hike (like last year) that maybe corrects. Economy slows 1-2% for a year or so because it’s a tax hike (ie fiscal consolidation).

D. Stocks down 80% and we go into a great depression on steroids. All investment dollars flee the US. I can’t tell you what happens next because my Bloomberg account gets shut down. They might even declare an Internet Holiday.

Here’s what’s craziest: THESE ARE ALL THE SAME THING. The name and the processes are different, the OPTICS are different, but the net is the same. There’s the government and there’s everyone else. The government either pays more out – in interest payments or transfer payments or vendor payments, or it takes back more in taxes or default or interest ‘savings.’ Everything the government net gets in ‘revenue’ the rest of the world loses in income. Everything the government dissaves (deficits) the rest of the world saves. Equal and opposite.  read more

COPY: Matt Bloom

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November 14, 2012 § Leave a comment

When the Fed buys assets, it purchases them by crediting banks with reserves. So the result of QE is that the Fed’s balance sheet grows rapidly—to, literally, trillions of dollars. At the same time, banks exchange the assets they are selling (the Treasuries and MBSs that the Fed is buying) for credits to their reserves held at the Fed. Normally, banks try to minimize reserve holdings—to what they need to cover payments clearing (banks clear accounts with one another using reserves) as well as Fed-imposed required reserve ratios. With QE, the banks have ended up with humongous quantities of excess reserves.

As we said, normally banks would not hold excess reserves voluntarily—reserves used to earn zero, so banks would try to lend them out in the fed funds market (to other banks). But in the ZIRP environment, they can’t get any return on lending reserves. Further, the Fed switched policy in the aftermath of the crisis so that it now pays a small, positive return on reserves. So the banks are holding the excess reserves and the Fed credits them with a bit of interest. They aren’t thrilled with that but there’s nothing they can do: the Fed offers them a price they cannot refuse on the Treasuries and MBSs it wants to buy, and they get stuck with the reserves.

A lot of people—including policy makers—exhort the banks to “lend out the reserves” on the notion that this would “get the economy going”. There are two problems with that. First, banks can lend reserves only to other banks—and all the other banks have exactly the same problem: too many reserves. A bank cannot lend reserves to your household or firm. You do not have an account at the Fed, so there is no operational maneuver that would allow you to borrow the reserves (when a bank lends reserves to another bank, the Fed debits the lending bank’s reserves and credits the borrowing bank’s reserves). Unless you are a bank, you cannot borrow them.

The second problem is that banks don’t need reserves in order to lend. What they need is good, willing, and credit-worthy borrowers. That is what is sadly lacking. Those who are credit-worthy are not willing; those who are willing are mostly not credit-worthy.

And we should be glad that banks are not currently lending to the uncredit-worthy. Here’s why: that’s what got us into this mess in the first place.  read more

PHOTOGRAPH: zerenga

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