Why price impacts from Quantitative Easing can be delayed
Lately I've had a number of conversations where people are trying to figure out if we are going to see inflation or deflation. Because things in the global economy are in such a shitty state worldwide people are justifiably worried about the direction things are going in. The data clearly shows that the real economy has been hurt pretty badly in 2020 but despite this we now see things like the Dow passing the 30000 mark and hitting record highs and you can already buy the hat. EDIT: Not even a year later and the DJIA is now past 35000. This is because policy makers have decided to employ monetary and fiscal policy on an unprecedented scale to try to avoid a crash in asset prices. Given that prices for equities have gone up without the real economy improving people are naturally worried about inflation, and justifiably so, because a lot of money has been created in a short period of time without the economy being strong enough to naturally support such a level of growth in money supply. The average person is worried about an increase in prices of items that they must buy. Economists are wondering if things will be inflationary or deflationary.
Quantitative Easing (often abbreviated to QE) is a policy that's been adopted in many countries in the last few years to attempt to manipulate the markets. Given the enormous amounts of money and the scarce information about QE In particular people are wanting to know what effects QE will have on the cost of living and inflation. When I first started the draft for this article a bit over 3 months ago I didn't have a good enough understanding of the details of QE to feel confident writing about it and research was slow going due to the enormous amount of disinformation out there. I think a large part of the discussion about if QE is inflationary for prices really comes down to if QE creates money that actually circulates. First I think a few definitions are badly needed because colloquially different people mean very different things when they talk about inflation and money. Even the Fed themselves keep changing their definitions of inflation and we seem to see a continuous shifting of the goalposts for inflation targets!
An increase in the total amount of money that's in existence in an economy.
Fractional reserve banking:
A system of banking where banks are allowed to loan out more than they have in deposits. The amount they must hold in reserves is some fraction of the total amount loaned out.
Bank reserves are the money that banks hold in reserves to support their depositors. This is to avoid situations where a bank run will cause the bank to not be able to cover the withdrawals from their customers.
A central bank is effectively a Bank's bank. Such an institution acts as the "lender of last resort" to the commercial banks.
Velocity of money:
How often a unit of currency changes hands over a period of time.
But first, what is money?
In this hyperfinancialized world that we now find ourselves living in money is a topic that comes up very frequently as more and more of the worlds work becomes priced in dollar terms, yet discussions about what money itself actually is come up very seldomly. You might have noticed before that all those definitions reference money but don't define it. This might sound a bit strange if you hadn't thought about it before, but ask yourself "what is money? How does money work?"
If you found it hard to answer (I certainly did) it's probably because money is a hard thing to define in exact terms. You'd think that people at the reserve bank who's job it is to think about these things would have a precise definition but they don't necessarily either, for example Alan Greenspan (pervious Chair of the Federal Reserve) mentions:
"The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition. "
So part of the issue in figuring out what is inflationary and what is not is figuring out what is money and what is not money. At the one end you have physical currency that circulates like banknotes, which are unquestionably money but then you start to get more complex instruments that do eventually allow transactions but are far less obviously liquid currency. This is the crux of the issue regarding the question "Is quantitative easing inflationary?" Which can only really be answered by asking if QE increases the overall supply of money and the velocity of money in the overall economy.
If you ask people what money is the most frequent answers are just the most tangible sorts of money. Currency that you can hold in your hand as cash is quite obviously money. Getting more abstract the balance that's in your bank account is something that you could fairly readily convert to cash, this is a form of money as well but it's one step removed from physical currency.
Many people hear about different "types" of money like M0, M1 and M2 and so on without really knowing what those are, here's a more technical definition of monetary aggregates. A key difference between these classes of money is how easy they are to actually circulate, the closer "money" is to people that can actually spend and transact with it the faster it will impact prices. Quick summary:
- M0: Is hard currency like banknotes and coins
- M1: All of the money in M0, plus traveler's checks and demand deposits
- M2: All of the money in M1, money market shares, and savings deposits
M2 matters a lot because it includes bank deposits, and seeing a huge number of people have some form of money in a bank account this is a good picture of how much money is in the overall system. Its important to note that the actual total amount of physical currency is far smaller than the money in the banking system. As this chart makes it very clear M2 has grown at a substantially faster rate recently, with a very worrying "going vertical" trend recently that doesn't match the strength of the underlying economy:
Because we have a debt based monetary system which allows fractional reserve banking we have a situation whereby the majority of "money" is created by the banking system via issuance of new debt in the form of loans. Essentially this is why we have a debt based economy. If you are interested in knowing more about debt I'd highly recommend reading "Debt: the first 5000 years" as this contains an especially good discussion of many of the concepts regarding debt and money with a number of historical references.
The banks can create money by creating loans of money exceeding the amount they have in deposits due to the way in which fractional reserve banking works. If a private citizen were to attempt to do this they may be subject to criminal charges for running a Ponzi Scheme if a business were to do it they might be the target of trading while insolvent regulations. This special privilege afforded to the banks ends up being a crucial part of why Quantitative Easing exists.
What is Quantitative Easing
Before we can answer the question "is QE inflationary?" we need to know what it actually is. QE is a great example of a policy that's complex enough to not be easily understood and as such is especially hard to actually debate in the broader economic and political landscape. If you are familiar with the details of QE already please skip to the next section.
In a fractional reserve banking system banks are able to loan out money to people without having to hold that much money in reserves. The amount of money that a bank needs to hold behind is the reserve. In this reserve banking system the bank can have reserves held for them at the central bank and they can use those reserves as the backing for their new loan issuance. Here's an article that explains exactly what's going on with the mechanics of Quantitative Easing and explains how the various entities in the system connect and what the finances look like in this arrangement. I highly recommend you read it if you are wanting to get a deeper understanding of what's going on with QE.
QE has been around for quite some time now, in late 1990s Japan the interest rates were already very close to zero so from a monetary policy point of view attempting to "stimulate" lending by reducing the interest rate further was not possible. Because reducing interest rates below the nominal 0% rate is difficult and requires a lot of politically difficult changes like removing physical cash out from the system, the 0% interest rate level is a barrier often referred to as the Zero lower bound. When you start getting closer to the zero lower bound other unconventional forms of monetary policy like QE start to become used by those who wish to manipulate yields downwards. Recently the actions of the USA Federal Reserve have created a situation where their balance sheet has grown at an unprecedented rate and much of this has been as the result of QE programs. Other central banks such as the Reserve Bank of Australia, which already was using a policy of yield curve control, have started to create QE programs as well recently. In most people's minds the growth of the reserve banks balance sheets is seen to be an expansion of the supply of money and therefore people think that inflation will be a very direct consequence of this balance sheet growth. QE does provides a way in which the Federal Reserve Bank can move money in the system but it's not necessarily something that ends up in the broader economy quickly. There's a lot of misconceptions going around the topic of money printing and quantitative easing, not helped by many insiders deliberately sharing misinformation when it helps their agendas.
One of the most important things to understand is that at the moment the way in which the USA Federal Reserve is going about QE is not the same as printing money and the differences are very significant. Specifically the Federal Reserve is not legally allowed to "print" money, have a look at the reserve bank act and you'll see that this is the case. The government can print physical money but the Federal Reserve at this moment in time cannot (keep checking this space closely, policy has been changing quickly during this crisis). But physical money such as that found in banknotes and coins is currently a small fraction of all the money that exists in the system, so the actual printing of money is not so significant up until the point we see massive denomination notes being printed like we have seen recently in Venezuela (For example the Bolívar was replaced by the Bolívar fuerte with a 1000-1 exchange in 2008 which was then replaced by the Bolívar soberano in 2018 but this time in an even bigger 100000-1 ratio). What the Fed can do is swap liabilities for reserves, this is significant for many reasons but it is not the same as printing money.
QE allows the banks to swap liabilities with the Fed in return for reserves at the Fed that the banks can then loan against. But the banks are not forced to actually loan money out and recently we have seen the banks tightening their lending standards as a direct result of low interest rates. If the banks were able to be forced to loan money this would change the situation greatly, but so far this has not happened (watch this space closely). The other thing is that the average person has no way to spend reserves held at the Fed (again watch this space very closely since there's been growing talk about central bank digital currencies). As you can see the bank reserves aren't the same as regular currency in the rest of the system, and these differences matter.
It turns out that creating this sort of debt with banks is just a matter of changing some digits in a database. You don't need to even print paper money let alone do something more energy intensive like running cryptocurrency algorithms or mining up precious metals from the ground. This ease in creating money is probably why Neil Kaskari said "There is an infinite amount of cash in the Federal Reserve. We will do whatever we need to do to make sure there's enough cash in the banking system.". The main idea here is that they are trying to convince people that their account balances as held at the banks are safe, and they probably are. Also there was probably an "infinite" amount of cash in Weimar Germany and Zimbabwe too but I digress...
So why doesn't the Fed come out and explicitly say that they aren't printing money? A large part of it is that they aren't legally allowed to print money directly as that's something that the reserve bank act doesn't permit them to do. But what they are doing is using the ambiguity of what constitutes money to try to get around this restriction. The Fed's purchasing of ETFs via Blackrock shows a willingness to push the boundaries of the mandate under which they are operating1, with some arguing that this is already well outside their legal charter. (It's worth mentioning that this is a charter and the Federal Reserve Bank isn't as clearly a government agency as many people out there think) But more to the point they desperately want to sell a narrative to people that they are in control of the rate of inflation, if deflation is going to happen they want to try to tell people that they can print their way out of it, even if they can't. Holding the confidence of the public is incredibly important for these people to have power, a theme covered in the book "Bluff: The Game Central Banks Play and How it Leads to Crisis" by Anjum Hoda. It is very important to note that all central banks aren't necessarily bound by the same regulations with regards to creating currency directly, significant differences exist in different countries.
One of the reasons that the inflationary aspect of QE is not so obvious is that at the moment the money it creates gets stuck in the banking system in the form of bank reserves far longer than regular cash does, but eventually it impacts the broader economy by aiding the formation and maintenance of asset bubbles. The other part of it is that the money created by QE overwhelmingly goes to the richest people in the economy, people who already have more than enough money behind them to not have to spend what extra money they get back into the economy.
This shows that if (or maybe when a sufficient crisis pushes the matter) the regulatory environment changes a large amount of currency could be created and distributed into the banking system very quickly. We wouldn't even need to fill wheelbarrows full of newly printed paper banknotes since a fully digital central bank currency system allows some numbers get changed on a computer somewhere and somewhere else instantly is credited currency to spend. This could avoid the issue Venezuela faced when it had to make even bigger denomination notes and the struggles it faced to pay for the printing and the chartering of planes to distribute said banknotes.
Currently the most popular form of banking in the world is fractional reserve banking. In this setup a bank can loan out more money than they actually hold in deposits. How much they have to hold behind in reserves is known as the reserve ratio. In more recent times there have been other requirements as well, perhaps most notably are the capital requirements that have been introduced. This arrangement naturally creates a problem if enough people in a bank wanted to withdraw their deposits at the same time, since the bank would be unable to pay everyone out in the case of a "run on the bank".
In the earliest days of fractional reserve banking runs on banks were a common issue, as time has gone on various mechanisms were created to make sure that the banks could continue to operate even if there was a higher demand from customers to withdraw their money. One such way banks could temporarily fund an increase in withdrawals or some other need to have more cash on hand is to loan the money from other banks via the interbank lending market.
As a response to banking crises reserve banks were set up in many places to act as a "lender of last resort" to provide liquidity to other banks in times of stress. However as time has gone on reserve banks have ended up doing more and more things. Increasingly reserve banks have been used to implement monetary policy decisions.
Specifically the actions of the USA Federal Reserve have created a situation where their balance sheet has grown enormously which is such a large number that people start to think that inflation might be an issues. There's a lot of misconceptions going around the topic of money printing and quantitative easing.
And this is one of the first bottlenecks to price changes we see hit. Banks had all this extra capacity on their balance sheets to loan money but this money impacted some parts of the economy far more than others. This is a perfect example of the Cantillon Effect - new money doesn't spread evenly through the system and it doesn't spread through the system at the same time either. As a result the areas closest to the money creation get to spend the newly created money first before the inflationary impacts start to hit everyone else hence gaining an advantage. In the aftermath of the issues in 2008 QE was used to recapitalize many of the banks, money was deliberated created in the system to go to the banks, perhaps a perfect example of the Cantillon Effect in action. This then started to impact the prices in the broader economy as money slowly moved out of the banking sector. The people working in banking and finance are a wealthy lot on average so the things they spent their money on saw price movements quicker than other items in the broader economy. For example the prices of antique cars and fancy boats went up a lot, as did "investable" artworks. Price increases in daily goods will take longer to manifest from QE because as yet citizens have no ability to directly spend any of the money held at the reserve banks. This inflationary effect is however already happening, as the costs of many items is going up already. With talk about digital currencies that allow citizens to have accounts directly at reserve banks we should watch this space very closely since such an introduction would be both an economical and political game changer.
The other issue that's been a bottleneck to inflation is that there's so much debt issued now that servicing this debt substantially reduces the amount of money available. This unproductive debt forms a drain on the real economy that inhibits the natural economic growth that in turn would drive demand for loans used for productive purposes. While QE might provide the banks with enough reserves to be able to issue new loans it doesn't help the real economy much if the demand for loans is low. If there's enough currency creation it might be able to overwhelm this otherwise deflationary factor at some point in time. The temptation to issue more debt to service the old debt will end in inevitable crisis of some sort or another because there's simply no way out of a debt spiral like that without either a systematic change (like a currency debasement or debt jubilee) or increased inflation. I suspect this is why so many efforts are being made to cause inflation, the current system that just keeps adding debt on top of debt will simply collapse if sufficiently deflationary conditions occur.
QE allows the banks to swap liabilities with the Fed in return for reserves at the Fed. The banks can then loan against these reserves. In the past this was an important aspect because of the nature of fractional reserve banking, more reserves means that more money could then legally be loaned out. What changed was that in the pressure to try spur on new loans the reserve requirement was dropped to 0% in 2020 March 3rd. In a very real sense the term "fractional reserve banking" itself doesn't really describe what's happening anymore. Perhaps now capital requirements are the main mechanism that prevents the banks from creating infinite new money (see Basel Accords for an example of this). But just like the reserve requirements we can see that these numbers and regulations are subject to change over time. A mechanism in which QE could be inflationary is if a bank can't loan money because it holds crappy assets that are putting pressure on the capital requirements then a swap from assets that the bank doesn't want to hold on its balance sheet for reserves could free up capital. This is effectively what happened in the aftermath of the 2008 crisis. This would have the impact of pushing up the price on these crappy assets if there's this backstop behind them.
At least initially if the banks held a lot of crap bonds then swapping these crap bonds for reserves makes a lot of sense from the bank's point of view. But once the worst items are moved then what? This is why QE in its current incarnation isn't as inflationary as if it were helping capital or reserve constrained banks. Eventually you can get a situation where there's no reserve or capital requirement getting in the way of the commercial banks creating loans they might just not want to issue them. However there's nothing stopping the banks from purchasing other assets instead of issuing unprofitable loans due to the artificially low interest rates.
The Fed was mostly set up to try to prevent inflation and has fewer tools at its disposal to actually deal with deflation. What we saw in 2020 was a shock that greatly reduced the velocity of money, so changes to prices of items of many items was temporarily slowed as a result despite enormous growth to the overall monetary supply. We then saw deficit spending of a size completely unheard of in many countries to attempt to deal with the shock to the economy from the pandemic, creating debts of such a level that they likely will never feasibly be paid off without inflation reducing the burden of those debts in real terms. Fiscal policy in many places shifted from asking if we should be doing deficit spending to now mostly debating how much? Eventually the point will be reached where people realize the debts can't ever be paid off. A historical approach to dealing with debt crises is talked about in "Debt: the first 5000 years" by David Graeber, in the past occasional debt jubilees were a strategy used to deal with widespread debt crisis situations. The idea being that if things get too far out of hand a large number of debts can be simultaneously forgiven as part of a certain one off event. The reason for having such events only occasionally and writing off a large number of people's debts at the same time is to try to avoid the perverse incentives that would occur if such a jubilee event was a regular occurrence or if it helped only specific individuals. The idea of a debt jubilee doesn't seem to be politically feasible just yet in the climate of 2020 and as such won't likely be discussed at all out in the open. This is partly because at the moment the current system and political environment is strongly favouring creditors over debtors. Any policy that uses taxpayer money to recapitalize the banks, much like the 2008 bank bailouts via the "Troubled Assert Releif Program, seems politically unpopular in the extreme. This is also partly because the terms of a debt jubilee might not be agreeable to a republic or a democratic country.
Will quantitative easing impact the cost of living
We are currently in an era that's facing a large number of deflationary forces. We have ageing demographics, lower population growth and technological improvements that are all exceedingly deflationary in nature. Modern technology and modern process improvement knowledge is perhaps one of the most deflationary forces we have ever seen, something I hope to write about soon. The sorts of deflation that come about from progress in technology and knowledge in a more functional and less sick system would be great for the average person because each dollar would go a lot further. But we are in a very sick financial system that has so much debt that any form of deflation now starts to pose an existential threat to the stability of the entire financial system. As a response to these deflationary forces policies have started to be put into place to try to force inflation of the overall monetary base. Given this debt trap facing the world at the moment we would need something rather big to happen to counter all those deflationary factors. As we have seen in places like Venezuela this is still possible, but inflation let alone hyperinflation requires a lot of things to happen to overcome the otherwise strongly deflationary forces at work.
For the vast majority of people reading this blog the important question is: "how QE will impact the affordability of living for me and my community?". I would also argue that over the longer time span this is one of the most important questions to the broader markets as well because if this gets too out of whack history shows very clearly that revolutionary changes start getting more and more likely. Really the amount of money that exists in the system in very abstract forms in monetary aggregates is not of that much concern to the average person, it's the changes in price levels that is a more pressing concern. After all most people don't care if the banking system has more reserves now than it did in 2008, since that money is just something that's stuck inside the banking system.
At this point in time it's far from clear how much QE will increase the overall amount of money in the areas of the real economy that so directly impacts the day to day lives of the 90% of the populace. Part of what makes this unclear in the short term is that if QE creates money that is then used to service debt then the repayment of that debt is associated with a destruction of money somewhere else due to how our current debt based monetary system works (this is a direct consequence of fractional reserve banking, repayment of loans means less money exists in the system afterwards). But one outcome does seems inevitable, QE as it is currently implemented almost certainly reduces the share of the overall money supply that is in the hands of the bottom 90% of citizens when ranked by wealth. This is because much of the money that is created that gets stuck in the banking system and only leaks out in ways that overwhelmingly benefit the rich. When money is moved around in the system as a result of QE the benefits seem to go to a small group, especially bondholders since a decrease in yields means an increase in bond prices. (not to mention the Feds backstopping of the bond market by being a buyer of last resort which also props up prices)
Specifically I think QE in it's current incarnation is a force that drives stagflation. Meaning that if you are a regular wage earner I think you will end up worse off as a result of unrestricted QE. Perhaps if we didn't have such an issue of rampant financialization influencing business decisions things would be different because cheap corporate funding could be quite beneficial to the general economy if that funding was then spent on productive things like expanding production or investing in research and development rather than just funding stock buybacks and other such schemes. This is why I think QE will almost certainly decrease the affordability of living over time for the average person.
How fast and how much the affordability of living drops for the average person is a far harder question to answer. As I'd mentioned before progress in technology means the possibility of getting more for less expenditure but that could be more than offset if the average person's wealth is dropping faster than technology is improving the purchasing power of their dwindling wealth. Under the current system I think any increase in price levels in the broader economy will be entirely determined by how much the velocity of money changes in response to QE and how much money is diverted to ever growing asset bubbles that are being fueled by cheap debt. A shrinking of the fraction of the overall monetary supply held by the average person will hurt them more if prices also go up at the same time, especially in areas that are non-optional expenditures such as food prices. In any area where QE can directly move cash I think we will see massive changes, for example a huge proliferation of zombie companies could be created because they can issue new crap bonds that can then be "guaranteed" to be bought up as part of some QE "buyer of last resort" program. Or cheap debt could finance massive stock buyback schemes that takes money out of the hands of the broader economy and redistributes it into the equity markets. Specifically how much will the money created by QE get "stuck" inside the banking system? In the case of the zombie companies I'm not sure what will happen, will the cash they raise via debt be able to be spent on anything other than debt servicing?
The only thing that seems to be a certainty is that a further erosion of the pricing mechanisms of the market will hurt the real economy over the longer term. These policies that are deliberately attempting to manipulate away the downwards portions of the business cycle are doing enormous damage to longer term growth and prosperity. For example these policies create more zombie companies which exist only because of artificially low interest rates and this is very bad for the real economy. Quantitative easing is perhaps one of the best examples of the Cantillon effect to be seen in recent times. When we look at the companies and people who are closest to the newly created money we see the most distortions. We see an example of this in the situations like Apple issuing corporate debt while simultaneously sitting on one of the largest cash stockpiles that a corporation has ever seen. This is effectively the corporation profiting very directly from the debasement of the currency, so is essentially extracting money from everyone else without their consent. Using freshly created money to fund stock buybacks will cause stock prices to change fairly substantially as a result. Eventually the money that enters into the equities market can make it out into the broader economy as well. These sorts of factors are why we have seen equity prices (in USD) rise so sharply in 2020 in some companies despite economic fundamentals being so poor in general. Many perverse incentives start to get created when companies survival is more dependent on getting access to cheap debt rather than being based on profitability or productivity, over the longer term I think this creates negative pressures on affordability because the substandard allocation of resources makes everything more expensive to produce.
The reason I think protracted QE does damage to the real economy is because it destroys proper pricing mechanisms. By interfering with the equilibriums for credit and debt many business models become possible that have poor fundamentals, and some business with good fundamentals find it hard to compete vs competitors that are have poor fundamentals but are propped up by their proximity to the easy money. Zombie companies that can only continue to exist with cheap debt cause a number of distortions to the overall economy. Sometimes these distortions are comical like the pizza arbitrage story, sometimes they are farcical like WeWork claiming to be a tech company in order to attract more investor dollars, frequently they create business models that are bad for the environment and sometimes prop up downright fraudulent behaviour. What they all have in common is that they are only possible in a world where there's extremely loose financing with low interest rates. Big investment funds that have to allocate a lot of money are finding it increasingly hard to get yields, so these companies that have a compelling growth story tend to get a lot of this investment money.
A good economy that's progressing will be deflationary in nature for the prices of goods. When people come up with new innovations and improvements it means that over time people get more goods for less money or higher quality goods for the same money. This sort of deflation is a great thing and we want to make sure that we have policy in place that helps people achieve these sorts of economic wins for everyone. Policies designed to inflate things at all costs and keep maintaining asset bubbles starts to pull the best talent away from more productive work as it rewards people for working on things that add no longer term value. What this misallocation of resources does is to effectively move a lot of skilled workers into working "bullshit jobs" instead of jobs that actually have some meaning and help the local economy/society/world/nation/environment/etc.
So over the long run I'd absolutely expect QE to lead to a reduction of purchasing power of each unit of currency because I think it's a really bad thing for the real economy to distort things the way that QE does. But crucially it might not reduce the purchasing power of each dollar via an expansion of the monetary base, at least not in the initial stages.
Overall I think QE is very bad for the affordability of living for the average person, mostly because the percentage of the overall money supply held by the lowest 90% (maybe even 99%) of the population will drop while the needs of those people will remain mostly constant. And secondly what money the median citizen still has will buy them less because QE hurts the overall productivity levels of the economy when the economy is exposed to its distortions over the longer term.
Is quantitative easing inflationary for prices?
While I think unrestricted QE is bad for the average person it's far less obvious how much it will increase or decrease the overall supply of money in the broader real economy given the context of the current debt crisis we are in. It seems relatively straightforward that QE is inflationary to the money supply in the sense that it is a mechanism that allows more money to be created by the banks but it's less obvious how that money can get out into the broader economy now that debt levels are at such an all time high. QE creates a situation where more "money" exists in the overall system. But what does QE do to price levels?
The creation of more currency that wasn't created from debt issuance it would always be very inflationary provided it was distributed in the real economy because it wouldn't come with an associated liability on the other side. Effectively currency that was freshly printed from the printing press could be spent easily and that would increase the velocity of money which would in turn increase prices. Specifically the Federal Reserve is not allowed to print money, have a look at the reserve bank act and you'll see that this is the case. The government can print money but the Federal Reserve at this moment in time cannot. What the Fed can do is swap liabilities for reserves, this is significant for many reasons but it is not the same as printing money. To be able to fund programs like QE they have to buy treasuries to fund everything. And currently that means that enough treasuries have to be sold to keep funding the expansion. If you've been wondering why there's this back and forth lately with the Fed and the Treasury department this is part of why. It is important to note in this situation that the treasury cannot ever default on it's bonds that are issued in USD because they are always able to debase the currency to service their debts if need be. Sure this would take a toll on the strength of the dollar and threaten the reserve currency status of the USD but it's precisely this reserve currency status that allows them to avoid defaulting on their debts since the debts are denominated in a currency they control.
When banks are reserve constrained and there's a large demand for new loans then QE is unmistakably inflationary because it very directly allows for the creation of new money that otherwise could not be created. This money then gets out into the real economy quickly in such a circumstance. I suspect in a high interest rate environment that was backed by a strong economy with high demand for loans you'd see very fast inflation from the introduction of QE due to the reduction of interest rates. But we are in an environment that's very close to the zero lower bound for interest rates at the moment.
However just because the banks can loan more money it doesn't mean that they are forced to actually loan money out. What we tend to see is banks tightening their lending standards when interest rates are lowered. If you find it counterintuitive that the lowering of interest rates combined with lower reserve requirements could lead to less loans being issued have a think about the situation from the perspective of the banks. If you were a bank and you had to loan money out at a real rate of 1% (or less) you'd only ever want to do this if the likelihood of being paid back the entire principle was very high. At a 1% interest rate you really can't have much of a chance of default without making a loan horrendously unprofitable to issue. This is why collateral requirements are going up, the banks want to have a higher guarantee they will be repaid given the lower interest rates. Now if something were to change in the political landscape for banking that either forced the intermediary banks to loan out money, or bypassed them entirely, directly to people that would actually spend it this would change the situation greatly, but so far this has not happened with perhaps the exception of a few stimulus cheques.
The issue is that there's now so much debt issued that servicing this debt will start to really drain money out of the economy. The temptation to issue more debt to service the old debt will end in inevitable crisis of some sort or another. By having some inflation -- provided it doesn't get too crazy -- the overall debt burden could be slowly reduced without having to discard the old system. There's a few issues facing the Fed however, the main one being that the Fed was mostly set up to try to prevent inflation and has fewer tools at its disposal to actually deal with deflation. What we are seeing in 2020 is a very deflationary situation and the high debt load itself is now an additional deflationary pressure.
Because debt is so high worldwide a deflationary crash now risks causing a complete collapse of the financial system. This is because deflation makes debt burdens heavier and the world is already in so much unproductive debt that there's no chance that debt can ever be paid off if deflation happens. As the debt level builds beyond a critical point of no return more inflation is required to make repayment possible at all. As a result of this I expect to see a lot of effort put into fending off extreme deflation. Deflation causes a lot of stress to debtors, and the vast majority of the world is debtors. Deflationary strains will start causing people to ask "who really owes who what?", the sorts of political pressures that any study of these questions creates will be very destabilizing to the financial system as it is currently set up.
There's a bluffing strategy whereby attempting to create a fear of inflation can increase monetary velocity. An example of this is talking about "abandoning the 2% inflation target" is a way of trying to bluff the markets into getting some inflation without really changing all that much on the policy side. The idea is that if you get enough people worried about inflation they might spend their money earlier to try to protect their current purchasing power against this inflation and hence increase monetary velocity. Part of the issue with this is one pointed out by Uneducated Economist in this video, much of the population isn't aware of the economic factors and/or simply doesn't care to do anything differently. Some might counter by saying that the average person hasn't had this little of a fraction of the economy in 50 years but also many businesses might not have anything they actually want to spend their money on and some zombie companies will just be spending money to pay off debt. If nobody wants to spend then it's really hard to get monetary velocity to rise. However the Fed, in its current setup, can't easily create monetary velocity by direct policy means. Will the bluff work? Probably the main reason that the Fed is not saying they are "printing money" is because they aren't legally allowed to do that under their current mandate. I'm not sure they will expand their bluffing in such a way that they are deliberately lying about what they can legally do but time will tell.
Something I feel fairly comfortable saying is that QE alone won't be hyperinflationary, there's just too many other deflationary forces at play right now. The data from the economic experiment that Japan has had with QE since the late 1990s shows this. But the structures set up by QE that allow so much money to be moved in the system could set the stage for inflationary forces if the regulatory and political climate were to change. Combine QE with fiscal policies that spend heavily and distribute money directly into the hands of the voters and that is highly likely to be hyperinflationary.
The other thing is that many of the people centrally planning the economy will also later try to fight against hyperinflation were that to become a genuine risk. The difficulty of all this is that an acceleration in the rate of money being created risks creating a tipping point where price stability gets bad enough to finally erode any remaining confidence in the underlying currency. A lack of confidence might create a hyperinflationary price shock as people collectively seek to abandon the fiat currency as fast as possible. The issue with hyperinflation is that prices start to go up very quickly as soon as people don't think their money will be worth as much in the short term future. I see this shift to a lack of confidence in the currency as the psychological - and political - difference between "regular" inflation and "hyper" inflation. Given the general apathy towards looking at economics in the general population I'm not sure what sort of event or change other than a huge shift in prices will be needed to start people thinking about inflation and purchasing power more. The massive shutdowns in 2020 slowed the economy enough for the velocity of money to plummet which meant inflation in the supply of money didn't show up in the prices of goods. However when the virus situation is resolved and reopening occurs there's a very big risk of massive inflation hitting. For now there are grumblings about how the prices of daily goods have already changed but confidence in the continuation of the current main fiat currencies surviving still remains because people think the higher prices are entirely due to the pandemic and don't attribute anything to the growth in the overall monetary supply. Unfortunately when the current fiat currencies do finally collapse (and all fiat currencies do eventually) I think a lot of people will likely be caught very off guard by it, I also think they are likely to then panic in response.
The next step will be highly political in nature
QE in its current form can't keep going on much longer, there's simply not enough treasuries to buy. Effectively this means that the Fed won't be able to create money in the banking system as easily by buying up the US federal debt because they may get in a situation where they have already bought it all. This has caused the Fed to start pressuring congress to pass more stimulus bills as these create new treasuries. And this is my main thesis, QE won't be especially inflationary until the point where something political changes that causes all the extra money creation to not be stuck in the banking system. At this point where fiscal policy changes to distribute the new money I wouldn't be surprised to see either a massive inflationary surge in prices occur (as velocity of money increases) or a debasement of the purchasing power of the dollar.
There's only so much deflation that an indebted country will bear, and while people might not understand all the complexities of the current system (a system that's un-necessarily complex by design) they understand the pain that deflation causes in servicing debts. The "free silver" campaign is an example of the sorts of political campaigns that are created in response to deflation. When William Jennings Bryan made the famous cross of gold speech the idea was to adopt silver as a monetary standard precisely because it was more inflationary, subsequently in the 1896 presidential election campaign questions of policy directly relating to currency was a huge factor. The gold standard had caused a deflationary situation where the vast majority of debtors were being disadvantaged for the benefits of a tiny number of creditors. Crucially from a political point of view the growth in the monetary supply was not equal and this was what turned the economic issue into a decidedly political one. Recently we are seeing the same, not all growth in M2 is created equal, who gets the new money is a massively political decision.
In recent times many people have deluded themselves into thinking that the economy is separate from politics. There's many reasons this has happened but covering that in the detail it deserves would be best for another post since this one is already very long. For the most part I think this is just a result of a growing ignorance. One reason is hinted at from the history around the debates on the gold standard and bimetalism in the late 1800s, people were very interested in the choices behind money and passionate enough that they formed political parties where monetary choices were core policy positions2. Back then people very clearly understood that politics had a huge impact on the economy so fiscal and monetary policy were seen as important political topics worth campaigning on.
The actions like the Fed being involved directly in purchasing ETFs or bonds for example is a situation where they are already acting outside their legal mandate as it was intended by the writers of the original legislation. However the state is really the only entity that would be able to enforce that mandate and recently it appears they deliberately aren't looking too closely. In previous times this would likely have been entirely scandalous but with a public completely fixated on a number of other issues this has received very little attention. But one thing we can almost guarantee is that if the current financial and economic crisis deepens that legal mandate will be changed somehow. Eventually problems will get big enough that they cannot be ignored, but right now a lot of this stuff is just "out of sight out of mind" for many.
In contemporary times monetary policy is not as prominent a topic in the political landscape as it used to be. For example letting interest rates be centrally-planned is a very political decision, but since this has become rather normalized people don't talk about it much. Even the idea that interest rates should be set by the market rather than an unelected board of bureaucrats is not even considered by many in the electorate. In the past the cycles of the market made certain monetary policy choices extremely obvious to the average person. Since the rise of Keynesian interventions that aim to suppress these business cycles we have fewer events that demand the attention of an otherwise disinterested electorate to be paid towards monetary policy. What has changed with these recent financial crises that started in 2008 is that people are increasingly realizing that in this environment with extremely political policies on stimulus and other market interventions that the economy and politics are indeed uncomfortably closely linked. As the economic crisis deepens these politically motivated economic decisions will become more prominent in the political landscape. Now that the interventions into the market are getting to unprecedented levels we are starting to see attention paid to the increasingly extreme mechanisms of the manipulations in the political sphere. We might not need the business cycle to fully run its course to see discussions on monetary and fiscal policy become a primary political topic again.
There have been some commentators who say that central bankers when acting in unison might be able to manipulate money creation in such a way that it debases the worlds currencies in a simultaneous manner without it being immediately obvious in the forex and foreign trade exchange numbers. The idea here is to try to keep the currency debasement as hidden as possible, in nominal terms, such that it is "out of sight out of mind" for most people and therefore doesn't attract the attention of the political circles. This allows more influence to be wielded without needing to be subject to accountability, transparency or just broader political discussion and debate. Much will hinge on the political attitudes toward central banking, especially if another major financial crisis directly threatens the viability of the banking sector. Most people expect there to not be any political support for another round of tax payer funded bailouts for banks so instead we have especially pernicious "bail in" laws that have been enacted that will use depositors money to "bail out" the banks in the event of a banking crisis.
As affordability of living gets worse for the average citizen and inequality grows the political pressure to change course will get stronger and stronger. The electorate might not know why they are getting a crap deal or why Main Street has been destroyed but they will realize they are getting a crap deal and that main street has been destroyed. So people will want some change, but what systematic changes will be caused by the political reaction be to this? For example we might see the Federal Reserve act changed to allow a digital currency, in effect allowing the Fed to print money that goes into the economy far more directly. We might see reserve bankers collude with elites to undemocratically seize power via a planned "great reset" (as the WEF themselves call this) or we might see the reserve banks abolished entirely. We may see a reintroduction of a gold standard or something similar that forces currencies to be backed by something tangible. Or a shift to something completely new like cryptocurrency based fiat. Or we might see some form of even less sound fiat money emerge if politicians decide to turn on the printing presses like Venezuela did.
As time goes on political attention might start to be put very closely on this situation, people might very rightly start to ask "why is it that are we wholesale bailing out zombie companies again?". All this bailing out is preventing the sorts of crashes in asset prices that would typically accelerate the demand for changes. We might not even need a "Minsky Moment" to happen before widespread opinion demands a change.
On the more extreme side we might see actions like angry protestors setting fire to the French central bank building.
When things get bad enough eventually politicians are compelled to deal with economic questions. The Glass-Steigall act of 1932 is an example of a political change that was in response to a market crash where depositors money was risked. Then the act being mostly repealed in the 1999 with the Gramm-Leach-Bliley Act was another example of a political change with economic consequences. This in part helped lead to the subprime mortgage crisis which led to calls from people to reinstate the sorts of protections found in the Glass-Steigall act once again. As the crisis that led to the repo market collapse in 2019 has continued to deepen we are once again starting to see an uptick of political intervention into the banking system occurring in many parts of the world. This is not all in the direction of tightening standards, for example in Australia the older regulations about responsible lending standards are being dropped lately. An unfortunately large number of policy makers have decided to try to prop up or "reinflate" the housing market bubble in Australia at all costs. Other regulations like bank bail-ins were stealthily passed a few years ago in many G20 countries and look like they may metastasize further. We will likely see more regulatory changes made as political pressure mounts or if the crisis deepens.
Any major event that would change the old financial system radically has a large chance of being entirely political in nature. Much like the 1920s currency crisis in Germany I think this current crisis is close to the point of no return for some fiat currencies as evidenced by the plans being enacted for new currencies such a central bank digital currencies to be rolled out. The current financial system looks like it's in a terminal state and the replacement of the current system will be a very political decision with broad reaching economic impacts. I hope that people can get together to make the new system as good as it can be, this crisis presents a huge opportunity.
- Banks, QE, and Money-Printing by Lyn Alden, good summary of the QE mechanism with some really detailed examples of how the accounting works in various situations.
- QE is Inflationary, and i have the charts to prove it by DesoGames, data backed analysis of the monetary growth and implications this has for inflation.
- Fed up by Danielle DiMartino Booth, information about how the Federal Reserve bank works from someone who used to work there.
- When Money Dies: The Nightmare of the Weimar Collapse by Adam Ferguson, the history of what happened in the Weimar Republic currency crisis/collapse of the 1920s. While dry at times there's a wealth of information in this book and just more broadly it's important to know the history about what's happened to past failed currencies to understand the impacts of monetary and fiscal policy.
- Lords of Finance: The Bankers Who Broke the World by Liaquat Ahamed, a book about events leading up to the great depression of the 1930s which covers some themes that are highly relevant now.
They do this via these "special purpose vehicles" where they lend to another organization that then buys what they want so that they can adhere to the letter of the law with the Federal Reserve act even if the actions completely violate the spirit of the law as it was framed. Clearly whoever is picked to buy the assets for this Secondary Market Corporate Credit Facility will do quite well from such a deal if they are able to extract management fees, Blackrock could receive millions of dollars in fees from such a deal without actually taking on much risk since it's freshly created dollars that are buying the assets. ↩
The choice of which monetary standard to adopt was highly contentious and led to a number of political factions. Broadly speaking most people at the time were arguing over what should back the dollar, the two biggest contenders were a gold standard and a silver standard. The reason this became such a divisive issue is that a standard backed by gold favored a different group of people as one backed by silver. On top of this there were geographical trends that divided these groups, farmers and more rural areas that were more likely to be debtors preferred silver whereas those issuing the loans tended to prefer the more deflationary gold standard. There were others who suggested that both metals could be used to back the dollar, a stance known as bimetalism. Unfortunately bimetalism has structural issues if there's a fixed exchange rate between the metals and the dollar since people will just start to hoard the more valuable metal while trading the less valuable one, this process is known as Gresham's law and likely explains why this system never got traction in the modern world. It's also interesting to note that there were experiences with a fully fiat unbacked currency at this point in the history of the USA. During the revolutionary war the Continental Dollar was created as an unbacked fiat currency to pay for war expenses, these inflated especially badly during the war. Perhaps this is part of the context in which Jefferson said "I am an enemy to all banks discounting bills or notes for anything but coin". It's highly likely that this brush with the effects of inflation by a completely unbacked currency drove the framers of the constitution to include the contract clause which explicitly references the usage of gold and silver. ↩