Effects Of QE: Follow The Money (And Banking Transactions)

Back on March 13, David Malpass, president of Encima Global LLC, wrote an op-ed for The Wall Street Journal entitled “The Fed’s Taper Is Already Paying Off”. In this op-ed, Malpass argues that the Fed’s purchases of securities, aka Quantitative Easing (QE), have inhibited bank lending to small businesses, aka job creators.

Malpass has observed that with the Fed’s commencement of the tapering of its QE in January and February of this year, bank lending has accelerated. Malpass argues that the slowing in QE is the reason bank lending has accelerated. Malpass concludes that the Fed’s tapering of its securities purchases is, in and of itself, bullish for the US economy.

Having mellowed (decayed?) since becoming eligible for Medicare, I now normally would read an op-ed like that of Malpass, chuckle, and then go practice my bass guitar. As a matter of fact, I cancelled my subscription of The Wall Street Journal several years ago because of the consistently poor analytical quality of its economic-related  op-eds. So, I would not have run across Malpass’s (Strunk says to add the “s” after the apostrophe) op-ed if it were not for some of the readers of my doggerel calling my attention to Malpass’s op-ed. Given that I have argued in recent commentaries that, all else the same, Fed tapering is bearish for nominal US economic activity and the behavior of risk-asset prices, some of my readers asked my opinion of Malpass’s thesis. Well, if enquiring minds want to know, here goes.

“Rather than creating or printing money, as is often assumed, the Fed borrows heavily from banks to   buy bonds … In 2013 alone, the central bank borrowed nearly $1 trillion from the banking system. It wasn’t created out of thin air. It is recorded as a liability of the Fed and an asset for banks… The Fed didn’t create any extra currency or private bank deposits. To make their loans to the Fed, banks hadto reduce other assets.” [emphasis added]

These comments by Malpass negate an important lecture given in every Money and Banking 101 course. That lecture explains how a central bank can stimulate nominal spending in an economy by purchasing securities in the open market. In a monetary system in which banks are required to hold only a fraction of their deposits as cash reserves with the central bank, the banking system is able to generate new amounts of credit and deposits that are some multiple of the dollar amount of securities purchased by the central bank. Ever since Professor Chester A. Phillips articulated the deposit and bank credit multiplier back in 1920, enrollees in most Money and Banking 101 classes have been taught that central bank purchases of securities stimulate bank credit (the asset side of the banking system’s balance sheet) and bank deposit (the liability side of the banking system’s balance sheet)  expansion . So, Malpass’s argument that Fed purchases of securities “didn’t create any extra currency or private deposits … and [t]o make loans to the Fed, banks had to reduce other assets” represents a new theory of money and banking that certainly deserves critical scrutiny. So let’s scrutinize.

Let’s go through the accounting of a Fed purchase of securities. (This would be a less tedious exercise if I knew how to draw T-accounts in Word, but I don’t. So, if you are interested in reviewing the lecture in Money and Banking 101, brew a pot of coffee before going on.)  The Fed conducts its securities purchases and sales with certain designated (primary) government securities dealers. These dealers are essentially conduits between the Fed and ultimate sellers/purchasers of Treasury and Agency securities. If the Fed solicits offers on securities it wants to purchase, these primary dealers, in turn, contact their customers –  e.g., banks, insurance companies, pension funds, mutual funds – with bids to purchase securities from them.

Assume that Primary Dealer A purchases $100 of securities from Pension Fund B and simultaneously sells these $100 of securities to the Fed. Let’s follow the “money”. The Fed credits Primary Dealer A’s bank account at Bank A for $100. On the books of Bank A, the cash asset item “deposits at the Fed” goes up by $100 and the liability item “deposits payable to Primary Dealer A” goes up by $100. On the books of the Fed, the asset item “securities owned outright” goes up by $100 and the liability item “deposits payable to Bank A” goes up by $100.

Let’s pause here to contemplate what has taken place. The Fed has purchased $100 of securities from Primary Dealer A and Primary Dealer A now has $100 more in deposits (and $100 less in securities) than it had before the transaction with the Fed. From whence did this $100 increase in Primary Dealer A’s deposits come? From me? From you? No, from the Fed. And from whence did the Fed get these deposits? It created them figuratively “out of thin air”.

Okay, let’s get back to the story. Remember that Primary Dealer A simultaneously purchased $100 of securities from Pension Fund B while selling $100 securities to the Fed. Pension Fund B needs to be paid for the $100 of securities. Primary Dealer A, immediately upon notice that its deposits at Bank A have been increased by the Fed, orders Bank A to transfer $100 to the deposit account of Pension Fund B at Bank B. On the books of Bank B, the cash item “deposits at the Fed” goes up by $100 and the liability item “deposits payable to Pension Fund B” goes up by $100. From whence did the $100 increase in Pension Fund B’s deposits come? From the deposits of Primary Dealer A. From whence did the $100 of deposits of Primary Dealer A come? From the Fed. And from whence did the $100 from the Fed come? From thin air.