Quantitative Easing: A Critique

Over the weekend, I posted a report on the strategy of the Federal Reserve to exit its position of excessive monetary ease. In that report I mentioned that, since August, the total amount of reserves in the banking system had shown a substantial increase.

Looking a little further into the data we find that the Monetary Base, defined as all financial assets that serve as bank reserves or could become bank reserves, rose from an average of $1,649 billion in the two weeks ending August 12, 2009 to an average of $2,001 billion in the two weeks ending November 4. (These data are on a nonseasonally adjusted basis, but the seasonally adjusted data are not significantly different.)

The Monetary Base rose by $352 billion during this period of time. (This was both on a seasonally adjusted bases as well as a nonseasonally adjusted basis.)

What I am interested in reporting on is the total amount of reserves available to the commercial banking system.

Technical Note: To get the figure for total reserves we must subtract the currency component of the money stock from the reported data on the Monetary Base. This amount, according to the Federal Reserve System, is total reserves (of the banking system from the H.3 release) plus required clearing balances and adjustments to compensate for float at Federal Reserve Banks plus an amount representing the difference between current vault cash and the amount of vault cash used to satisfy current reserve requirements. This total reserve amount is different from the total bank reserves reported in the H.3 release on Aggregate Reserves of Depository Institutions and the Monetary Base.

This calculated measure of total reserves in the banking system rose by $351 billion during the time period under review. In other words, currency in circulation outside of commercial banks increased by only $1.0 billion from the August 12 information to the November 4 data.

Excess reserves in the banking system increased in this 13-week period from $709 billion to $1,059 billion, a rise of $350 billion. Thus, all the increase in bank reserves during this time period came in excess reserves, the required reserves held behind the deposits of the banks remained flat.

The truly remarkable thing is that the Monetary Base averaged around $848 billion in the two weeks ending August 13, 2008, while the total reserves in the banking system calculated using the method discussed above amounted to $72 billion.

Thus, in the time between August 12, 2009 and November 4, 2009, the Federal Reserve added $352 billion to the reserves of the banking system, a system that only averaged $72 billion in total reserves in the two weeks ending August 13, 2008. That is, the Federal Reserve added about five times as much reserves to the banking system in a 13-week period in 2009 as the complete banking system had in total in August 2008!

However, during the later time period, total bank credit in the banking system dropped by about $150 billion, loans and leases falling around $142 billion.

While bank reserves were increasing rapidly, the effective Federal Funds rate remained relatively constant. It averaged 16 basis points in August 2009, 15 basis points in September and 12 basis points in October. It continued to average around 12 basis points in the first half of November.

The question that needs to be asked is whether or not this scenario was what the Federal Reserve hoped to achieve when it initially went into what it called Quantitative Easing.

My understanding of quantitative easing was that Fed actions were required to combat a Liquidity Trap, a situation in which interest rates could not be pushed lower by adding more reserves to the banking system. Because interest rates could not be pushed lower, aggregate economic demand could not rise. However, it was argued that as the central bank continued to add reserves to the banking system, loans would still be granted to customers and the money stock would increase. Having more funds available, even though the interest rate on the loans could not go lower, was the quantitative effect desired, and as these funds were added to balance sheets spending would increase and the economy would be stimulated.

I don’t sense in the figures presented above the presence of a liquidity trap. The banking system seems to be demanding reserves and, in order to keep interest rates from going up, the Federal Reserve is very abundantly supplying banks reserves. That is, rather than exhibiting a fear that short term interest rates cannot decline any further, the Fed is afraid that short term interest rates (as well as rates on longer term Treasury securities and mortgage rates) might actually rise. This is consistent with the almost obsessive effort the Fed is making to be sure that the market knows the Fed is not going to let interest rates rise and that it is going to keep interest rates at current levels for “an extended period” of time.

This, to my mind, is not quantitative easing. It is just a continuation of the strategy the Fed has been following since September 2008: In policy actions, do not err on the side of providing too little stimulus.

This is not a refined, sophisticated monetary policy. Throwing everything you can against the wall to make sure a sufficient amount of what you throw against the wall sticks is something one does when one is desperate and unsure about what one is doing. You can achieve your goal with this strategy, but the problem is that you have a big mess to clean up afterward.

And, if I am correct in this analysis, the Federal Reserve is currently only exacerbating the size of the mess that will have to be cleaned up.

Comments

[derryl:]

The Fed is providing virtually free money to the banking system so they can use it to make profits to cover loan and derivatives losses. Money center banks are using this free money to game the equities and futures markets, and making lots of profits. Many banks take the Fed's money for .25% and 'invest' in Treasuries paying 3.5%, a safe but unspectacular 3.25% profit on the spread.

What banks are NOT doing with the money is leveraging it up by lending to overindebted American businesses and households. So the "money multiplier" impact of adding these excess reserves is zero.

I think the Fed knows the US private sector is incapable of taking on and servicing more debt, or profitably investing new loans, even if the semi-solvent banking system is willing to risk further balance sheet damage by making new loans. So the Fed provision of this money is just a straightforward measure to help the banks earn profits to repair their balance sheets.

Insofar as banks use this money to earn trading profits, the American citizen on the losing end of the trade is paying "taxes" to rebuild the banks' balance sheets. Insofar as banks use this money to 'invest' in Treasuries, it is taxpayers who will be paying the interest that becomes the banks' 'profits'. So this is just another way for the Fed to transfer money from American taxpayers to insolvent banks.

I think it would have been better to let some or all of them fail in an orderly resolution. Wealth would be redistributed in the capitalist way, from losers to winners. Maybe at the beginning of the panic it was necessary to prop up the insolvent banks while the resolution mechanisms were being put in place. Now that the panic is over it is a good time to revisit the orderly unwinding of the too big that have failed.

Nov 16 09:01 PM

[The Khan:]

And what does the country get for it? One author on Alpha (sorry, can't remember who) summed it up for me yesterday when he pointed out that, for the sum used to bail out AIG, the Chinese are building 16,000 miles of high speed rail as part of their stimulus package.

What do you think your grandchildren might prefer to be enslaved for ... zombie AIG resurrected (to die another day), or a national high speed rail network?

Why are we doing this? Is anyone in the driver's seat?

Nov 17 10:11 AM

[The Khan:]

And what does the country get for it? One author on Alpha (sorry, can't remember who) summed it up for me yesterday when he pointed out that, for the amount used to bail out AIG, the Chinese are building 16,000 miles of high speed rail as part of their stimulus package.

What do you think your grandchildren might prefer to be enslaved for ... zombie AIG resurrected (to die another day), or a national high speed rail network?

Why are we doing this? Is anyone in the driver's seat?

Nov 17 11:17 AM

[flow5:]

The FED's policy tool, interest on reserves (IOR's), the FOMC's interest rebate on member bank reserve balances (which Congress made the taxpayers responsible for), has induced widespread dis-intermediation among the non-banks (the most important economic sector in this recession/depression -- or 80% of the lending market). I.e., the intermediaries have shrunk in size & the size of the member banks has remained essentially the same.

The non-banks are financial intermediaries - intermediaries between saver & borrower. The member banks are new money and credit creators (they always create new money in the lending process, member banks do not loan out existing deposits).

A trillion dollars + in monetary savings (if you count just the verifiable portion in excess reserves), was siphoned out of the non-banks (e.g., hedge funds, investment banks, finance companies, insurance companies, mortgage companies, pension funds).

The financial press has attributed this to deleveraging. However, the member banks (20% of the lending market), has suffered no dis-intermediation.

Monetary savings (savings held beyond the income period), are impounded within the banking system. They are lost to investment, consumption, or to any type of payment (if held in this form). I.e., savings held within the monetary system have a transactions velocity of zero, and are a leakage in the Keynesian national income concept of savings.

Such a "cessation of circuit income" has adverse effects on production and employment, and requires large dosages of money to counter-act.

Thus under one view, the quantitative easing performed by the FED (an increase in legal reserves), has been substantially erased. But we are not done.

If the FOMC raised the average reserve ratios on member bank deposits, the volume of required reserves would increase (which if large enough, could induce bank credit contraction), ceteris paribus.

This process is the same as if the FOMC raised the remuneration rate on excess & required reserves, vis a’ vis other competitive instruments and yields. It would also increase the volume of legal reserves, ceteris paribus (which also acts to reduce the monetary system's lending capacity).

Quantitative easing was tried, but there were opposing forces that rendered it immeasurable.

The solution is to redirect savings to the non-banks, and velocity (consumption & investment), will rebound, without unnecessarily forcing prices (stagflation), higher. This re-routing was successful in the housing crisis of 1966 (such targeted redirection is used in a command economy). In 66, both the member bank's and non-bank's profits were revived, and the housing market (and the economy along side it), recovered thereafter.

Nov 18 01:03 AM