Why The Fed Needs QE Infinity

by: Nick Abe, CFA

Summary

The 2008 financial crisis was exacerbated by the fact that there aren't enough dollars in existence.

Total credit market debt outstanding to M1 was 36.8x in 2008; QE has helped to reduce that figure to 19.9x - still 4x higher than 1959.

Absent additional QE, that figure will continue to drift upwards as total credit market debt outstanding has only decreased in five quarters out of the last 224.

When QE3 was first discussed, many Fed critics labelled it QE Infinity, a joke about how the policy would be ineffective and need to continue in perpetuity because it would never achieve its goal. The critics were wrong - QE did accomplish its goal: restoring stability to financial markets and increasing the chances of inflation. The reason it worked, however, is not largely acknowledged, and I think that's due to a basic lack of understanding of how "money" works. Even the Fed doesn't seem to fully understand why it worked and, by extension, why stopping it (regardless of where rates are) is bound to lead to problems.

How money works

The monetary system of any economy is a closed loop, with the exception of central bank printing (electronic or paper) and destruction of currency. In every transaction, there is a buyer of money and a seller of a good or service. There is no creation or destruction of actual currency possible in any transaction - again outside of the central bank. Let's say you opened a business that was ultimately unsuccessful - you might think that the money you spent was destroyed or "lost". That's true from your perspective, but any money spent actual went into the hands of other individuals or businesses. So your loss was their gain.

In the case of debt transactions, the same holds true; no actual money is created or destroyed in a debt transaction. You borrow money from the bank for your business, which in turn comes from deposits or investments others have made with them, and you spend it as you see fit. There are many more layers to this transaction, but every dollar actually exists (either as electronic money or paper notes). While this may seem obvious, I don't think people understand the macro implications.

How debt works

Debt works in the exact same way as money. For every debt transaction, there are more layers, but there is always another side. When you borrowed money for your business, it came from the bank, which came from depositors. So now you owe the bank which in turn owes the depositors. If you cannot repay the loan, the bank takes the first loss and the depositors absorb any remaining losses (well, obviously there is a whole capital structure - but we are keeping this as simple as possible). If you did repay the loan, it would be because your business was successful and you generated revenues - revenues which are supplied through the savings of others (i.e. people purchasing products from you by taking money out of their bank account).

So here is the super obvious macro implication of "for every buyer there is a seller": you cannot reduce debt without reducing savings. Put another way, in order for debt to increase, someone else's savings must also increase. While we like to say things like "America is addicted to debt" - it is really just another way of saying "others are saving too much money". Total credit market debt has only shrunk in five quarters (Q1 2009 to Q2 2010) in the last fifty six years. That's because of what I explained before, every increase in savings (excluding money printing) will be met with an offsetting increase in debt.

Zero sum games

We've all heard the expression "it's a zero sum game", which is a good way to explain the macro implications of how money and debt work. Obviously on a micro (individual) basis you can save money or go into debt, but on a macro basis, you can't because either one or many individuals had to have an equal amount of savings in order for you to have access to that debt in the first place. What is not a zero sum game are the assets that we typically go into debt to purchase.

Take stocks as an example. An IPO is a simple monetary transaction, the company gets your cash and you get a share in their company. A company may IPO 100% of their shares in a $100 million transaction at $10 per share and as a result it is a zero sum game. As soon as the shares begin trading, they may trade up to $15 per share - and this is where it is no longer a zero sum game. Every share traded is zero sum (buyer and a seller), but the change in value in the total company has "created" $50 million in equity that wasn't there the day before. It is not necessary for more than 1 share to trade at $15 in order to create this new equity either.

The same is true, of course, of houses - the cost to buy the land and build the house are zero sum monetary transactions. But once one house on your street sells, it immediately raises (or lowers) the value of all the houses on your street "creating" equity. For example, if a developer spends $100 million building 100 homes and then sells those homes for $150 million ($1.5 million per home), and then a purchaser turns around sells one house for $2.5 million, it creates $100 million ($2.5 million minus $1.5 million x 100) in perceived new equity in the community.

The dangerous thing here is when the zero sum games work against creating new equity. If one of those houses on the street sold for $0.5 million instead, then it puts the loan to value (LTV) on all the homes at 200% (even assuming a healthy 33% down payment) and all of those house owners in deep trouble. If the loans are up for refinancing, the bank won't lend them 200% LTV and everyone in the neighbourhood will be forced to sell (or walk away from their mortgages), further dropping prices.

The role of debt

Debt plays a key role in the economy; in a perfect world, older people would build up savings and earn a rate of return on those savings by lending it to younger people who are looking to get established (maybe buy a house or pay for school). In a world without debt, those that wanted to buy something would be limited to paying whatever cash they had on hand (or in the bank) and capitalism would be far less efficient. For example, a wealthy person could buy anything by bidding $1 above your bank balance (assuming you were the only other interested party). From a price discovery perspective, it is vital that debt be readily available to those that investors are willing to lend to.

So far all I've done is spend almost 1,000 words stating the obvious, but I think it was important to understand why QE worked and why some level of QE is required for the future. All of the things that I have discussed are key parts of any monetary system, a system which is basically the oil to any economic engine. With insufficient oil, no engine (even the ones in those Quaker State ads) can run for long, and the current monetary setup has a very small oil tank that relies on the engine recirculating it very quickly to be effective. Any kink in a hose (or the system) could kill the whole thing. Using a larger oil tank and thicker hoses reduces that risk.

Short squeeze

As discussed, there are a finite number of actual (i.e. paper cash) and electronic dollars in existence. This is reflected on the Fed's balance sheet as currency in circulation (paper cash) and deposits (electronic cash). We won't involve repos or anything else to keep things simple. As of June 30, 2015, the total cash in the US system (using this measure) was about $3.8 trillion against a total credit market debt of $59 trillion (Jan. 1, 2015). In stock terms, that's a short interest of 1,552%. If you use the M1 money supply instead, it is a much larger 1,990%. It's important to state another obvious thing here: if you were worried about a short squeeze on a stock, you would buy it because you think it could become more valuable. That's exactly what happened to the dollar in the financial crisis of 2008. The second quarter of 2008 had the highest total credit market debt to M1 on record: 3,680%. There was a short squeeze and it became insanely more valuable against every measure (housing, stocks, commodities, etc).

That's why QE worked. There was a short squeeze on the dollar because everyone needed dollars at the same time. There was a negative feedback loop as all of the non-zero sum investments (housing and equities, but primarily housing) were cratering, forcing further selling to meet obligations. QE added dollars to the monetary system ending the negative feedback loop.

To give a further idea of just how "short" we are of US dollars, even after QE1, QE2, and QE3, there still aren't enough US dollars in existence to pay just the current time and savings deposits outstanding. That's how far away we are from a disaster - people cashing in their GICs.

Why QE Infinity is a good idea

So obviously we are no longer (or at least weren't prior to these past few weeks) in financial crisis mode anymore, why is QE Infinity a good idea? Because we don't want to go through any more financial crises. It's really that simple. The potential downside of QE was supposed to be rampant inflation - which never materialized and likely never will. But here are the reasons why the risks outweigh the rewards.

First, because QE is all electronic, there is no choice but for the funds created by it to be held "in reserve" at the Fed. If the Fed buys $100 billion of Treasuries from JPMorgan (NYSE:JPM), then JPM gives the Fed the Treasuries and its account at the Fed is credited for $100 billion. If it then decides to use that to buy some assets from Wells Fargo (NYSE:WFC), then JPM gets debited the $100 billion and WFC gets the $100 billion credited to its Fed account. There is no way for the "cash" to be withdrawn from the Fed and then "lost" in the economy. If the Fed felt there was too much cash available at any point, it could simply sell the Treasuries it purchased and "delete" the cash it created.

Second, the Fed has a stated dual mandate of full employment and 2% inflation. Assuming those goals are equally important, it has relied heavily on the private sector to meet its inflation goal. Total credit market debt to the M1 money supply was just 4.9x (490%) in 1959 before expanding to the aforementioned 36.8x (3,680%). Any increases in inflation along the way were primarily the result of the purchasing power "created" by the creation of all of that debt and all the risk associated with that debt fell onto the private sector.

Third, due to changes I previously wrote about, banks are no longer constrained by any kind of reserve ratio requirement in their lending. Their primary constraint is capital. In order to increase the effective money supply to the economy, banks would need to see large increases in their capital. If there were concerns that the effective money supply was increasing too rapidly, capital requirement could simply be increased. Generally, less leverage is viewed as a positive thing and more stable. Increasing the M1 money supply and reducing the "short interest" in the dollar (as expressed by total credit market debt) will reduce the possibility of future short squeezes. Increasing capital requirements at banks (again if required) would also have a stabilizing effect.

Fourth, QE can continue regardless of the path for interest rates. It may actually make it easier to increase interest rates in the future as the market (housing, stocks, or any market) would be less vulnerable to financial shocks.

Fifth, it seems to help people feel good about the markets and the economy in general. Animal spirits and all that stuff. So good, in fact, that all that buying of government debt doesn't push yields lower - but actually higher, as shown in the chart below:

And a bonus, I wouldn't implement it in the way it was implemented before. It really doesn't make sense to increase interest rates when inflation is effectively zero percent. Generally speaking, the increase in interest rates is only going to the wealthiest of Americans at the expense of the poorest. A DE ("direct easing") program is likely to be more effective at spurring both employment and inflation. It could be as simple as writing a cheque to people with their tax returns. If each tax payer received $1,000 from the Fed (in the form of a direct deposit with their financial institution) reduced by $10 per $1,000 of income (such that you had no bonus cheque for incomes above $100,000), it would be more effective than QE, involve less printing, help the inequality gap, and do more to spur inflation.

Overall, however it is implemented, the Fed just needs to recognize that QE was successful not because it dropped interest rates, but because it increased the stability of the financial system by increasing the size of M1 (especially relative to total credit market debt outstanding). Further QE has limited downside and the potential upside of continued financial stability.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.