Hard Money Versus Soft Money

by: Shareholders Unite

Here is 'hard money' guy, Peter Schiff, on Greece:

Rather than allowing Greece to default, which would have put real teeth into Europe's previously untested commitment to fiscal responsibility, Europe proved it was all bark and no bite. The net effect has been to demonstrate that the ECB will monetize the debts of any member-state that has borrowed too much. As this understanding sinks in around the globe, the euro just sinks.

Well, the understanding has sunk in around the world, and then some. The only thing that has failed to sink is the euro, quite the contrary. In fact, after this (which was written on May 19 of this year), something much more monumental happened, the ECB announced an unlimited bond buying program.

This can be seen as a victory of the 'soft-money' Club Med coalition of Latin eurozone countries, which managed to overturn ECB policy towards a more 'soft-money' approach. How curious the euro rallied very hard on that news. From a low of $1.20 just six weeks ago we're now well above $1.30.

Isn't unlimited bond buying tantamount to 'currency debasement,' at least according to the hard-money guys like Peter Schiff? Or perhaps the world doesn't work the way they think it does. Well, it isn't entirely clear cut. One could argue that it wasn't the euro that was rising, but the dollar that fell. First on the expectations of further QE, and then on the Fed indeed delivering a little of it. And Schiff's money is on the dollar in terms of 'softness.'

One could also argue that the ECB also promised to fully sterilize, that is, offset any monetary effects of its possible bond buying program. But still, to have the Bundesbank utterly isolated as the lonely single vote against, and then seeing the euro rally so strongly as it did, it is curious at the minimum.

Equally curious is that the hard money people usually propose a return to the gold standard but are rarely in favor of the euro. But the latter has acted in a very similar deflationary way as the gold standard did in the 1930s.

The way it's constraining public expenditures and force austerity without any offsetting monetary stimulus or devaluation, they should love it. It's 'hard money' par excellence..

The Fed's QE
While some of the hard money people would agree that the Fed has a role to play in softening the business cycle, by lowering interest rates. However, under the present conditions, that simply isn't enough. When households are deleveraging, that is, cutting borrowing and spending or even paying off debt to repair balance sheets, the resulting loss in demand can be so pronounced that not even zero interest rates by the Fed is sufficient to revive demand.

Even Milton Friedman argued that the Fed could have prevented the 1930s depression by preventing the big fall in monetary aggregates (M2 in particular). Although M2 is a little better behaved this time around, it isn't immediately clear how the Fed would achieve a rise in M2 (bank deposits, currency in circulation and some other assets). Short-term rates are already effectively zero.

Expanding base money (M0, or bank reserves and currency in circulation), which is directly under Fed control only increases excess bank reserves further, without any traction in the economy. It's Keynes' famous pushing on a string, or liquidity trap condition.

QE actually isn't different in principle from ordinary open market operations (OMO) that the Fed carries out to achieve the desired Fed funds rate (the interbank lending rate). Instead of buying short-dated paper, the Fed simply buys longer dated ones.

The transmission mechanism or how QE is supposed to work
QE is often equated with 'money printing' but this isn't strictly correct. Just like normal open market operations, the Fed buys assets and credits the accounts of the banks selling these assets. These bank accounts banks keep at the Fed are part of the bank reserves or base money (MO). This isn't money, something to keep in mind.

There are two main ways this is supposed to work in stimulating the economy:

  1. The suppression of long-term interest rates. By acting as a buyer the prices of long-term assets rise, which means interest rates fall, or so it is in theory
  2. Banks lend out some of the reserves into bank loans, and only by doing that is some of these bank reserves (base money) converted into real money, that is, bank deposits held by customers with which they can pay.

So far the theory, the practice is a little harder. There is scant evidence pointing to any lasting effects of QE on long interest rates. If there is such an effect, it's quite small. This isn't terribly difficult to explain either. Long-rates are basically determined by inflation expectations.

And here comes the ironic fact that by waving the danger flags of "QE = money printing, hyperinflation is just around the corner," it is the hard money people who could very well blunt any effect QE could have on long rates. If the general public expects QE to be inflationary, the effect might even be negative, with long rates could actually rise as a result of QE!

This isn't just theory, QE has a habit of scaring people out of the dollar and into commodities and gold, supposedly as an inflationary hedge.

Modern Monetary Theory
So QE could actually be deflationary due to the inflationary expectations of the hard money people. This is quite funny, when you think of it, but the irony doesn't stop there. At the other end of the 'hard money' spectrum we find the proponents of the 'Modern Monetary Theory' or MMT.

They also think that QE might be deflationary. The Fed does nothing but substitute one asset, bonds (or other long maturity assets) for another, bank reserves. Since the former earn interest, but not the latter (well, a minuscule 0.25% to be precise), the net effect is, according to the father of MMT, Warren Mosler:

QE in fact does nothing for the economy apart from removing more interest income from the economy, particularly as the Fed adds relatively high yielding agency mortgages to its portfolio.... Functionally it works to strengthen the dollar and weaken demand, reversing the initial knee jerk reactions described above.

So we now have a situation in which the two extremes on the hard money scale both point to deflationary effects of QE, although the hard money people unwittingly so (but their beliefs trigger rate rises).

Base money
However, we've identified another channel through which QE could have an expansionary effect on demand and hence stimulate the economy. The asset purchases by the Fed are simply paid for by crediting the banks bank accounts at the Fed. These are (part of) bank reserves, or base money, or 'high-powered money.'

Banks do not need so many reserves, as they pay little or no interest. So they would like to lend them out to make the money work for them, increasing bank lending to households and businesses. In fact, in textbook economics, this is often assumed to be more or less automatic.

If banks need to hold 10% of their bank lending as reserves, any additional reserves can be lend tenfold, the famous money multiplier (not to be confused with the Keynesian multiplier).

Now, and here is where we have to part ways with the MMT people (or at least some of them), as they argue that:

No bank can lend reserves except to another bank. You can think of all these reserves as imprisoned for life-they'll never get out. Rather, eventually as the economy recovers the Fed will sell the treasuries back to bank and will debit their reserves by the amount of the sale. Presto-the reserves will be gone. Without ever causing any Weimar hyperinflation. [L. Randall Wray]

This strikes us as manifestly not true. Banks could, in principle, lend out excess reserves. And by doing so, they create money as deposits for businesses and households (part of the money supply) are created when they borrow from banks.

Two useful questions have to be asked at this juncture:

  1. Are banks are reserve constraint under the present economic conditions.
  2. Are banks ever "reserve constraint".

To begin with the latter question, there are many who argue that banks are never really reserve constraint in principle. If profitable lending opportunities to the private sector exist and a particular bank needs reserves, it can borrow these from other banks in the money market.

Or, as the ultimate source of these reserves, it can borrow from the Fed. The worst which can happen is that the Fed makes this borrowing a bit more expensive if they deem credit conditions and the economy in general are running too hot. But banks will get the reserves they need.

Now, if banks are not reserve constraint, there is no reason to expect them to start a lending spree when the Fed floods them with even more reserves. Which leads us to the first question.

Under the present economic circumstances, there is no doubt whatsoever that banks have all the reserves they need. The interbank lending rates are effectively zero, and banks sitting on a mountain of excess reserves:

Increasing these reserves, whether through normal open market operations (buying short dated assets) or QE (buying long-dated assets) simply just adds to this, without having any effect.

Economic diagnosis
While it's useful to ponder over the exact nature of the transmission mechanisms of QE and even more fundamental issues, like the validity of MMT or the hard money thesis, the context matters a great deal. That is, before one discusses the effectiveness of certain policy measures like QE one should consider what economic problems these are supposed to cure.

We have previously proposed Richard Koo from Nomura for the next Nobel prize for providing the best diagnosis of the present economic woos. Guess what, even the hard money people from ZeroHedge agree...

The diagnosis is rather simple. The economy is weak as long as the private sector is repairing balance sheets, damaged from the financial crisis and subsequent asset price implosion (mainly housing). Repairing balance sheets means borrowing and spending less, and paying off debt instead. No amount of bank reserves or low interest rates will have much, if any, effect on the demand for bank loans, and thereby on money creation. QE, and monetary policy in general, are pretty powerless.

You might want to keep that in mind before you rush into gold and commodities, or out of the dollar and Treasuries. It's mostly in the mind..

Disclosure: I 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.