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Why Quantitative Easing Isn't Printing Money

Marshall Gittler, Head of Global FX Strategy | IronFX
Thursday, 23 May 2013 | 3:31 AM ET
The Washington Post | Getty Images

The title of a recent article I wrote for CNBC.com was "How Gold Rallied for Years on a 'Misunderstanding,' " but it's obvious from the comments I received that I did not clear up these misunderstandings.

So I'd like to explain in a bit more detail why quantitative easing (QE) is not printing money and why bank reserves aren't money.

Let's take a look at the balance sheets of the actors involved. Here's what the T-accounts for the balance sheets of each institution, showing the assets on the left and the liabilities on the right, look like before quantitative easing:

As you can see, Bank ABC's assets consist of 50 reserves at the central bank, 50 loans and 40 bonds. The central bank's balance sheet has assets of 70 T-bonds and T-bills, but against liabilities of 50 in reserves (the aforementioned reserves of the banks) plus 20 of notes and coins in circulation—what we usually call money. The Treasury has assets of 110 and liabilities of 110, namely the T-bonds and T-bills that the banks and the central bank hold.

Now, the central bank embarks on quantitative easing. It buys up all the bonds that Bank ABC holds. What do the balance sheets look like now?

Bank ABC has only shuffled the composition of its portfolio around. It's exchanged bonds for reserves in what is no more than an asset swap. There is no increase in the size of its balance sheet.

The central bank's balance sheet, on the other hand, grows substantially. On the asset side it gains 40 bonds and on the liability side, reserves increase by the same amount. Note though that there is no change in cash in the hands of the public—what we know as money.

The whole operation leaves the Treasury's balance sheet unchanged. No new bonds are issued, no revenues received.

So we can see that while the central bank's balance sheet does expand, the only impact in the private sector is to change the composition of the banks' balance sheets, exchanging bonds for reserves. The total assets of the private sector don't change. Hence no money is being created any more than, say, if someone sold their stocks and put the money into bonds.

Now, some people will argue that reserves are money. But let me explain why I don't think reserves are money.

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What is money? Money has three functions: a medium of exchange, a store of value and a unit of account. Bank reserves are a store of value; they may be a unit of account; but they are definitely not a medium of exchange.

Only financial institutions can hold reserves at the central bank. You can't go into a store and buy a loaf of bread with bank reserves, as you can with, say, a dollar bill or a checking account at a your local bank. Reserves just sit there. Although they do earn interest, that doesn't mean they are money. You can rent out your house and get an income stream from that, too, but that doesn't make your house money.

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Finally, one should also look at the intentions of the economic actors holding the bonds in the first place. As Nomura Research Institute Chief Economist Richard Koo points out, the banks, bond dealers or whoever held those bonds in the first place held them as a store of value, not as a medium of exchange. When the Fed buys the bonds away from them, they are apt to replace them with another store of value, such as stocks, rather than a medium of exchange. The money simply goes from one asset to another and does not contribute to expenditure that boosts growth and, ultimately, inflation.

Of course there is likely to be some leakage. Some of the reserves exchanged in the sale may be cashed in for money. There is also the "wealth effect" as the value of these stores of value rise, but that is not creating money, just inducing freer spending of the money that exists.

The process would be inflationary if the banking system were to use those reserves to increase their loans. This is the fundamental concern of those who fear that QE is going to cause inflation or hyperinflation, and it is not unreasonable.

However, this is putting the cart before the horse, particularly during a balance sheet recession, which why I said the purchases of gold were based on a misunderstanding.

As the Bank for International Settlements (BIS) put it: "In fact, the level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly."

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The proof that QE is not inflationary can be seen in Japan. Japan ran a QE regime from 2001 to 2006, and yet is still in deflation. The reason their QE didn't work is because even with interest rates at zero, nobody wanted to borrow. There was no demand for loans. Bank lending started falling on a year-on-year basis in November 1998 and was consistently negative until September 2005. Until the banks start to lend out the reserves, no money is created and no inflationary pressures build. Q .E .D (quod erat demonstrandum).

The author is the head of global FX strategy at IronFX, an online trading firm specializing in forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously head of the forex committee at Deutsche Bank Private Wealth Management.

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