How Effective Has QE Been?

under construction

We have written a number of essays on quantitative easing (QE) as practiced by the Fed. We also have just finished our series on Understanding Money with the publication of Understanding Money: Part 5 – It’s All Money. As we were finishing we realized that a number of questions in our mind about QE might be tidied up using our ideas on money. This essay examines the monetary mechanics of QE and attempts to quantify its impact on the money supply and hence the economy.

The Fed’s Money: Chicken or Egg?

In the Understanding Money series, we established that creating money (debt) was a bilateral process by which currency or MZMc is exchanged for new money (debt) with non-zero maturity. All Money other than MZNc has the following properties:

  1. a maturity, either determinate or indeterminate, that is not zero although for practical purposes in some cases (deposit and checking accounts) it may be considered to be zero;
  2. a yield or interest rate, usually not zero;
  3. a term structure, possibly indeterminate or null; and
  4. its creation involves a bilateral exchange of a collateralized new debt or money instrument for MZMc of equal value.

But what of the creation of MZMc which we have established as a debt instrument? In terms of the above four properties it has some unique characteristics:

  1. It has true zero maturity and is the only form of money that does so;
  2. it’s yield is always zero;
  3. the above two points result in a null term structure; and
  4. its creation is a unilateral sovereign act aided by its self-referential nature.

Its sovereign fiat backing establishes that its nature as we have described it is legitimate. Call it the primaeval egg of money creation, it is the true basis for all money. All money is created from MCMc and all money collapses and disappears into MZMc.

The life of a Federal Reserve note (FRN) is interesting. As we have described, once a year each Federal Reserve bank takes delivery of a specified quantity of currency from the Treasury Department and stores it in its vault.

At this point it will be helpful to consider inside the Fed versus outside the Fed or the economy. Consider the Fed to be a black box for which it is difficult or impossible to know what is going on inside. Currency inside the Fed’s vault is not in the economy and is not part of MZMc by definition. It is still valid currency, kind of like an egg that hasn’t hatched yet into an animal functioning in the economy.

The act of money creation, commonly called printing, occurs when the Fed buys something. Traditionally it only bough Treasury instruments (debt) but with the advent of the banking crisis in 2007, began buying other financial instruments. Where does it get the money to buy something? It goes into its vault and grabs a handful (or suitcase full) of MZMc and uses that. Instead, it may credit the reserve account of one of its primary dealers (PD), that select fraternity of institutions with which it trades exclusively. If a PD wishes to use some of the deposits in its reserve account, then some official has to scurry into the vault, grab a handful, and give it to the PD.

The Fed DOES NOT give money away. It always uses money for a bilateral transaction in which it exchanges MZMc for a financial asset with non-zero maturity of equal or greater value (imposing a haircut on the asset seller in some cases). This is all recorded very tidily on its balance sheet (see: Tracking the Fed Balance Sheet). The total assets it has purchased are shown by asset class under assets and the total money it has spent to purchase them, under liabilities shown as “Federal Reserve notes, net of F.R. Bank holdings (WCURCIR)” and “Other deposits held by depository institutions (WRESBAL)”.

In terms of the total money supply  (total credit market debt outsanding) as we have defined it, the size does not change. Pushing $1000 of MZMc into the economy by removing $1000 of say Treasuries with a 5-year maturity from the economy (taking it inside the black box) leaves the total credit market debt or total money supply in the economy unaltered. What is altered however is the term structure of the money supply. $1000 of 5-year money has been replaced with $1000 of MZMc which increases the liquidity in the economy.

Since MZMc is the basis for all money creation, adding more into the economy gives financial institutions the ability to create more money of non-zero maturity (debt). But recall that we have said this is a bilateral process. It takes a willing lender and a willing borrower. And the latter recently reached the point where, leveraged to the hilt, they either couldn’t or wouldn’t borrow more.

The result has been for QE as practiced by the Fed, a build up of reserves of lending institution and in particular, excess reserves. In other words, the egg is cracked but not fully hatched. The Fed laid the egg but the borrowers can’t use it. After all, since they can’t lend it (no credit-worthy borrowers) what would they invest it in, especially when the Fed gives them 25 basis points on their deposit (which is more than our bank gives us)?

How Big Is the Leak in the Dam?

The key question based on the prior discussion is how much of the new MZMc has moved out of reserve accounts into the economy? We will try and get some idea using FRED.

How Many Eggs has the Chicken Laid?

Figure 1 in A Brief Note on the Velocity of Money shows the growth of MZMc as CURRCIR (purple line) plotted on a vertical log scale to show the regularity of its exponential growth (linear). What this graph doesn’t tell us is is the growth in MZMc unusual? In Figure 1 below we compare MZMc to GDP. During the period that GDP data is available, both GDP (red line) and MZMc (green line) grew regularly with few pauses or reversals visible at this scale. In fact, the biggest hiccup in GDP occurred during the 2009 recession and MZMc growth paused before accelerating to resume its regular growth rate. The ratio MZMc/GDP (blue line) is more revealing. It tells us that the rate of growth of currency was less than the rate of growth of GDP until the early 1980s at which point the growth in MZMc outstripped the rate of growth of the economy.

From about 2003 and leading up to the 2007-2009 recession, we an uptick in GDP growth causing the ratio to move downwards once again into early 2008 at which point the growth of MZMc which hadbeen flat for several months suddenly spiked up. This corresponds to the introduction of QE1.

Figure 1. MZMc/GDP (blue) plotted against MZMc (green) and GDP (red).

The point we would take away from this is that given the regularity of growth of MZMc cited from our earlier essay, QE had the effect of returning the growth of MZMc to its regular trajectory, one that nicely tracks the growth of GDP. It is interesting to note that the 2007 recession undid the uptick in GDP growth that started in about 2003 and returned it to its regular rate.

What Can the Fed’s Balance Sheet tell Us?


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