10-Nov-10 News -- Europe and Asia bash quantitative easing

[vincecate]

The US dollar is unique, and things that apply to other currencies do
not apply to the US dollar. That's because the US dollar is the
world's reserve currency, and is the most credible currency in the
world.

What countries hold as reserves or use for international trade is up to them. There are lots of countries that seem very unhappy with the dollar. It can stop being the key reserve currency.

Calling quantitative easing "printing money" is very misleading
because it's nothing at all like printing money. It's creating money
through debt, and hedge funds and investment banks do the same thing.

The Fed is buying up debt. The way it pays banks is by crediting the banks "reserve account" with the Fed. If the bank were to then take out the money as paper money the Fed would print it, but that does not happen so much, so it mostly stays on the computers. But it is the electronic equivalent of printing money. The Fed is not creating debt, they are buying it for cash.

This is very different than the "money creation" done by banks etc. In their case they have accounts with "demand deposits" where people can spend the money at any time, so balances count as money, but they have really loaned out the money for years. This is more like fraud than printing money. This system can only theoretically work when there is a central bank that can create unlimited amounts of money to "provide liquidity" to the banks.

The US currency is like the Titanic, [...]

Well, here is one thing we agree on.

[vincecate]

So if you're expecting a "normal" crisis based on that book, you may want to do further research. What's going on here is anything but normal in terms of the previous 8 centuries of financial folly, with the exception of the collapse of the Bardi. But if you want to tell me how this isn't like the collapse of the Bardi specifically and how it is more like some other collapse, I'd be interested. Up to the point that Bernanke went down the rabbit hole with QE1 (put the 1.25 trillion of MBS on the Fed's balance sheet) I would have agreed with Rogoff or whoever wrote that book, but not now. Nothing like this has been done since the 14th Century banking crisis.

I don't mean to suggest that anything of the scale of this coming banking/debt/currency collapse has ever happened before. Even 14th century one will really be tiny compared to this one. But even in a small country the general pattern is the same.

First, banks using fractional reserve lending always run into trouble. If your deposits are "demand deposits" and your loans are for many years, you are bound to have trouble sometime. To me honest banking would have matching duration deposits for loans. If I had my way banks could only make a 10 year loan if they had enough extra 10 year deposits (money from 10 year bonds). With this change banks would not be "making money" and things would be far more stable.

Anyway, after the banks run into trouble the government tries to prop things up. But a few years later the government debt and the currency have big troubles and even fail (default and hyperinflation). The pattern is the same, but the scale is far grander this time than ever before. The misery will be far greater too.

[John]

Dear Vince,

> The Fed is buying up debt. The way it pays banks is by crediting
> the banks "reserve account" with the Fed. If the bank were to then
> take out the money as paper money the Fed would print it, but that
> does not happen so much, so it mostly stays on the computers. But
> it is the electronic equivalent of printing money. The Fed is not
> creating debt, they are buying it for cash.

No, the Fed is creating money through debt, with one step of
indirection.

If the Fed weren't creating money through debt, then QE would have no
effect at all. US Treasuries are almost completely liquid, and they
can be used in place of money for many purposes. So if you were
right, then the Fed would be replacing one form of liquidity with
another.

If the Fed were buying the bonds directly from the Treasury, it would
be obvious that they're creating money through debt. But it's illegal
for the Fed to do that.

So the Fed is buying the bonds from the banks who buy it from the Fed.
That will create a huge further demand for Treasuries, which will be
satisfied either by the US issuing more Treasuries, or by existing
Treasuries selling for much higher prices. Either way, money is being
created through debt. And if the price of some Treasuries goes up,
then the price of all Treasuries goes up, so that every portfolio of
Treasuries in the world becomes more valuable, creating an asset
bubble.

There's no way for the Fed to create money without creating debt.
that's why everyone's complaining about borrowing money that their
children will have to repay. There's no free lunch.

John

[Higgenbotham]

I don't mean to suggest that anything of the scale of this coming banking/debt/currency collapse has ever happened before. The misery will be far greater too.

That's just it. We can cut out all the stuff in the middle.

Just as a thought to get started. Let's say somebody hits me on the head with a hammer and I get a bump on my head. Dr Bernanke takes a look at it. I ask Dr Bernanke what will happen if someone hits me 10 times as hard on the head. He says I will get a bump 10 times larger. I tell him that I need a really big bump on my head and give him a hammer. He hits me on the head, cracks my skull and kills me.

When the banking system collapses this time, we are in unknown territory because the ramifications will immediately spread outside the realm of finance, as they did post 1346. A retaliatory cyberwar may be launched immediately. The electrical grid may shut down intermittently. Hundreds of millions may die within months.

I'm going to make a prediction. This is totally serious. I don't believe I've made any specific stock market crash predictions on this forum during 2010 because I can't recall thinking the market would crash this year until now. Even when I told shoshin last week that I want to be short, I didn't have a huge opinion that it would crash, just that it might drop a bit. But anyway, I now think we're seeing indications that the stock market is going to crash and it's going to be a whopper. I'm predicting the stock market is going to start sliding further and is going to crash in the second half of December and in January. This gives everyone here a great opportunity to laugh at me and call me a fool, but that's what I really think is going to happen. And I'll also predict this crash is going to be bigger than the 1929 crash; in other words, the Dow will lose more than 50% by the end of January and probably closer to 2/3.

[vincecate]

Dear Vince,

The Fed is buying up debt. The way it pays banks is by crediting the banks "reserve account" with the Fed. If the bank were to then take out the money as paper money the Fed would print it, but that does not happen so much, so it mostly stays on the computers. But it is the electronic equivalent of printing money. The Fed is not creating debt, they are buying it for cash.

No, the Fed is creating money through debt, with one step of indirection.

If the Fed weren't creating money through debt, then QE would have no effect at all. US Treasuries are almost completely liquid, and they can be used in place of money for many purposes. So if you were right, then the Fed would be replacing one form of liquidity with another.

If the Fed were buying the bonds directly from the Treasury, it would be obvious that they're creating money through debt. But it's illegal for the Fed to do that.

So the Fed is buying the bonds from the banks who buy it from the Fed. That will create a huge further demand for Treasuries, which will be satisfied either by the US issuing more Treasuries, or by existing Treasuries selling for much higher prices. Either way, money is being created through debt. And if the price of some Treasuries goes up, then the price of all Treasuries goes up, so that every portfolio of Treasuries in the world becomes more valuable, creating an asset bubble.

There's no way for the Fed to create money without creating debt. that's why everyone's complaining about borrowing money that their children will have to repay. There's no free lunch.

John

I don't see what is different between what I am writing/thinking and what you wrote here.
The Fed makes new money as it buys up debt. Check.
As it buys up bonds it helps make asset bubbles. Check.
The Fed does not hand out money it buys debt (though sometimes paying full price for toxic assets comes close to handing out money). Check.

How are we different?

[John]

How are we different?

You said, "This is very different than the "money creation" done by banks etc." No,
it's not.

John

[vincecate]

You said, "This is very different than the "money creation" done by banks etc." No, it's not.

1) If regular banks could make money the same way the Fed does, then how come they go bankrupt? You don't think the Fed can go bankrupt, right?

2) When we say "banks make money" it is because the definition of money counts demand deposit balances, even when the real money has moved on to be loaned out and used someplace else. So the money is counted twice. The Fed makes new money (not a counting twice or definition issue).

3) The Fed makes money when they buy anything (could work for bonds, stock, land, whatever). A regular bank makes money only when they loan out money that is also counted as in a demand deposit account.

4) The type of "money" a regular bank makes can result in a "liquidity crisis" when too many of the guys with "demand deposits" want their money at the same time. With part of the money loaned out it is actually impossible for them to pay off all their demand deposits on any random day (see "bank run"). The Fed's money making can never cause it to have a liquidity crisis. They could print money to pay every bank if all the banks wanted to take out their money. In fact, part of its job is to "provide liquidity" to banks that are solvent but have a "liquidity crisis".

5) The Fed can decide to issue $1.7 trillion or $600 billion or whatever amount of money (yes, political pressure provides some bounding). A private bank can not issue an arbitrary amount of money.

It is a very different kind of "money". The central bank has powers that regular banks do not have.

[Higgenbotham]

Some general thoughts.

What money is and can do depends on:
The form it is in
Who holds it
The economic and regulatory environment

Let's say a bank is holding a 10 year government note. Once Glass Steagall was repealed, I believe they could use that note as collateral at a certain percentage of market value to speculate. So a 10 year government note becomes something different in a different regulatory environment even though it's still a 10 year government note. There are other nuances too as various financial institutions can't or won't all do the same thing with an identical asset.

If the 10 year government note is then bought by the Fed, it becomes something different yet, as the Fed will either create bank reserves or cash depending. If it's bought from a bank, bank reserves are created and then once again we need to go to our above criteria of "who holds it" and "the economic and regulatory environment" in order to ascertain the effects. As much as I bash the academic economists and the guys at the Fed, they do understand these concepts pretty well in the moment. They understand that the banks are very constrained in what they can do with these reserves in this economic environment, but not so much in this regulatory environment. I believe a bank can temporarily get a higher degree of speculative leverage per dollar of reserves than they can per dollar of 10 year government notes. Previously, I had mentioned that the banks are able to push the prices of exchange traded goods and financial assets. Anyone can see this dichotomy by walking through the grocery store. The price of anything that is exchange traded or related tends to be high and unstable (cheese, for example, as milk is exchange traded - bet not many know that), whereas the price of anything that is not exchange traded or related has tended to fall for the past 3 years. This category would be locally produced items that do not require a lot of transport and/or premium items that are not bulk commodities.

The process of analyzing the movement and creation of forms of money is therefore not simply a matter of accounting. Even an identical form of money is not identical in effect depending on who holds it and the changing economic and regulatory environment. So when John Galbraith says the purchase of a note by the Fed in exchange for bank reserves is a duration swap, it is at the precise moment in time that the transaction takes place but beyond that, it depends. If a bank becomes more levered up in a speculative play because they did that transaction, then it has the potential to become more than a simple duration swap once time t=0 has passed. Nobody can know that. The Fed can track it and have a better idea of what is happening in the moment than perhaps any other entity, but they still have a pretty lousy track record in predicting the future.

[John]

Dear Vince,

So I guess now we're "different," after all.

> 1) If regular banks could make money the same way the Fed does,
> then how come they go bankrupt? You don't think the Fed can go
> bankrupt, right?

The Fed can't go bankrupt because it's not in debt. It's the
U.S. Treasury that will go bankrupt (default on its bonds).

By the way, investment banks and hedge funds don't always go bankrupt
either. During the bubble, they used a separate corportation - a
structured investment vehicle - that was supposed to protect
themselves from bankruptcy.

> It is a very different kind of "money". The central bank has
> powers that regular banks do not have.

Not it's not. It's the same thing, but it only differs in scale.
A single bank might be able to create only a few billion or tens
of billions of dollars in new money, but put together all the
investment banks and hedge funds in the world, and you come to
hundreds of trillions of dollars.

John

[Higgenbotham]

1) If regular banks could make money the same way the Fed does, then how come they go bankrupt? You don't think the Fed can go bankrupt, right?

The first thought that comes to my mind is that the Fed's liabilities are Federal Reserve Notes and bank reserves. Its assets at the moment are US Treasuries of various durations and Mortgage Backed Securities.

In the case of a regular bank, its deposits are liabilities and the loans outstanding are assets.

So the answer to that in my mind (nobody has ever asked) is that the Fed can technically go bankrupt if its assets are wiped out, but the process is entirely different.

Forgetting about the FDIC for now, when a bank goes bankrupt, the value of its liabilities exceed the value of its assets and the depositors get so many cents on the dollar. Either the first to the bank window get paid or the bank is shut and the depositors are partially paid off.

In the case of the Fed, there's no bank window to go to and anyone who has the authority to shut the Fed down and repeal the Federal Reserve Act before the US government defaults isn't likely to. The Fed would not technically go bankrupt until its assets are completely wiped out through government default.

For example, with the obviously deficient MBS they are holding, the MBS will be jettisoned from their balance sheet and the ultimate burden will go to the public through higher prices than would have otherwise occurred, but ultimately lower wages, lower profit margins and bankruptcies.