Quantitative Easing

There is a common perception that money which is generated by quantitative easing flows into business or the stock market through some direct transmission mechanism. “The stock market must go higher with 1 trillion of funds flowing into it“ is an often repeated statement.

This transmission mechanism is rarely questioned and it doesn´t really exist in this form. So I want to ask some simple questions and try some answers.

Every economic institution follows the laws of double entry book keeping and this is even true for the Fed and any other central bank. When the Fed “creates“ money through a transaction (i.e. buying treasuries or lending out money in another way) it creates an obligation towards the public (at least in theory) and a claim on the government or other institutions (mostly banks). Likewise a bank will swap two items on its left side of its balance sheet when selling treasuries to the Fed, securities for cash.

So, what happens when a bank sells treasuries to the Fed?

  1. When a bank sells treasuries which it used to hold on its balance sheet it will receive cash which it may use for lending or other investments
  2. When a bank sells recently acquired treasuries (being a primary dealer in treasuries) it will also receive cash
  3. A bank may deposit its cash in interest bearing accounts with the Fed and can use those deposits as collateral for credits. Those credits will come in cash which can be lent out to customers or used for other investments

In case a) less liquid assets get converted to liquid assets and additional money becomes available for investments or lending. Case b) is equal to a) but it becomes more obvious that banks act as an intermediary for the government and money flows from the Fed to the government with a short time lag, enabling the banks to capture a margin like a dealer who is selling cars to the public for a margin of x%. Finally c) enables banks to enlarge their balance sheets by taking on more credit.

So, who stands to profit from these transactions? Obviously the participating banks capture a riskless profit from buying and selling treasuries. So this strengthens financial institutions´ balance sheets and may encourage them to increase lending to other economic institutions. But ultimately the main beneficiary is the government that gains a source of credit (the Fed) that finances a spending deficit that could not have been financed otherwise.

So, how does this money flow into the stock market? To some extent money may come from banks´ lending to investors who leverage their investments into the stock market. It may flow into the stock market through leveraged buyouts and similar transactions. These transmission effects may exist, but there is no evidence that the ca. 2trn US$ of base money created by the Fed have gone this way since 2009. The ultimate recipient of that money was the US government and that institution is an unlikely active investor in the stock market. Quite obviously the money was used to cover budget deficits of ca. 1trn US$ p.a. to a large extent.

With QE4 the Fed had also started buying mortgage-backed securities. The transmission mechanism is fairly comparable to treasuries, with the main difference being that money flows from the Fed to mortgage originating institutions (or other holders of mortgage backed securities) and hopefully to the mortgage taking public. In this role the Fed acts like Fannie and Freddie Mac, with the additional benefit of clearing up mortgage assets that used to sit on financial institutions´ balance sheets.

The stock market is not a direct beneficiary and most likely not the biggest indirect beneficiary either in both transactions – treasuries and mortgage backed securities. In the case of treasuries, the government is the recipient of funds and it is more a case of damage averted than benefit generated. Given the huge deficits that were created in the aftermath of 2008, there would have been not enough financing without the intervention of the Fed. Needless to say that through low interest rates created by this policy (10-year yields having decreased from 5% to 2%), the government´s burden was greatly reduced and financing through the Fed has come for free since all interest earned was returned to the government. In the case of mortgage-backed securities, money may flow into the housing market, but that remains to be seen.

These explanations aim to demonstrate that Friedman´s helicopter example does not apply to quantitative easing. The money generated by the Fed does not rain down on the public as a gift. It is rather an additional obligation for banks (and their customers) or the government absent other creditors. That money has to be returned unless the Fed is willing to scratch out the US government´s debts, which it could do in theory but which would destroy the entire concept of fiat money and create the first institution in the world which gives up double entry book keeping.

The stock market has certainly benefited from the Fed´s policy through lower interest rates. Future cash-flows are rightfully discounted at lower rates, yielding higher values at present. Likewise investments by real companies can be conducted at lower financing costs. But these are different arguments from the helicopter argument because obviously those advantages vanish quickly when discount rates are raised, either directly through a reduction of the monetary base or by increased inflation expectations (or nominal interest rates).

To a large extent the stock market´s surge was based on psychology. Since everybody hears and is lead to believe that “free money“ is “sloshing around“ and “trillions“ are flowing into the stock market, investors are following the money´s presumed way. As in any bubble it is rational to follow that strategy as long as everybody follows it. However, nobody understands the ramifications and future effects of this unprecedented increase in the monetary base (except for some historians). Given the uncertainty of end results it seems unwise to rely on a transmission mechanism that is based on temporarily rational assumptions about mass psychology.

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