Murphy Triple Play
* I wrote this a while ago, but it slipped through the cracks. The people at Campaign for Liberty wanted me to rough up Greg Ip and his “myths” about QE, which I was only too happy to do. (Incidentally, I know some readers thought I had been unfair to Ip when I blogged about him here. Just be aware that I had already submitted the article before your gnashing of teeth.)
* Whenever the liberty movement starts gaining momentum, I find it wise to thin the herd by lopping off a subset of those who disagree with the inner core of Austro-libertarians. To that end, in this piece I outline what I consider the Chicago School’s Achilles Heel. Here’s the intro:
In a recent post “Triumph of the Austrian Economists,” David Frum laments the displacement of the respectable Chicago School as the economists of choice among the political Right. Frum fails to see that conservative Republicans are justified in switching their allegiance to the Austrian economists, because supply-side monetarists have a glaring blind spot when it comes to the Federal Reserve.
* After severing links with Chicago School monetarists, I next turn to the antiwar activists who are boycotting Amazon and I explain why I think they are mistaken too. (It’s hard work being this exclusive.) Two excerpts–one silly, the other serious:
A silly Star Wars analogy may help: The boycotters presumably liken Amazon to Lando Calrissian, who sold out his friend Han Solo in a deal with the Empire. But this isn’t at all accurate. Amazon didn’t deliver Assange over to the authorities; his jilted lovers did. Amazon’s “betrayal” merely meant that the WikiLeaks site was down for a few hours, and all Amazon did was end its business relationship with the pariah organization. It would be as if the Millennium Falcon needed to refuel, and the first planet they stopped at told them to keep moving because they were on Vader’s blacklist. Now if that had happened in the movie, and then after hitting the next depot (three hours away) the rebels circled back and starting firing on the first place for not selling them fuel, the audience would have been quite perplexed. That’s not what the good guys do. The good guys study the schematics of the Death Star; they don’t figure out which groups of non-combatants they should punish next for not joining the rebellion.
and
# If you want peace, then you should renounce threats, property destruction, and of course violence. Those are the techniques of the government.
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# The American empire of military occupation and surveillance ultimately rests on American public opinion. I am ashamed to say that I once was, what we would now call, a “neo-con” (though the term was not in usage at the time). But as I delved deeper into the works of Austrian economists and Old Right conservatives, I realized my intellectual confusion. It made no sense to oppose the welfare state and government meddling in the domestic economy, while supporting the trillions the U.S. government spent on foreign adventures. Since I personally was convinced of the poverty of militarism, I know that others can be likewise converted.
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# The truth is on our side. That is why WikiLeaks poses such a threat to the ruling class; they scurry like cockroaches from the light. Those who desire peace need not resort to hostility and aggression. They simply need to bravely speak the truth.# In the long run, the truth will out. Good will eventually triumph over evil.
Countering your last point, “In the long run, the truth will out. Good will eventually triumph over evil.” Remember what Dark Helmet (the ruling class) once said. “Evil will always triumph because good is dumb.”
With all due respect, count me as one of those that believe you, like most other commentators, do not understand QE. Like I said in a different post on this blog, it’s a horrible, disastrous policy, but for none of the reasons you and the others like Peter Schiff claim, in my opinion. With that said, I have a question that may help be better understand what I’m missing.
I think we both agree that QE adds reserves to the banking system. And those reserves pay 25 bps to banks. On the other side of a QE transaction (which nobody seems to pay attention to) the Fed buys a 10 yr. treasury, yielding, say 3%. That 3% asset is gone, removed from the banks balance sheet and no longer free to trade in the private sector, and replaced with reserves yield 25 bps (QE is an asset swap, nothing net new is created). A sizeable amount of interest income has been removed from the private sector, right? So my question is how come the deflationary impacts from the massive reduction in interest income is not consider in your inflation view? Income is clearly being removed from the private sector. Isn’t this highly deflationary?
Also, I (correctly) recognize that the banking system is never reserve constrained, and a bunch of excess reserves are meaningless since reserve requirements are never in consideration when a bank makes a loan and a bank can and will always hit its legal reserve requirement in the funds market. But I’ll run with your belief for a moment and believe reserves are actually required making loans. So, correct me if I’m wrong, but it is your belief that it’s probable that ultimately those excess reserves will find their way into the market, causing inflation, correct? So my question is, why does it matter if a bank swaps treasuries with the Fed for reserves before this run up in lending takes place? The bank could just as easily create those loans (or create reserves first, since you seem to believe reserves are required before lending) by repo’ing their treasury portfolio?
Sorry, this looks more like a double play to me 🙂
This is my uneducated understanding of this particular aspect of “The Mess”:
The government needs money to pay a drunken union donut eater so it borrows it from A, who earned the money doing valuable work in the market, and who gets a bond in return. Absent the government, A would have been compelled to lend to a real entrepreneur. The governnment gives the money to the donut eater who drinks it all up and now it’s gone. The government is broke, and has no real assets with which to pay off the bondholder and can’t tax B, the public, due to political reality. If the government taxed B to pay A, there is no inflation. Instead, the Fed creates money out of pixie dust and buys the bond. This new money dilutes the existing money supply.
I could be wrong but that’s my primitive understanding. It’s just another aspect of “where’s all the stuff gonna come from to pay off all of this debt”.
AP Lerner,
If you could elaborate on how Quantitative Easing is not quantitative, that would be helpful.
My understanding is similar to Bob’s.
AP, are you just saying that, since the banks already have excess reserves, adding more reserves to the banking system will not necessarily cause the banks to pyramid more loans on top of those reserves? You’re suggesting that, in a debt-deflationary environment, banks are not fully loaned up and therefore not constrained by the amount of reserves they’re holding? But even if that’s the case, and the additional reserves don’t cause a 10x expansion of the money supply like they would if the banks were already loaned up, doesn’t it still cause a 1x expansion of the money supply since, as Bob points out, that money really is spent by the government before entering the banking system as reserves?
“since the banks already have excess reserves, adding more reserves to the banking system will not necessarily cause the banks to pyramid more loans ”
Correct. Banks are never reserve constrained.
“in a debt-deflationary environment, banks are not fully loaned up and therefore not constrained by the amount of reserves they’re holding?”
Regardless of the environment, banks are never reserve constrained and reserve requirements can always be met in the funds markets since loans always create additional deposits. Reserves requirements play no role in determining the size of bank loan portfolios. A bank will never check its reserve position before making a loan. Reserve requirements regulate the composition of bank balance sheets, not the size. Capital dictates the size bank balance sheets. Banks will always make loans they deem profitable up to their capital requirements, not reserve requirements.
If the reserve requirement was 0, do you think banks would be ‘fully loaned up’ all the time? Would countries with a 0% reserve requirement be in a constant state of high inflation?
“doesn’t it still cause a 1x expansion of the money supply since,”
No
“that money really is spent by the government before entering the banking system as reserves?”
Correct. So all the Fed does is change the composition of bank balance sheets using open market operations (which is that QE is – a long duration open market operation). Nothing net new is created, but make of balance sheets does change. And via this portfolio rebalancing, asset bubbles are created.
Back to my question: is the lower interest income in the private from replacing long duration, higher yielding assets with short duration, low/no interest bearing assets deflationary?
Bonds are not money. They do not bid up the prices of goods and services. When the fed creates new money out of thin air to buy bonds they replace it with money that can be spent immediately and bid up prices. You will have more money chasing the same amount of goods and services.
Also if swapping bonds for cash has no net effect, can you explain why M2 has been rising so much over the past few months since the fed started QE lite and now QE2
Thank you for the reply.
“Nothing net new is created, but make of balance sheets does change.”
Aren’t new Treasury bonds issued as a result, though? Are you saying that QE has no impact on whether or not the Treasury issues new bonds?
Absent QE, would the Treasury issue the same amount of bonds, only they would be higher-yielding since the Fed would not be expanding the market for them? If so, why then doesn’t the lower yield resulting from QE encourage the government to issue a greater amount Treasury bonds?
I see your point that the exchange of bonds for reserves might be a wash and possibly deflationary, but then isn’t the issuing of the bond by the Treasury “creating something new”?
“When the fed creates new money out of thin air ”
The Fed does not create money out of thin air. They create reserves out of thin air that are paying 25 bps. In exchange for those reserves, they remove an equal amount of longer dated, higher yielding assets from the private sector. This is operational fact, right?
“can you explain why M2 has been rising so much over the past few months ”
~9% of GDP deficits. The Federal deficit has moved from ~$40B as of the end of September to currently $150B as of November month end.
“Are you saying that QE has no impact on whether or not the Treasury issues new bonds?”
Correct. All QE does is change the composition of bank balance sheets, reducing duration and interest income, and often leading to asset bubbles. The ole Greenspan playbook. Only instead of QE of bills (open market operations) we are getting QE of longer dated assets. It does not impact the federal governments decision to deficit spend. (as an aside, I posed a question to Dr. Murphy regarding how the government funds big spending initiatives like TARP before raising taxes or new debt which he has not responded too. Maybe you could offer up some thoughts? It’s in the comments of this post: http://consultingbyrpm.com/blog/2010/12/jeff-tucker-interviews-murphy-about-the-econ-textbook.html)
“Absent QE, would the Treasury issue the same amount of bonds”
Yes. QE is nothing more than a longer dated version of open market operations and does not ‘fund’ anything.
“only they would be higher-yielding since the Fed would not be expanding the market for them?”
Maybe. Depends on a number of other factors.
“but then isn’t the issuing of the bond by the Treasury “creating something new”?”
Yes, when deficit spending occurs. Net financial assets are created by deficit spending, not by QE.
“~9% of GDP deficits. The Federal deficit has moved from ~$40B as of the end of September to currently $150B as of November month end.”
This doesn’t make sense to me as an explanation of why M2 has been growing so much since QE lite and QE2 have been announced. Please explain.
“Back to my question: is the lower interest income in the private from replacing long duration, higher yielding assets with short duration, low/no interest bearing assets deflationary?”
No, the interest income doesn’t disappear when the Fed buys bonds from the private sector. They just hand over the interest to the Treasury at the end of the year and the government spends this money.
If the federal reserve doesn’t create anything new when they buy bonds, exactly where does the money come from to buy these bonds? I understand why there would be no net change if I bought a bond from a private individual. My bank account goes down and his goes up by equal amounts, but who’s checking account goes down when the fed buys the bonds?
“This doesn’t make sense to me as an explanation of why M2 has been growing so much since QE lite and QE2 have been announced. Please explain”
So when the federal government spends in excess of what it brings in in taxes, net new bills/notes are not created?
“They just hand over the interest to the Treasury at the end of the year and the government spends this money”
This is operationally incorrect, but just to play along, isn’t interest income lower in between the time period the Fed buys the bonds, waits for its year end, then the treasury gets authority to spend? Hasn’t income been removed from the private sector?
“If the federal reserve doesn’t create anything new when they buy bonds, exactly where does the money come from to buy these bonds?”
Nothing NET new. The Fed creates reserves (out of thin air, if that helps) but removes a longer duration, higher interest asset at the same time. The NET result is the bank that sold the treasury security to Fed has a balance sheet that is exactly the same size, but made up of different, shorter duration, lower yielding assets. This is pretty basic double entry accounting.
“My bank account goes down and his goes up by equal amounts, but who’s checking account goes down when the fed buys the bonds?”
Can you really compare/analyze the governments balance sheet the same way you compare/analyze a household or other private sector balance sheet? Aren’t there significant differences? I’m not sure this example is valid.
“So when the federal government spends in excess of what it brings in in taxes, net new bills/notes are not created?”
If you mean that the federal reserve prints notes to pay for this excess spending then yes I would agree. That is the whole point of QE. Otherwise where do the notes come from? Nobody else is allowed to run the printing press.
Also could you please explain why the massive deficits in the beginning of the year didn’t cause M2 to rise and could you point me to any chart that shows a correlation between M2 and deficits.
“This is operationally incorrect, but just to play along, isn’t interest income lower in between the time period the Fed buys the bonds, waits for its year end, then the treasury gets authority to spend? Hasn’t income been removed from the private sector?”
Why are banks selling these bonds to the treasury? If they get more money by waiting why not wait? Do they intend to now spend the money they thought they would save in bonds? Does this not cause more money chasing the same amount of goods?
“The NET result is the bank that sold the treasury security to Fed has a balance sheet that is exactly the same size, but made up of different, shorter duration, lower yielding assets. This is pretty basic double entry accounting.”
Yes, the balance sheet is now more liquid and they have more money to spend. They have more money to spend because the Fed created reserves for them for their bonds. If the banks now have more money on hand whether in reserves or cash, who has less so that their is not more money chasing the same amount of goods?
“Can you really compare/analyze the governments balance sheet the same way you compare/analyze a household or other private sector balance sheet? Aren’t there significant differences? I’m not sure this example is valid.”
If a bank sells a bond to the fed they now have more money on hand to spend today, correct? Who has less because of this today?
If QE is pushing M2 higher, then why did M2 collapse during 2009 while QE part 1 was taking place?
There is a big difference from QE1 and QE2. QE1 was primarily used to buy toxic assets from the biggest banks who then parked the money at the Fed gaining interest. QE lite and QE2 are being used to buy government debt from a variety of different sources and a large percentage of this doesn’t even have the option of being parked at the Fed. This round is filtering into the economy already and now the banks are even starting to loan there reserves.
“QE1 was primarily used to buy toxic assets from the biggest banks ”
This is factually incorrect. QE1 was 100% treasuries and agency MBS. Nothing toxic there
“This round is filtering into the economy already and now the banks are even starting to loan there reserves.”
Not only is this fatually inaccurate, it’s operationally inaccurae since banks do not need reserves before making loans.
http://www.calculatedriskblog.com/2009/12/consumer-credit-declines-for-9th.html
What are you talking about AP? Do you believe that Goldman Sachs and the rest were selling valuable MBS? The Fed started buying toxic MBS because TARP was never used for this. Remember TARP stood for Troubled Asset Relief Program but was never used to purchase these toxic assets?
Check out this article that gives some of the details on the Fed loans. http://www.economicpolicyjournal.com/2010/12/totally-busted-truth-about-goldmans.html
Also I didn’t bring operational procedures on how the banks make loans. Your second point is attacking a straw man. I said that this round of QE2 is filtering into the economy and that can be seen in the recent big growth in M2. Plus the banks are starting to increase loans as can be seen in the money supply data released this past Thursday. Get a subscription to Wenzels daily report on economicpolicyjournal.com if you want up to date figures on what is happening to money supply.
I suppose you weren’t able to show me where you came up with your deficits correlation to M2 growth? Also were you able to figure out an answer to any of the other questions you ignored?
“Whenever the liberty movement starts gaining momentum, I find it wise to thin the herd by lopping off a subset of those who disagree with the inner core of Austro-libertarians.”
I like this. Thinning the herd in the present makes the herd stronger in the future.
It’s science.
It seems like every new article you write links to/references more and more previous articles (which is good!). You are slowly building up a summary of Austrian Economics that will just be one Mises daily with 100 links.