14 May 2015

How the Bankers Arranged for a Stream of Billions in Subsidies

Federal Reserve 65 Comments

I have not seen too many people comment on this; here’s one guy mentioning it last August. The punchline is that amongst other favors, private bankers have managed to use the financial crisis such that they now receive a stream of billions of dollars in income from the Federal Reserve. Moreover, this amount could rise substantially over the coming years.

The banks now receive “interest on reserves” from the Fed, a policy that was instituted back in October 2008. This means that when a bank keeps its reserves parked with the Fed, then it will be paid interest on them; this didn’t happen before October 2008. There are various ways to describe this policy, but one accurate way is to say at this point the Fed began paying banks to not make loans to their customers. The rate is currently a measly 25 basis points (0.25%), but it is expected to increase in the near future.

Specifically, the Fed has said that if and when it begins raising interest rates (probably later this year), it will not follow the textbook approach of selling off assets from its balance sheet, and thereby draining reserves from the system. On the contrary, the Fed will raise interest rates by increasing the amount the Fed itself pays to bankers, to keep their money parked at the Fed. For example, if the Fed wants the short-term rate (what’s called the “federal funds rate”) to rise to 1 percent, then the Fed will increase the amount it pays to banks for their reserves (perhaps to a bit less than 1 percent). If the banks can earn a guaranteed 1 percent from the Fed, then they would never lend their reserves to anybody else–even each other–for less than that.

One implication of this plan is that the Fed will be on the hook for funneling huge amounts directly to the banks. These wouldn’t be loans, these would be interest payments–direct income for the banks. Right now excess reserves are about $2.4 trillion. Assuming this is the ballpark for the next year or two, and that the Fed eventually raises its target rate to 3 percent, that would involve annual interest payments of $2.4 trillion x 3% = $72 billion.

Notice that this is effectively coming right from the taxpayers, in the sense that the Fed has been remitting its excess earnings to the Treasury, making the federal budget deficit lower than it otherwise would be. So, other things equal, if the Fed pays bankers $72 billion annually to not make loans to their customers, then that is effectively coming from the taxpayers.

I daresay before the crisis, if any banker had proposed such a scheme, that it would not have met with the public’s approval.

65 Responses to “How the Bankers Arranged for a Stream of Billions in Subsidies”

  1. Kevin Erdmann says:

    I’m not sure this is all its cracked up to be. If the Fed hypothetically reduced its assets by selling $2.4 trillion in treasury bills to the banks, which they retained on their books, there would be little difference, quantitatively.

    • Matthew Swaringen says:

      Little difference as a percentage, buy 72 billion a year is quite a bit of money to give banks for doing nothing and risking nothing.

    • E. Harding says:

      Maybe in the future, but certainly not now, as the T-bill rate has long been under .25%.

    • E. Harding says:

      Also, treasuries sold by the Fed aren’t all sold to banks.

  2. E. Harding says:

    Indeed, as a Brazillian commentator on John Cochrane’s blog pointed out, IoR is pretty much “wiping ice”-both inflationary and helping lead to higher nominal interest rates at the same time. So, if we define “tight money” the way Scott Sumner does, higher IoR may result in looser money!
    Real tighter money would simply be done by unwinding QE.

  3. baconbacon says:

    I don’t think this criticism is particularly compelling. Interest is only paid on reserves, which are highly liquid. If the Fed raises rates the majority of the money should end up in depositors’ pockets as banks jockey for funds.

    • Bob Murphy says:

      I don’t follow you, baconbacon. If an individual bank lends out reserves, it doesn’t earn interest from the Fed. Also, many people are saying they are going to just pay the higher interest rate on *excess* reserves.

      • Kevin Erdmann says:

        Bob, the interest flows to depositors. The net effect on banks’ return on invested capital should be negligible.

        Your interpretation of this requires that the banks can pay depositors interest that produces profit above competitive rates of return on their capital base. If they can’t do that, then they won’t make any significant profits from the excess reserves. If they are able to do that, they don’t need excess reserves to do it.

        • Bob Murphy says:

          Kevin, the owners of those reserves are the commercial banks. They are the ones directly receiving the interest payments from the Fed.

          The whole point of this is that the Fed does *not* want the commercial banks to grant loans to their customers with those (excess) reserves.

          If you are making a competition argument, and saying that banks will compete for the reserves by offering higher interest rates on their checking accounts (to induce customers to switch their deposits from one bank to another), OK that’s an angle I hadn’t considered and I need to think that through. But your comment makes it sound like you think the Fed is directly paying the interest to the public, which is not true.

          • Transformer says:


            is it really correct to say?

            “Kevin, the owners of those reserves are the commercial banks.”

            While they are held by banks and it is the banks that get the IOR, the reserves really mostly represent deposits owned by non-banks and that the banks may themselves have to pay interest on to keep. (This is implied by the latter part of your comment)

            Do you agree ?

            • Bob Murphy says:


              I think my statement is correct (unless his name isn’t really Kevin).

              Let’s say you put a green $100 bill into your local bank. Your checking account balance goes up by $100. Legally speaking, you just made a loan to the bank. You are a creditor of the bank. They owe you $100 (more), but the $100 is now their property. Then suppose they use clearinghouse operations to effectively send that $100 bill to the Fed itself. Now the commercial bank’s reserve account with the Fed goes up by $100, and they are paid interest on it.

              • Transformer says:

                I see 2 issues with this post:

                1. As long as banks have the option of buying bonds that pay interest at least as high as IOR, IOR is not really much of a net benefit to them. Therefore whether the CB increases IOR or just sells bonds. and causes the interest rate on bonds to rise, is a wash.

                2, As IOR increases, competitive pressure will cause the interest rate that banks have to pay to keep reserves to increase and this will cap the profits they earn from them.

              • Transformer says:

                And a third one is that the reason increased IOR would be needed is that other lending opportunities are appearing that will give the banks other options for their reserves.

    • Bob Murphy says:

      OK in light of Kevin’s comment I now understand what you are saying baconbacon. That’s an angle I hadn’t considered before, you’re right it might mean the banks end up sharing some of the interest payments by raising the rates they pay to depositors.

      • Joseph Fetz says:


        If you remember, there used be what was called Regulation Q, which made interest on demand accounts illegal. However, the Dodd-Frank Act effectively repealed that. I don’t think that this was coincidental.

        Think about it this way. The Fed has a ton of junk on its balance sheet, so it really can’t use the regular approach to raise interest rates. Also, part of the problem in the past is that when raising interest rates, this tends to be deflationary. And, of course, it is typically when the Fed raises rates after a long period of low rates that brings in another crash.

        Now, however, they have a way of raising rates that is both inflationary and lose. I’m guessing that their hope is that due to this that it won’t bring a crash along with it.

  4. guest says:

    “There are various ways to describe this policy …”

    I remember hearing someone a while back (don’t remember who) refer to it as a “pre-emptive bailout” ahead of the next crash.

  5. guest says:

    “One implication of this plan is that the Fed will be on the hook for funneling huge amounts directly to the banks.”

    Wouldn’t it be funny if people just stepped out of the way by refusing to use all fiat money, then watching the Fed and the crony banks trip and fall?

  6. Geoff says:

    I am glad that someone is pointing out that this whole story of the Fed raising rates is little more than another bank bailout. I used this piece as a basis for an article on why there won’t be bank bail-ins in the U.S.

    • guest says:

      “You have your money indirectly confiscated on an almost continual basis because it loses its purchasing power because of the Fed’s monetary inflation.”


      “The first time the Fed bailed out the banks in 2008, it received a lot of criticism from the American people. Since that time, it has used two other methods to bail out the banks – buying mortgage-backed securities through quantitative easing and paying interest on bank reserves. These two other methods have yielded little criticism from the American public.

      “If the Fed can bail out the banks quietly with little criticism, why would we see a bank bail-in that could start something of a revolution? The answer is, we won’t. The Fed will keep quietly bailing out the banks and the American people will unknowingly accept it.”

      That sounds quite plausible.

    • guest says:

      “What hasn’t made sense to me is the Federal Reserve’s policy of paying interest on both required and excess reserves.
      Why would the Fed simultaneously start the counterproductive policies of quantitative easing (QE) and interest on reserves (IOR)? Why would the Fed pursue the deflationary policy of IOR throughout the crisis when labor markets were weak and inflation was usually below their target? What if they could have achieved their policy goals as well or better by sticking to more traditional policies and not been stuck with such a large balance sheet and potential exit problem?”

      The Fed, pursuant to all central banks’ policy of inflating the money supply (the whole point of a central bank), had to acquire such a large balance sheet in order to continue tricking people into thinking that the USD makes a good currency.

      People would have just let their Treasury Bonds mature and cashed out. The Fed bought them with printed money to make it seem like they were still good investments (but instead further destroyed the value of the dollar for later users of dollars).

      The government wanted people to continue thinking that the Fed-induced speculative housing prices were sustainable, so it had the Fed buy securities.

      Interest on reserves:

      Who Benefits From the Fed?

      “One way to think of this payment is as a sort of bailout. Since the payments on reserves are paid out from the Fed’s operating revenues, it reduces its end of year profits by the same amount. Since these profits would normally be remitted to the Treasury, the policy of paying interest on reserves has been, in effect, a fiscal policy involving a transfer from the Treasury to the banking sector.”

      Reducing the Fed’s balance sheet (it can’t; it’s stuck):

      Peter Schiff And The Coming Housing Collapse: The Fed, Instead Of Lehman, Owns The Mortgage Market

      “This is irrational exuberance, according to Schiff, as the market is fully subsidized by the Fed. “The U.S. government is guaranteeing all mortgages, and then buying them up,” explained Schiff, “it’s an artificial market, but the Fed, rather than Lehman Brothers, owns it.” …”

      “The day of reckoning will come when the Fed starts to tighten, according to Schiff. …”

      “That is when “public selling will overwhelm the Fed,” Schiff says as “the big buyers are only there because the Fed is.” …”

      “With bond prices falling and rates surging, banks will be left with depreciating assets (Treasuries) and stuck with low yielding long-term loans. As the “rug is pulled from under the banks,” the housing market will collapse as well, Schiff believes. The housing market will also breakdown.”

      Ask an Austrian Economist

      Peter Schiff:

      “Rising interest rates will collapse the capital value (i.e., the market price) of assets banks hold. If they have existing T-bonds at 3% and interest rates on newly issued T-bonds rise to 6%, the price that investors will be willing to pay for the 3% bonds collapses. When that happens, banks become insolvent.”

  7. Anonymous says:

    One implication of this plan is that the Fed will be on the hook for funneling huge amounts directly to the banks. These wouldn’t be loans, these would be interest payments–direct income for the bank.

    Wait, where did those “reserves” come from in the first place? The Fed handed them to the banks right? Then the banks hand them back to the Fed again… and collect “interest” on their hard earned savings?!?

    Is my jigsaw short a few pieces? The picture seems to be missing a bit.

  8. Neil says:

    Can anyone explain how the Fed will obtain the money to pay this interest to the banks if they are not going to be selling off assets from their balance sheet? Will it be created/printed? Thanks.

  9. DMS says:

    I don’t see it as a bank bailout, but I also don’t see QE as any kind of new monetary policy either. Please excuse the length of the post, but the implication is to stop any worrying about QE at all, so it is worth going through the detail, if correct that is. Bear with me and consider the following:

    Step 1: Assume only the real economy and the Treasury, no Fed just yet. (This is not a bizarre, unrealistic assumption – it just makes the narrative clearer by not having to trigger any Fed preconceptions).

    Step 2: The Treasury issues notes to fund government spending, which are purchased in the real economy (causing whatever distortions your particular brand of economic theory predicts, but not relevant to our question here).

    Step 3: The Treasury decides it wants to swap the previous notes, which were non-redeemable and fixed-rate, for newly issued notes that are redeemable and floating-rate. The floating rate is changeable by the issuer, i.e. the Treasury, starting at 25 bps. The new notes are exactly equivalent to interest-paying “excess reserves”. The Treasury gives this process the name “Quantitative Easing”.

    Step 4: Instead of retiring the previously issued notes (which the Treasury now owns itself), the Treasury sets up a quasi-independent entity called the Fed. It capitalizes the Fed with assets (the fixed-rate notes previously issued by the Treasury) and with liabilities (the newly issued floating-rate notes which are now the responsibility of the Fed). The Treasury makes interest and principal payments to the Fed on the old notes, and the Fed funds the interest on the new notes from these flows (in fact earning a tidy spread in the current environment). Note that the Fed is entirely solvent, though it has portfolio risk from its unmatched interest and principal flows, i.e. the inherent risk of an interest-rate swap, along with redeemability.

    Step 5: The Treasury endows the Fed with a printing press, and the right to print legal tender with it (i.e. dollars). This removes the swap risk effectively, introducing the potential for future distortions if the press is in fact used. Note that the press has NOT been used yet. Lastly, The Treasury also gives the Fed all the powers and duties it actually has today in reality.

    Step 6: The Fed keeps swapping redeemable, floating-rate notes for previously issued (or newly issued by the Treasury) non-redeemable, fixed-rate notes, to the tune of $75 billion per month.

    So, we’ve arrived at today’s situation exactly, which seems to me a whole lot of nothing. The Fed is simply a mechanism for the Treasury to execute a massive restructuring of its liabilities, from longer-term (non redeemable) and fixed-rate to short-term (immediately redeemable) and floating-rate.

    If I have this correctly characterized, then I do not see how QE represents any monetary policy at all (either loosening or tightening) since the printing press has been and remains idle. Importantly, I also do not see the process as introducing some new risk for future inflation or other calamity from the swap, in the sense that the risk was present before – if the banking market wants to move out of these new notes and the Fed starts using the printing press, this would be no different than if banks wanted to move out of the old notes and the Fed accommodated that with the printing press. In theory there is a new “run on the Fed” risk since the notes are immediately redeemable, i.e. previously the Fed could have chosen not to buy the old notes, but now the Fed must effectively do so owing to redeemability. But this seems a very odd and unlikely scenario and not the source of the hullabaloo over QE. Lastly, it doesn’t represent any kind of bank bailout that I can see per Bob’s original post – banks have simply reconfigured their assets.

    I have spun on this endlessly and cannot figure out I’ve missed. Can someone please explain why we should care about QE at all?

    • guest says:

      Not sure if this helps, but you said:

      “Please excuse the length of the post, but the implication is to stop any worrying about QE at all …”

      “Step 2: … (causing whatever distortions your particular brand of economic theory predicts, but not relevant to our question here).”

      The reason that QE is a concern for Austrians is because of the distortions it causes, so they are relevant to the question.

      Are they just not supposed to be relevant up to a certain number of steps, in your argument?

      In Step 5, you say that the printing press hasn’t been used yet. Did you mean just the one that the Treasury gives the Fed?

      Because the equivalent of the printing press was used in Step 2. So, the economy has already been distorted by that point.

      • DMS says:

        Thanks much. You may be finding the spot where my confusion (or insight) resides:

        There are distortions associated with government spending, and also with how that spending is funded, but those are not relevant to QE per se.

        In theory there are “distortions” from a swap of one kind of obligation for another (Treasury Bonds for Interest-Paying Reserves – “IPR”), but they are not obvious and don’t seem to apply here.

        My central point is that what looks like money creation (use of the printing press in step #2 that you suggested) is NOT money creation when the result is an equivalent, off-setting balance of IPR. That is true even though the literal process of money creation – use of the printing press or its electronic journal entry equivalent – actually did take place as you note. But what is missed is an additional transaction, the immediate “purchase” by a bank of a newly issued note to replace the old sold note, and that “purchase” is an IPR balance. So money is injected per the Fed’s bond purchase, and then immediately drained per the Fed’s IPR “sale”. This is quite consistent with basic monetary theory, and all I’m saying is that this is equivalent to no money creation in the first place and no effective use of the printing press as an end result. Of course this assumes bond purchases exactly equal IPR balances, which they very nearly do.

        I am all aboard the non-distortion train, but I don’t see the end result of QE having any material distortions, given my swap argument. So I still don’t see why anyone, Austrian or otherwise, should care about QE.

        And lastly, to be more provocative to Bob, given the Fed is currently making money from its swap program (i.e. QE), those represent foregone profits from the banking sector – they are the inverse of the swap trade that the Fed is profitably pursuing. So not only is it not a bailout from the Fed to the banks, it is a subsidy from the banks to the Fed! (That isn’t strictly true of course, but it is as true as calling it a bailout)

        Thanks for responding, but I still don’t get what people are saying about QE, Bob or anyone else, and continue to wonder what I am missing.

        • guest says:

          Can I have some more clarification, so I can better understand the scenario?

          In Step 3 you say:

          “The Treasury decides it wants to swap the previous notes, which were non-redeemable and fixed-rate, for newly issued notes that are redeemable and floating-rate. The floating rate is changeable by the issuer, i.e. the Treasury, starting at 25 bps.”

          What are you imagining is the difference between fixed rate notes and floating rate notes which can be changed (fixed?) by the issuer?

          And are you saying that the first notes are non-redeemable because they don’t represent anything?

          Also, are you saying that the second notes are redeemable, but only for the unredeemable first notes? Or are you saying that the second notes are redeemable for some item with use-value?

          • DMS says:

            I am walking through an equivalent set of transactions that gets you to the exact same state of play that we are in today, and that shows no money has been created at the end of the day, i.e. QE is not a monetary stimulus, assuming that Excess Reserves held at the Fed equal bond purchases by the Fed, which they very nearly do.

            Let me try to clarify. QE essentially has two components: purchase of longer duration Treasury Bonds by the Fed, and the paying of interest on Excess Reserves held at the Fed. I am saying that in my Step 3 it is AS IF there was the issuance by the Fed of a new kind of redeemable IOU (redeemable by the holder at any time) – call it an “IOR Note” which is simply the balance of Excess Reserves held by a member bank. In other words, Excess Reserves with Interest are equivalent to an immediately redeemable note of the same value, with a floating interest rate set by the issuer (i.e. the Fed) . Furthermore, it is AS IF the bank simply swapped its previous holding of Treasury Bonds for these new IOR Notes. Consequently, no money has entered the economy, only the types of securities held by banks has rebalanced.

            What literally happens is the following: the Fed buys an existing bond from Goldman in the open market by “printing” new money (i.e. paying for the bond through an electronic journal entry crediting Goldman’s account). Then if that money never leaves the account at the Fed, but instead sits earning interest as Excess Reserves, nothing has changed in the monetary system, other than the makeup of Goldman’s portfolio of government securities (again, considering its Excess Reserve balance as a security, an “IOR Note”).

            So I was simply highlighting that QE is a security-swapping program, not an injection of monetary stimulus. By the way, this explains the lack of inflation, as well as any particular economic stimulus from monetary theory.

            I have not heard it described this way, but I believe that QE3 is simply Operation Twist redux. In both cases the Fed buys long duration Treasury Bonds, but instead of selling short-duration Treasury Bills off of the Fed’s existing balance sheet (of which there is a constrained supply), it “sells” zero-duration “IOR Notes” (of which there is nearly a limitless supply). And of course this is definitely a market distortion of interest rates associated with the twist of the yield curve, and there should be an Austrian view of those effects, but I’m trying to make sure I’ve got the QE mechanics straight before going down that rabbit hole.

            • Tel says:

              Hypothetically speaking: let’s suppose I wrote a 100 year bond and offered that for sale to the Fed, they could buy my bond and put USD in my hand and that would be totally neutral by the same argument, right?

              No money created at all, and if I would run out of spending power at some point I still sell a few more 100 year bonds to the Fed and I’m liquid again. Totally neutral, let’s get started. Any time you ready.

              • DMS says:

                Well, no, that would be standard monetary easing by the Fed. Not sure what you mean by “I wrote a 100 year bond”, but you either have a genuine marketable security (meaning it has real cash flow obligations behind it) or you don’t. If the former, then the Fed is just performing standard easing by printing money to buy your bond. If the latter, then yes, by definition having an ability to create assets from the ether would have odd consequences, but it would still be easing if the Fed was willing to buy it irrespective of its cash flow characteristics. Buy in either case, if you leave the newly printed cash on deposit at the Fed, it is in fact neutral, with no effective money created.

              • Tel says:

                The US federal govt has run up a debt larger than 100% of GDP and they actually spent that money (i.e. exchanged bond notes for cash, then circulated the cash in various government programs).

                There might be a few regular citizens who still believe that these government debts will eventually be paid, but I would suggest not many, because recent bond purchases have primarily been driven (slightly indirectly) by Fed printed cash. Suffice to say that it seems obvious that if the Fed had never purchased those government bonds, and the government was depending on a genuine open market price for those same bonds, they would have found interest rates would have been higher (lots higher) and government spending programs would have faced serious cuts.

                So yes, they really are creating something out of nothing, and there are plenty of signs of inflation out there as well. We also have some counterbalance from debt deflation as still mortgage holders go into nonpayment (not as badly as earlier years) and the student loan / vehicle loan defaults are just getting started… these offset the inflation to some extent.

            • guest says:

              “Fed buys an existing bond from Goldman in the open market by “printing” new money (i.e. paying for the bond through an electronic journal entry crediting Goldman’s account). Then if that money never leaves the account at the Fed …”

              It’s credited to Goldman’s banking account, right? So it’s in the banking system?

              If so, then Goldman’s going to treat that as money.

              • DMS says:

                Thanks, you’ve really helped me get my head straight. I think this is the real story of QE:

                – Yes, there is newly printed money, sitting “in the system”, as Excess Reserves
                – This is regarded as an easy money policy, with attendant fears of inflation
                – There is also a fear of great financial strain when the Fed ends QE and there is unwinding
                – It also feels like the banks are getting a payoff/subsidy from getting interest on their cash balances


                – With IOR, the system behaves instead as if there were simply a swap of securities within banking portfolios
                – With IOR, the newly printed cash is not mobile, and there is no effective monetary easing and no inflation
                – There is no Keynesian or Monetarist stimulus, nor is there any Austrian credit expansion (see twist below however)
                – To the extent needed, unwinding should be unremarkable, as it won’t be a draining of liquidity per typical fears, but rather a different security swap in the future
                – Lastly, it is wrong to interpret IOR as a payoff or bailout to the banks. Instead, they are simply earning a different return from a different security within their portfolios

                To summarize:

                1. As a thought experiment, if the Treasury had originally financed its operations by issuing something like the “IOR Note” as I’ve labeled it, instead of with longer duration bonds, then we’d be in exactly the situation we are in, without any of the issues typically discussed (inflation, unwinding risks, stimulus/distortions, banking bailouts, etc.). In this thought experiment, the Fed has taken no action and no money was created
                2. However, since the thought experiment is not how the process actually unfolded, the Fed’s actions are indeed an intervention. And though only acting as a New Operation Twist, and not as an expansionary monetary stimulus, such a twist is a distortion of the free market in loanable funds. I don’t know what the Austrian perspective is on the Fed’s execution of a yield curve twist. I have researched it a bit to no avail, but I’m now convinced all the other forecasted effects of QE are not relevant, and this distortionary twisting is the issue at hand.

              • guest says:

                Maybe this will help:

                From the Austrian perspective, Treasury Bonds is a debt that the government imposes on citizens without their explicit consent. So future purchasing power has been artificially created out of thin air.

                When the Fed buys the bonds from someone, that is the moment that the USD supply increases:

                The Fed as Giant Counterfeiter [by Robert P. Murphy]

                “Modern Counterfeiting, Fed Style …

                “At this point let’s review exactly what happens when the Federal Reserve buys Treasuries from private dealers. Let’s say the Fed wants to buy $1 million worth of T-bills from Joe Smith. So it writes Joe a check for $1 million, drawn on the Fed itself. Joe hands the T-bills over to the Fed, where they end up on the asset side of its balance sheet. Joe then deposits the check in his personal checking account, which goes up by $1 million.

                “So at this point the Fed has increased the money supply by $1 million.”

              • DMS says:

                I think Bob’s article is consistent with what I’m saying, but it misses the neutralizing effect of IOR. QE has the effect he references in the first half of the article, i.e. it pushes down long-term rates unnaturally. But it isn’t doing so by money creation as he suggests in the second half. The Fed CAN run the printing press as he suggests, but with IOR it isn’t really doing so. Here’s a grand simplification using my “IOR Note” concept – think of it as if the Fed issues IOR notes into the open market in return for cash, and then turns around and uses that cash to buy bonds directly from the Treasury. That is equivalent to where the system sits today, and no printing press has been engaged, or needs to be engaged.

              • guest says:

                “think of it as if the Fed issues IOR notes into the open market in return for cash …”

                “… no printing press has been engaged, or needs to be engaged.”

                In your thought experiment, IOR notes equals the first set of notes plus 25 basis points, right?

                If so, then the 25 basis points is the equivalent of printing 0.25% more of the first set of notes.

              • Tel says:

                the Fed issues IOR notes into the open market in return for cash, and then turns around and uses that cash to buy bonds directly from the Treasury.

                So look at the trajectory of cash in your scenario:

                * cash moves from commercial bank over to Fed (in return for IOR note)

                * cash moves from Fed over to government (in return for Bond) via intermediate temporary bondholders.

                * cash is spend by government and disburses into the general population.

                So basically you are saying that the commercial banks are ultimately stumping up the cash to keep government spending going. Surprising to think any of those banks have such large amounts of liquidity available to be able to do that, especially after 2008.

                That is equivalent to where the system sits today, and no printing press has been engaged, or needs to be engaged.


                Strange that the M1 money keeps going up then. If the cash really flows as you outline above, why does M1 go up? Where is the extra M1 sitting right now?

              • DMS says:

                Government spending is funded by whoever purchases government debt. In my interpretation of QE, that doesn’t change – all that is happening is the conversion of long-term government debt into zero-term government debt, but the amount (and presumably even the sources) are the same.

                An asset swap from long-term debt to zero-term debt would increase M1 dollar for dollar, as M1 only includes the latter in its definition.

              • guest says:

                “The Fed CAN run the printing press as he suggests, but with IOR it isn’t really doing so.”

                The interest paid comes from the revenues from debt that has been “bought” with printed money.

              • Tel says:

                Government spending is funded by whoever purchases government debt.

                Whoever could it be? I can’t imagine, wherever will I look? Oh wait! What about this guy?


                There you go, the Fed owns as many treasury bonds as China and Japan put together, and the Fed is the only major entity that has been significantly increasing it’s holding of US treasury bonds. From the low point in 2009 up to today the Fed has increased it’s treasuries by five times over.

                Egats! Mystery solved, the Fed is funding government spending. It all fits together now.

                all that is happening is the conversion of long-term government debt into zero-term government debt

                The US government prints US treasury bonds, surely you accept that much. I mean who else could be printing them? So we know the total amount of bonds on issue is increasing because total US federal debt is increasing. Nothing in the least be controversial so far I hope.

                We also know total M1 is increasing and total Fed holdings of treasury bonds is increasing… all relevant totals are increasing. Yet somehow this is supposed to be “neutral” ?

                But here’s a different way to think about it. Suppose every time the US treasury prints a new treasury bond, they also wave a wand over said treasury bond and it turns into cash immediately. Would that be printing money? Effectively, that’s exactly what happens. The US treasury prints a bond, and the Fed turns that into cash for them.

                So back to the original question, what if I print a bond and the Fed turns my bond into cash for me, what that be money printing when I do exactly the same thing government is doing?

                After all, I’m merely converting my long term debt (the 100 year bond) into short term debt (cash). What could possibly go wrong here?

              • DMS says:

                Well, I’ve firmly convinced myself over my own internal objections that QE is much ado about nothing, so let me take another stab at explaining why.

                It doesn’t matter whether you issue the bond or the government does – there is still no new money created when it is sold using the processes of QE. That is because a similar obligation is swapped for it, and even though you get cash, cash was drained out of someone else’s portfolio to buy the newly issued zero-duration note.

                In your example, the Fed waves a magic wand over your long-term bond and magically converts it into a zero-duration note. That’s all that QE is doing – no new money. In reality it is two steps – the Fed first waves a magic wand over someone else’s pile of cash and turns it into a zero-duration note, and transfers the lost cash through its magic wand to your pile of bonds.

                There are many, many reasons to worry about dangerous Fed interventions – I’m just saying QE as currently constructed, or as forecasted to continue, is not one of them.

                This is with the caveat that I’m still wondering about the Austrian interpretation of the twisting yield curve, but I think I’m nearing a solution.

              • guest says:

                “… there is still no new money created when it is sold using the processes of QE. That is because a similar obligation is swapped for it, and even though you get cash, cash was drained out of someone else’s portfolio …”

                Ok, that’s what I needed. It’s a common misconception.

                When the Fed “buys” Treasury Bonds from Joe Sixpack, it isn’t drawing from its reserves to do so. It is creating money out of thin air.

                No obligation is swapped for the Treasury Bond by the Fed.

            • DMS says:

              Again, the Fed CAN create money out of thin air to buy Joe Sixpack’s bond, but with QE it is NOT doing so. It is effectively issuing zero-duration notes (in the form of Excess Reserve Balances at the Fed, what I call an “IOR Note”) which a different Joe Sixpack is buying with already existing cash balances. This is the misconception of QE – that the money supply is increasing. It manifestly is not, though various definitions of money might change (for example M1).

              Of course, both Joe Sixpack’s are doing this ultimately through primary broker-dealers, but it’s okay to think of an individual borrower/lender in the economy as making the security swap and exchanging the cash.

              • guest says:

                I don’t see how you’re thinking of the interest that’s paid on reserves as cancelling out the money creation that happens when the Fed buys Treasuries from Joe Sixpack.

                The only sense in which the interest on reserves are being bought is that the banks trade money now to the Fed and get more money from the Fed later.

                The Fed is paying interest from existing money, but that existing money came from selling assets that were bought with printed money.

              • guest says:

                “Of course, both Joe Sixpack’s are doing this ultimately through primary broker-dealers …”


                Replace Joe Sixpack with primary broker-dealers.

              • DMS says:

                Maybe I should stop being so pedantic and instead ask it as a question. How is there any newly created money flowing in the economy?

                If there have been $2.8T of bond purchases and consequently that much cash flowing out, but a corresponding inflow of deposits at the Fed of $2.8T (with an attendant IOU from the Fed, what I call an IOR Note), then all that has occurred is a swapping of obligations, no new money creation.

                The exchange of money now by the banks for money later from the Fed is ultimately paid for by the proceeds the Fed receives from its government bond holdings, which were pre-existing in the economy. So when the banks get their money back from the Fed, it isn’t newly created money from Fed printing, but money that would have flowed in the economy absent the existence of the Fed, i.e. the payoff of government bonds by the Treasury.

                And we don’t need to fear future inflation from the swap. Suppose the Fed has pre-printed $10T and stuck it in the vault. It initiates QE and buys bonds by dipping into its vault cash. Then, that cash comes right back around as a deposit at the Fed (again in exchange for an IOU – a piece of paper), and that cash replaces the cash taken from the vault dollar-for-dollar. Nothing has changed monetarily and the Fed has the same power to release cash from its vault as it did previously before QE – yes, something to worry about generally, but not as a specific consequence of QE.

              • guest says:

                ” It initiates QE and buys bonds by dipping into its vault cash. Then, that cash comes right back around as a deposit at the Fed (again in exchange for an IOU – a piece of paper), and that cash replaces the cash taken from the vault dollar-for-dollar.”

                I think I understand how you’re thinking about it, now.

                Not all of the money that was printed to buy Treasuries ends up as deposits in the banks.

                Remember, Goldman is treating the printed money as actual money, no matter how much it chooses to deposit in the bank. They consider it to be liquidity, and their business decisions are based on that.

                Even if they chose to keep all of their money in the banks, and the banks in turn kept their reserves at the Fed, the price that Goldman is willing to charge for its services has been affected because it believes it has X amount of increased purchasing power.

                The amount of stuff in the economy hasn’t been directly effected, and so the marginal utility of that stuff to consumers hasn’t directly changed.

                So, some attempts by capitalists to engage in economic activity will not be justified by consumer preferences, and will therefore have to result in some kind of crash/”supply shock”.

                Those are the malinvestments/distortions that Austrians talk about.

              • DMS says:

                That’s right, and I agree. But that is not the question that Austrians (or others) seem to be asking, i.e. “What are the distortionary consequences of a Fed-induced yield curve twist in the absence of monetary stimulus?”, which is what all my babbling was trying to get at.

                Instead, the discussion centers on inflation, current or future, or distortions that stem from excess money creation, not a twisting yield curve.

                For what it’s worth, and opposite to my prior thinking, I believe the distortions of QE are small, if noticeable at all. Or at least I have not seen a sound argument that grants the security-swapping model I’ve described and then can demonstrate why that is necessarily bad for the overall economy, or in what degree.

              • DMS says:

                I should have added that I wish the Fed would mind its own business and not have initiated QE in the first place, but now that QE is a reality, I just don’t see the dire consequences others seem to.

              • guest says:

                I think I get what you’re doing, now (I keep saying that).

                You want to focus on just the twist of swapping longer term bonds for shorter term ones.

                (You appeared to be saying that no money printing was going on at any point in your scenario, so that’s why I focused on that.)

                The longer term Treasury Bonds that the Fed owns were bought using money it got from swapping out shorter term ones in Operation Twist, which was done to postpone the day of reckoning.

                It can’t go back to short term bonds without a correction/crash.

                US Treasurys Are ‘Junk,’ Dollar Headed for Collapse: Schiff
                May 1, 2012

                ““As far as I am concerned, U.S. Treasurys are junk bonds,” Schiff said on CNBC Asia’s Squawk Box.” “And the only reason that the U.S. government can pay the interest on the debt, and I say ‘pay’ in quotes because we never pay our bills. We borrow the money so we pretend to pay, but the only reason we can do it is because the Fed has got interest rates so artificially low.”

                “The Fed has been keeping rates on benchmark 10-year Treasurys low by purchasing bonds via quantitative easing (QE) , and this will ultimately be the U.S. economy’s “undoing,” Schiff said.

                ““Unfortunately, we are going to get more QE than Rocky movies, because the only thing keeping this phony economy going is this QE,” he said. “And the minute you take it away, it’s going to collapse.””

              • guest says:

                When Infinite Inflation Isn’t Enough
                November 8th, 2012

                “As the Fed extends the average maturity of its portfolio, it is locking in the inflation created in the wake of the ’08 credit crisis. Back then, we were promised that the Fed would unwind this new cash infusion when the time was right. Longer maturities lower the quality and liquidity of the Fed’s balance sheet, making the promised “soft landing” that much harder to achieve.

                “The Fed cannot keep printing indefinitely without consumer prices going wild. In many ways, this has already begun. Take a look at the gas pump or the cost of a hamburger. If the Fed ever hopes to control these prices, the day will inevitably come when the Fed needs to sell its portfolio of long-term bonds. While short-term paper can be easily sold or even allowed to mature even in tough economic conditions, long-term bonds will have to be sold at a steep discount, which will have devastating effects across the yield curve. …

                “… Also, when interest rates rise – the increase made even sharper by the Fed’s selling – the Fed will incur huge losses on its portfolio, which, thanks to a new federal law, will become a direct obligation of the US Treasury, i.e. you, the taxpayer!”

    • Bob Roddis says:

      The “distortions” are a continuous and purposeful process of the theft of purchasing power from the non-elite for the benefit of the elite pursuant to a system that is so purposefully complicated and convoluted so that it remains obscure and unintelligible to the public. The concept of “theft” appears to be ubiquitous and is not obscure.

      • DMS says:

        Just to be clear, I am no fan of the Fed, and by no means am I trying to argue for QE, or any other monetary manipulation. What I have concluded, however is that QE is neutral in terms of money supply manipulation. And that seems deeply counter-intuitive to me and contra to all other gnashing of teeth about QE, one way or the other, that I am aware of. Hence my post for help.

        • Bob Roddis says:

          Neutral to whom?

          • DMS says:

            It is neutral to holders of money balances.

            It is neutral to lenders (in terms of unexpected inflation).

            It is neutral to borrowers (in terms of unexpected inflation).

            It is not neutral to the operations of the capital market broadly, owing to the artificial twisting of the yield curve. That impact is indeterminate, and potentially minor, but I just don’t know for sure.

  10. Max says:

    The non-demagogic reason to oppose IOR is that the Fed shouldn’t borrow from JP Morgan at 0.25% if, for example, Fidelity is offering to lend to the Fed at 0.05%. And the Fed has been doing just that. The difference between the open market rate of interest and IOR should be in favor of the Fed or neutral, not in favor of banks.

  11. Cosmo Kramer says:

    “If the banks can earn a guaranteed 1 percent from the Fed, then they would never lend their reserves to anybody else–even each other–for less than that.”

    Not gonna happen.

    What they are doing makes total sense with them not wanting to drain reserves. They only way for them to raise rates is for them to raise the floor. What I said above implies that lending will not disappear, or even stumble. Banks will still make loans……. as the spreads will still be there to be sufficiently profitable.

  12. Major.Freedom says:

    The real meaning of “exit strategy” was never about “going back”. It was about how to perpetuate the transferring of real wealth given the new circumstances.

  13. Z says:

    This is just survival of the fittest. The bankers found a way to gain more money and power, and they went for it. There’s nothing ‘right’ or ‘wrong’ about it.

    • Bob Roddis says:

      It is wrong to use power to steal money and purchasing power.

  14. Brent says:

    I don’t see how the deposit customers gain anything. By lowering rates so much, banks don’t really want more depositor money, as there are costs to these accounts that exceed the benefits of having the additional reserves. If .25% from the Fed is enough to keep banks holding onto massive excess reserves, I fail to see how 0% would convince them to go make a bunch of new loans. The 0.25% ends up as basically a free gift to the banks.

  15. guest says:

    Not very off-topic:

    The following link shows why I keep saying that the only reason the USD seems like it is money is because the Fed is ripping off other countries, which results in a relative stimulus to Americans. It’s also what Peter Schiff means when he says we’re exporting our inflation.

    The USD only seems to work because it results in theft from other countries (moreso than from within the United States).

    To be sure, our relative freedom would be sufficient to result in a better standard of living than the Chinese, without the exporting of inflation. But other countries *are* being ripped off by using the USD, and this Fed-induced artificial boom in American “consumerism” (I want to be careful here) needs to be corrected and replaced by free market, commodity-money-based (circulating physical gold, for example, not gold-backed paper) non-crony consumerism.

    (Consumer preferences being the basis for all economic activities, consumerism, per se, *is* the economy, and to oppose consumerism is to fight reality.)

    IOU’s: China Buys Treasury Debt

    “Meanwhile, the U.S. Treasury sells its debt to the Chinese central bank. “Suckers!” This debt will never be paid off.

    “The Chinese central bank gets IOU’s that pay almost zero interest. This helps the Federal Reserve keep interest rates low. In the meantime, we Americans get to buy Chinese goods cheaper than would otherwise have been the case. …”

    “… The Communist apparatchiks think that China’s urban masses can be kept quiet by having the PBOC create yuan out of nothing — fiat money inflation — so that the PBOC can buy IOU’s from the U.S. Treasury that pay almost no interest. Then Americans can buy Chinese-made goods that could otherwise have been sold to the Chinese people.

    In short, the Communists are subsidizing American consumers (cheap goods) and American politicians (low interest rates/more debt). The Chinese masses are paying for this: reduced wealth. Americans get this wealth.

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