Koo says QE2 drove speculation, but what about the real economy?
Richard Koo was out with a note yesterday that was sharply critical of the Federal Reserve’s second round of quantitative easing (hat tip Zero Hedge). While Koo sees QE2 as having created speculative flows into commodity markets, he also wanted to set the record straight about what QE2 does and does not do.
In the debate surrounding these issues, I was struck by (1) the misconceptions of QE2 held by some market participants and (2) the fundamental problems inherent in QE2. In this report I would like to touch on both of these questions.
Turning first to the market’s misconceptions regarding QE2, many investors believe that the large-scale quantitative easing programs implemented by the Federal Reserve and the Bank of England have left the markets awash in money, and that this money is providing substantial support for the real economy and markets.
The Fed’s balance sheet is now three times its pre-crisis size, and the Bank of England has taken similar measures. This balance sheet expansion has been the focus of much attention in the markets.
When a central bank triples the size of its balance sheet, the amount of liquidity being supplied to the market is also tripled. Under ordinary conditions, that would result in a tripling of the money supply, the key indicator of the money available for use by the private sector.
A tripling of the money available for consumption and investment by the private sector puts strong upward pressure on GDP and prices, including asset prices. That is why investors had such high expectations of quantitative easing.
Koo is pointing to the money multiplier fallacy that comes from the concept that banks are reserve constrained. Of course, none of this is true. Banks are never reserve constrained in our non-convertible floating exchange rate monetary system; They are capital constrained.
Theoretically, banks could lend out up to 10 times their reserves if the reserve ratio is 10% (money multiplier: loans = 1/reserve ratio). In reality, however, banks make the loans first and then look to the reserves afterward. That means some banks are short reserves and must borrow them in the interbank market.
When the entire banking system reaches the reserve limit, the central bank could theoretically create a credit crunch by refusing to increase reserves. But then the Fed would not be able to manipulate short-term interest rates. The Fed Funds rate is dependent on the central bank’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target. So in practice, central banks always increase the level of reserves desired by the system in order to maintain the interest rate.
My point is that the money multiplier is a fallacy in a fiat currency credit system and we see that now that we are in a balance sheet recession in which credit growth is subdued due to private sector deleveraging.
In reality, however, the money supply has betrayed market expectations inasmuch as it has increased only modestly in response to quantitative easing, if at all. To understand the significance of this, we need to understand the relationship between the money supply and central bank-supplied liquidity.
When a central bank provides liquidity to the market, it buys government debt or other securities in exchange for cash. The previous owners of those securities, typically financial institutions, take that money and attempt to turn a profit by loaning it out.
If borrowers use the money to buy goods and services, the providers of those goods and services will take the money they receive and deposit it at their banks, leading to an increase in private-sector deposits.
Banks receiving those new deposits will increase their lending accordingly. If the new borrowers also use the borrowed money to buy goods and services, the providers will again take the proceeds and deposit them in a bank account, driving further growth in private-sector deposits.
Both private-sector deposits and lending continue to increase as this process is repeated. However, banks cannot lend out the entire amount of new deposits because a portion must be set aside as statutory reserves. This creates a leakage in the cycle of increasing deposits and lending equal to the increase in statutory reserves.
Consequently, the process of deposit growth will continue until the entire amount of liquidity supplied by the central bank is set aside as reserves. If the statutory reserve ratio is 10%, the deposit growth process will end once the liquidity injected by the central bank has been transformed into deposits worth 10 times the initial amount.
The money supply data, composed mostly of bank deposits*, are closely watched by market participants because of their close relationship to GDP and price levels. The numerical relationship between the money supply and the initial liquidity injected by the central bank is called the money multiplier. In the previous example, the multiplier would be 10.
*Strictly speaking, the money supply includes bank deposits, currency, and coins.
Money supply has shown little change despite sharp increase in liquidity
What actually happened, however, is quite different. Market liquidity in the US and the UK almost tripled. But the money supply, which represents funds actually available for use by the private sector, has increased little if at all since the financial crisis in 2008.
Koo shows some useful charts on the breakdown in the money multiplier in the US and the UK to make his last point clear.
Koo realizes that:
The decline in private-sector credit in the US and the UK is attributable to both the unwillingness of banks to lend and the unwillingness of the private sector to borrow. The two factors are rooted in balance sheet problems and are indications that both countries remain in balance sheet recessions.
But he does the reader a disservice by pretending as if the reserve requirement is a constraint, when in fact it is not. In any event, because credit growth is subdued, there is no wall of money created by QE, rather there is a wall of money displaced by QE. And this money has flowed into riskier assets like high yield, emerging markets, stocks, commodities and precious metals. This portfolio rebalancing was exactly the intended consequence of QE2:
QE2 Is Equivalent to Issuing Treasury Bills. In actual fact, all QE2 does is drain the real economy of interest income by swapping an interest-bearing government liability for a non-interest bearing government liability. This decreases aggregate demand in the economy. So the real economy effects of QE are to slightly lower aggregate demand. This is offset by changing interest rate expectations, which alter private portfolio preferences, and lower risk premia, leading to credit growth, leverage and speculation, forces which should pump up the real economy.
Here’s the thing, though. These effects are temporary. When the salve of liquidity-driven markets is taken away, economic weakness from the balance sheet recession returns. If the economy can sustain recovery longer, the rise in assets can be sustained. However, if enough economic weakness is revealed when the curtain is pulled from in front of the Wizard, then…
In late March when the Fed hawks were trying to grab the bully pulpit to disabuse us of the possibility of QE3, I said the QE2 trade is now officially over. My conclusion? Pressure from the hawks would anchor the debate on QE and QE2 would end as anticipated, followed by economic weakness without an immediate QE3. I wrote:
Can we start dumping risk assets now? Seriously. The QE2 trade is now officially over. Remember guys like David Tepper telling us last September that they were going to run with the Bernanke put? Well now there’s the Bullard call instead of the Bernanke put. Bullard is telling us the jig is up. QE2 is finished…
So, the Fed has basically just announced it will stop QE2. It will then start selling Treasuries. And remember, this is at the same time the Treasury is selling $10 billion a month in mortgage securities. Only after this will rates be hiked. That doesn’t sound like a bullish scenario for risk assets. Could bond yields fall even though the Fed is selling if the economy swoons as a consequence?
This is exactly what is happening.
Koo piece embedded below.