And what will happen if QE is tapered or stopped?
‘Quantitative easing’ is understood in this note as the purchase of assets from the non-bank private sector by the central bank. (Other definitions are available!) The central bank finances these purchases by issuing cash reserves to the commercial banks, while the bank deposits of the non-bank private sector increase as it receives the proceeds of its asset sales. As bank deposits can be used to make payments, they are money. The effect of QE is therefore to cause an increase in the quantity of money, with bank balance sheets showing extra deposits on the liabilities side and extra cash reserves on the assets side. The change in banks’ cash assets measures, more or less, the effect of QE on the quantity of money. (I say ‘more or less’ because there are some technical caveats. They may become important, but they are not relevant to this note and are not further discussed.)
The Federal Reserve’s ‘QE3’ operations are an example of this form of quantitative easing. The Fed has purchased mortgage-backed securities, mostly from non-banks (but also to some extent from banks, one of those ‘technical caveats’), and that has boosted banks’ cash reserves enormously and been a major positive influence on the quantity of money. QE is expected to be ‘tapered’ soon and ended at some point in the next few months. What effect will that have on the growth of the quantity of money in the USA? Will M3 – which has been rising slowly since 2011 – continue to increase? The analysis in this note suggests that, unless banks were to resume the expansion of ‘bank credit’ in the usually understood sense (i.e., of claims on the private sector), the growth of US broad money would come to a complete halt with a cessation of QE. It is very important for International Monetary Research subscribers to realize that the Fed does not analyse the monetary situation by inspection of quantity-of-money data; its officials would have no interest in the conclusion I will now reach.
Money, bank assets, and nominal national income and wealth: a recap
As I explained in the weekly e-mail of 23rd July, standard theory says that the equilibrium level of national income (and wealth) in nominal terms is determined by the interaction between the demand to hold money balances and the quantity of money created by the banking system. (This was noted by Keynes at the end of chapter 7 of The General Theory. Neither Keynes nor any other top-rank monetary economist has ever questioned the observation I have just made. Admittedly, the world is full of low-grade, self-styled ‘economists’.)
Non-bank private sector agents have a money demand function, with their demand to hold money depending on the level of income (and/or wealth), the attractiveness of money relative to other assets and other variables. With the quantity of money given, and with the non-income variables in the demand function also set at particular values, the money demand function implies that one and only one level of nominal national income (and wealth) is consistent with macroeconomic equilibrium. In that sense the quantity of money determines nominal national income. Further, if (quite a big ‘if’ in practice) the non-income variables in the money demand function are stable over time, theory says that changes in the quantity of money and equilibrium national income are equi-proportional.
I have slipped in ‘wealth’ in parenthesis in the above two paragraphs, although – for most of the subscribers to International Monetary Research – it is ‘wealth’ that is vital. The term ‘wealth’ does of course include the stock of equities and real estate (i.e., all of commercial and residential property). Over the medium and long runs the value of a nation’s wealth rises with its gross national product. (National product is the correct concept, not domestic. Foreign income is capitalized on a nation’s stock exchange.) So, if the quantity of money is key to the level of equilibrium national income, it is also fundamental to the value of equities and property.
So how do bank deposits grow? They grow when banks increase their liabilities by expanding their assets. The growth of the quantity of money is equal to the increase in banks’ assets minus the change in their non-deposit liabilities. In recent decades banks’ assets have been dominated by claims on the private sector, mostly in the form of bank loans, but also including large amounts of securities of various kinds. However, banks must also retain some cash on their balance sheets (to meet deposit withdrawals and for settlement of inter-bank positions), and they also lend to the state and to overseas entities.
In the three decades to the Great Recession (i.e., until mid-2007) new bank lending to the private sector was by far the most important influence on monetary growth. However, since late 2008 the pattern has altered radically. A drastic tightening of bank regulation, combined with the greater difficulty of funding assets in the inter-bank market, has checked the growth of lending to the private sector. Even short-term interest rates of virtually zero have not been sufficient to spark a meaningful credit revival. Faced with an almost unremitting regulatory onslaught, many banks have been obliged to shrink (‘to deleverage’) their holdings of risk assets. The quantity of money would have fallen heavily in several countries in the five years from late 2008, if ‘bank credit’ had been the only active force at work changing the size of banks’ balance sheets (and hence of banks’ deposit liabilities, which are money).
Nevertheless, in most countries the quantity of money has continued to grow in the Great Recession, even if a very slow rate by the standards of the preceding 50 years. In terms of the so-called ‘credit counterparts arithmetic’ to the quantity of money, most of the explanation is to be sought in the deliberate creation of money by the state (usually the central bank) by means of the QE operations discussed in the introduction to this note. The next section considers the size of the QE3 impact on the growth of US banks’ deposits in 2013, and compares it with the effect of changes in their other assets. The important point we need to remember is that – if banks are not growing their assets at all – they cannot be growing their liabilities, and the great majority of their liabilities (85% or so) are the deposits that constitute the quantity of money.
Composition of banks’ assets growth in 2013
In the eight months to August 2013 US commercial banks grew total assets by just over $620b. or, at an annualized rate, by just over 7%. These banks’ deposits constitute about three-quarters of the USA’s M3 broad money measure. The 7%-or-so growth of banks’ total assets has therefore been accompanied by a moderate rate of broad money growth (of about 3% – 5% at an annual rate for much of the last year/18 months), strong asset prices and a reasonable economic recovery. (Note than an important constituent of M3 – the money held in money market mutual funds – is not growing at all at present, because of a marked tightening of regulations. So M3 has been increasing at a slower rate than commercial banks’ assets.)
What were the influences on the $620b. increase in banks’ assets in the eight-month period? The chart above gives us the answer. The message is about as clear-cut as any that can be delivered in the very murky subject of monetary economics. In 2013 the growth of banks’ assets – and hence the associated growth in broad money – has been almost entirely due to QE3. Banks were expanding their ‘credit’ (i.e., their loans to the private sector and their securities) in the opening months of the year, but that stopped in April/May. (The explanation is probably the application of the simple leverage ratio to banks’ assets, again checking their plans to grow their businesses.) ‘Other assets’, which include trading assets and inter-bank lines, have certainly not been ‘flavour of the month’ since the start of the Great Recession, and they have gone down by over $75b. so far in 2013. With bank credit flat or down, and miscellaneous assets falling, US banks’ total assets would have dropped in 2013, if it had not been for the extraordinary rise in their cash assets. That rise in cash assets is attributable to QE3 operations.
My further conclusions are that
- Without QE3, the growth of the broadly-defined quantity of money would have come to a halt in the USA this year, and
- In the absence of a major easing of bank regulation (i., a reversal of the trends that have been in place since late 2008), the tapering/ending of QE3 is likely to lead (at best) to a marked slowing in the growth of the quantity of money, and perhaps even to another period of falls/stagnation in the quantity of money.
QE and American economists
It is very important for subscribers to understand that the Fed does not analyse the macroeconomic situation in the way that I have done in the last few paragraphs. In 2009 Ben Bernanke, chairman of the Fed, said that he disliked the phrase ‘quantitative easing’, which was understood to refer to the quantity of money, and instead favoured ‘credit easing’. In his thinking the purpose of the Federal Reserve’s operations was to reduce ‘credit spreads’, since he viewed the so-called ‘credit channel’ as the centre of the transmission of monetary policy to the economy. The purchases of mortgage-backed securities in the QE3 programme have not been intended to raise the quantity of money, but to keep down ‘the rate of interest’ (meaning ‘bond yields’, in fact) and the cost of mortgage finance to potential home-owners.
For a number of reasons which I have discussed elsewhere (see, for example, essays 17 and 18 in my 2011 collection Money in a Free Society), I regard the credit channel as a delusion, and instead believe in the traditional monetary theory of national income (and wealth) determination. To me it is remarkable that US broad money would have been more or less flat in 2013 without the QE3 operations. It is possible that the shrinkage of banks’ risk assets, as they respond to new regulations, is largely complete, although I doubt it. (That certainly is not the implication of most press coverage of the banking industry, both in the USA and elsewhere.)
The conclusion has to be that – if QE is tapered and/or ended altogether – the deleveraging of the banking industry favoured by international regulatory officialdom will result in continued weak growth (or even resumed stagnation) of the quantity of money in the USA. Although leading indicator indices of economic activity in the USA are alright at present, the outlook for early 2014 is still not for the well-above-trend growth usually seen at some point in US recoveries. A period of beneath- trend growth, with another rise in unemployment, cannot be excluded. If a tapering/ending of QE is followed by M3 stagnation for some months, asset markets – including the stock market – are likely at best to go sideways as the economy adjusts to the implied greater strain on balance sheets. Let us hope that any such ‘growth pause’ is only temporary. Intellectually, the threat remains the indifference of many economists, central bankers and regulators to the effect of bank deleveraging on broad money growth, and hence on equilibrium national income and wealth.Tags: Bank for International Settlements, Bank of Japan, Barrick Gold, Central bank, European Central Bank, Financial institution, Gold as an investment, Quantitative easing, United States