On the Money
Quantitative easing is often described as ‘printing money’. But that statement is incorrect and portrays a misunderstanding of what QE really is.
How much US dollar currency is there circulating in the world? All the actual folding notes issued by the US Federal Reserve, and held in bank vaults and purses and wallets and under beds, how much is that?
In December 2007, at the beginning of the GFC there were $830 billion of greenbacks in circulation (including currency in bank vaults). Then, d uring the three rounds of quantitative easing in the GFC the Fed created $3.5 trillion of new money to buy bonds. Therefore, the amount of US currency in circulation today must be about $0.83 trillion + $3.50 trillion = $4.33 trillion, right?
Wrong. The amount of US currency in circulation today is only about $1.25 trillion. Yes, there has been $3.5 trillion of US dollar QE, but US currency has only increased by $500 billion. The reason this makes sense is because despite what you will often hear commentators say, QE is not ‘printing money’. QE is the creation of new money, but there are two types of ‘base’ money. The first is folding currency and the second is the balances that banks have in their accounts at the Fed.
If we look at how the balance sheet of the Fed has changed during the GFC then it will become clear.
The Fed’s balance sheet
In December 2007 the Fed’s assets and liabilities are in their normal state - the Fed’s main asset is Treasury securities ($779 billion) and its main liability is currency in circulation ($830 billion). As the US economy has grown over time the Fed has printed up more and more currency to match the growth of the economy – $830 billion by Dec 2007.
What does the Fed do with new currency that it creates as the economy expands? The Fed hands over the new currency to the US Federal Government in exchange for Treasury securities (bonds and notes). Note that the Government’s insistence on having a monopoly over the creation of currency plus the value it claims from the creation of new currency (called seignorage) is actually a form of taxation.
Now look at the Fed’s assets and liabilities for Mar 2015. Assets have increased by $3.6 trillion, mostly through the purchase of nearly $1.7 trillion of treasury bonds and $1.8 trillion of agency bonds (the bonds of the housing agencies, Fannie Mae and Freddie Mac).
QE is the creation of new reserves
How did the Fed pay for the purchase of all those bonds? $500 billion of Treasury bonds were purchased when new currency was printed. The rest were purchased with Fed cheques. When the Fed buys bonds by writing a cheque, the Fed adds the bonds to its assets, and the seller of the bonds has the cheque (the Fed’s liability). The cheque is deposited in the bond seller’s bank account. Now the bond seller has a bank deposit and the bank has the Fed’s cheque. The bank then deposits the cheque in the bank’s account at the Fed.
In the table above there is a liability of the Fed called ‘Reserve accounts of banks’. Those reserve accounts are the accounts of banks at the Fed. Before the GFC banks held only $21 billion in their accounts at the Fed. After the three rounds of QE banks now have $2.44 trillion in their accounts at the Fed (these are called Fed reserves).
Fed reserves are money – just as much as currency is money. In fact Fed reserves (the money in the accounts of banks at the Fed) can easily be turned into currency. If a bank needs $40 million more of currency for its branch operations, then it will send an armoured car to the Fed and withdraw $40 million from its account at the Fed - turning reserves into currency.
So it is true to say that in conducting QE the Fed purchased bonds using newly created money - $500 billion of new currency and $2.4 trillion of new reserves. But it is incorrect and misleading to say that QE is the process of ‘printing money’ to buy bonds. Even in normal times the Fed prints new currency and uses the proceeds to buy bonds as the economy grows.
Getting back to normal
You can see in the table that the process of QE has grotesquely distorted both the Fed’s balance sheet and the balance sheets of US commercial banks. A big part of ending the GFC is the unwinding of QE and the restoration of the Fed’s balance sheet to a healthy state of essentially only Treasury securities on the left hand side and currency on the right hand side. I am going to write about how that unwinding process will be conducted and what it means for financial markets in future newsletters.