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Central Banks Versus the People

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By Delusional Economics, who is determined to cleanse the daily flow of vested interests propaganda to produce a balanced counterpoint. Cross posted from MacroBusiness.

As you are surely aware by now, the US Federal Reserve has announced a new round of quantitative easing which like the ECB’s outright monetary transactions (OMT) is a new program of large scale asset purchases by a central bank. I thought I’d spend a bit of time today talking about these programs because once again I have noticed some large misconceptions in the media about what these operations are, and more importantly, what the likely outcome of them is.

As I have stated before, one of the major issues I have with the reporting of these types of programs is that they are referred to as “money printing” which, although at some level is technically correct, provides a fairly deceptive view of what is actually happening and in many cases simply adds to the confusion as to what is actually going on.

The reason these operations are referred to as money printing is because when a central bank makes purchases of financial assets it does so by adding amounts to the reserve accounts of banks that either 1) own the asset or 2 ) are the registered bank of the holder of that asset. In the case of 2 ) the bank will also create a deposit for the account holder. The difference here is quite important so I’ll come back to this point later.

It should be noted, however, that the creation of new reserves is not unique to QE, in fact all reserve banks create, and destroy, reserves on a daily basis in order to maintain the interbank market rate. See here for more in this topic. The purchase and sale of securities adds or drains reserves available in the banking system which controls the short term interest rates banks charge each other to borrow funds. This is the basic process in which central banks set interest rates.

Unorthodox monetary policy tends to be larger and sustained purchases of a particular types of financial asset in order to a) supply interbank liquidity to ensure monetary policy transmission, b) reduce systemic risk and/or c) reduce longer term interest rates. The ECB’s OMT probably covers the first two, QE3 the third.

In the case of QE3, Ben Bernanke has stated that the Fed will purchase US$40bn/month of mortgage backed securities. By doing so the amount of securities held by the private sector will reduce which bids up the price and in turn lowers the yield. As MBS are used as a benchmark for mortgage rates this purchases is expected to bring down the long term interest rate paid by US citizens on their home loans.

In the case of OMT, Mario Draghi’s plan is for the ECB to purchase sovereign debt of certain Eurozone nations again to bring down the yield. The difference being that OMT is more about financial stability and monetary policy transmission. But in both cases the basic idea is that the reserve bank will purchase securities in the market and by doing so will drive down interest rates. For QE3 the target securities are MBS , for the ECB’s OMT it is periphery government bonds.

Now for the catches.

There are obviously side effects of these programs, these aren’t my major focus today so I’ll skip over them but it should be noted that these operations lower the respective currency relative to other currencies and tend to lift equity and commodity prices in the short term as the additional liquidity finds a new home. The overall outcome of these side effects is inflationary pressures in food and energy that potentially decrease consumption and therefore reduce overall economic activity.

What you may have also noticed about these programs is that it is possible that there is no overall direct effect on the public. Unless a household or business themselves happen to be a holder of a particular type of financial asset then the public doesn’t actually receive any of this money. As I stated above, in the case where a bank is the owner of an asset all that occurs is an asset swap which creates excess reserves in the banking system. That is, in either case the major outcome of these policies is simply a change in composition of the asset side of commercial bank’s balance sheets.

For households and businesses the real outcome is potentially interest rates are lower than they otherwise would be, as Ben Bernanke stated:

Our mortgage-backed securities purchases ought to drive down mortgage rates and put downward pressure on mortgage rates and create more demand for homes and more refinancing.

So basically these operations are all about trying to get households and non-financial corporations to borrow more money through commercial banks and spend their savings in the economy. That is, these programs are aimed at increasing the velocity of money which includes both an increase in private sector debt and a lowering of deposit based savings. None of this is about giving money away as suggested by the term “money printing”.

Notice the term “ought to” in Mr Bernanke’s statement. It’s important because whether or not this actually occurs is dependent on two things. Firstly, the decision of the banks as to whether they will pass on lower rates to consumers and expand their loan books, and secondly, how exactly the private sector will act in the face of lower rates in terms of new loans and savings.

These two points play a major part in what we are seeing in Europe and why ECB’s balance sheet expansion is failing there. In places like Spain the retrenchment of the private sector after an an asset shock is being made worse be the attempted de-leveraging of the government sector, as I said:

So with the external sector in this state and the private sector unable and/or unwilling to take on additional debt as it attempt to mend its balance sheet after an ‘asset shock’, the only sector left to provide for the short fall in national income is the government sector. If it fails to do so then the economy will continue to shrink until a new balance is found between the sectors at some lower national income, and therefore GDP.

The inability and/or lack of desire for new credit is by the private sector is the tell-tale signs of a balance sheet recession which has the following attributes

• A balance sheet recession emerges after the bursting of a nationwide asset price bubble that leaves a large number of private-sector balance sheets with more liabilities than assets.

• In order to repair their balance sheets, private sector moves away from profit maximization to debt minimization.

• With the private sector de-leveraging, even at zero interest rates, newly generated savings and debt repayments enter the banking system but cannot leave the system due to the lack of borrowers.

• The sum of savings and debt repayments end up becoming the leakage to the income stream.

• The deflationary gap created by the above leakage will continue to push the economy toward a contractionary equilibrium until the private sector is too impoverished to save any money.

• In this type of recession, the economy will not enter self-sustaining growth until private sector balance sheets are repaired.

So QE and OMT are monetary programs that, in part, aim at increasing the leverage of the private sector, but they have only attempted to address the supply side of the equation. Fiscal policy in the EZ is continuing to lower the private sector wealth and by doing so is reducing the demand for credit which in turn is further weakening the economy. This dynamic appears to be more that offsetting the expansionary monetary program which is why you have seen the ECB’s response continue to become larger and larger over time. The Eurozone is therefore likely to continue to see poor economic outcomes even under the open-ended OMT because the insistence on the fiscal compact as a pre-cursor to renewed intervention is likely to be completely counter-productive.

I think the jury is still out on whether the US is seeing expansion in the real economic activity, but there is no doubt it is performing better than the Eurozone. Whether that continues has a lot to do with what happens in regard to the “fiscal cliff”, which is their own version of the fiscal compact.

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20 comments

      1. steelhead23

        This vid asks, “Is this an episode of the Twilight Zone?” The answer was, “No.” However, I think a better answer was that this is “Groundhog Day,” but unfortunately we are merely along for the ride.

  2. Skeptic

    The reason the MBS purchase program does not seem make much sense is that it has another purpose.

    The banks still carry enormous civil liability risk for their selling of dodgy MBS assets to private groups. The FED purchase of these securities is a stealthy approach to reduce the liability and national outrage if these assets fail to pay sufficiently. You can be sure the FED will be buying specific targeted MBS at a premium.

    1. C

      You know, I wish that I could read your comment and think:

      “No, of course not. Our government wouldn’t make such a back-room deal to bail out the bankers who broke the law and stick us with the consequences. Nor would they sell it under the positively Orwellian title of ‘Job Creation.'”

      But these days…

    2. OpenThePodBayDoorHAL

      Let’s be clear, the mission of the Fed is to “ensure the stability and solvency of the banking system”. That very mission conflates “the health of the banks” with “the health of the economy”. It’s the received wisdom that one must support banks at all costs because the negative consequences of bank failures certainly can and do transmit to the economy as a whole.
      Nobody argues that in 2008 we wanted to see lines of people waiting outside Citibank only to discover what the term “fractional reserve banking” really means. QE3 is a continued delayed effort to help banks repair their balance sheets, pure and simple. What we haven’t done is reform the TBTF system in any meaningful way, or had a debate or discussion on how to allow banks to fail rather than endlessly backstopping bad lending decisions.
      Sure maybe housing is a transmission mechanism but not allowing the market to clear means we’re just trying to blow another bubble.

  3. Richard Kline

    So DE, not to clash audibly with your perspective, but in my view central bank policy _is not_ directed at pushing down rates for credit available to the larger economies, whether in Europe, the US, or elsewhere. Yes, that is what central bankers are _saying_ is the purpose they pursue. Perhaps yes, they even believe this delusion themselves. Not so: this is all about asset protection. Secondarily in Europe this is about preserving regional governmental access to normal bond funding. The larger economy can go hang, really.

    [The following is largely excerpted from my comment to Eugene Linden’s post put up by Yves, but is relevant in this context so repeated below.]

    I’m unconvinced that the actual mission of the Fed, the ECB, et. al. is to push risk out the curve. The Fed’s mission is to protect asset prices, and indeed to keep them rising if at al possible.

    I don’t say this lightly; moreover, this is historically a new program even if not actually new. The function of central banks and large government treasuries for much of the 20th century was to backstop employment as a way of supporting demand. This became the function through hard learned experience, and not through any love for ‘the little people’ on the part of central bankers. Some success at stimulating demand and the manifest evidence of the effects of demand collapse had central bankers an many key policy makers get religion. This began to change in the late 1980s. Alan Greenspan didn’t invent ‘assets first’ monetary policy, but his putative success in his early years in the 1990s made it easier to sell that program. Japan has had significant success at protecting asset values too. Not that assets haven’t declined there relatively, but the absolute collapse that should have followed the speculation has been staved off—and the cost of suppressed employment, but hey, the little people don’t count in the new paradigm.

    We are all Japan now. The belief that the core mission of central banks is to protect asset prices is absolutely in force. Forget whatever Bernanke and others _tell themselves_ they are doing, what they are in fact doing is trying to ringfence the financial assets of the plutocracy and target a value of same to support. In short, demand support has been thoroughly JUNKED. Nobody atop the system cares if unemployment rises and stays high, _so long as central governments and their actors protect the asset values of the rich from price declines due to demand declines_. The poor can eat chips; indeed, unemployment is good, say the billionaires, something to induce a little wage discipline on the masses. The rich and the central bankers only supported employment under duress. Now, the wealth is figuring simply to save their own assets and let the rest of society slump.

    I’m quite serious in this view. And in fact, the program isn’t new in and of itself. What we really see is a return in the broad picture to the ‘hard money’ policy of major 19th century banking, when credit rationing was intended to restrain non-insider speculation and thereby preserve access to and prices of the assets favored by the richest. What is very new since Greenspan turned his hand to it is the use of massive central banks money drops via ‘moneys of account,’ that is money simply created at a keyboard at the discretion of central bankers and their designees. Looking at what Greenspan did, he was a serial bubble blower of speculation with the idea that he could clean up any peripheral erosion by printing money and giving it to the rich, directly or indirectly. Let’s leave aside discussion of the extent to which he succeeded in the latter; he certainly succeeded in the former.

    But the new policy has really taken hold, now. Every major economy is on it: pixelate money under the veil of ‘liquidity’ and let it loose, ideally targeted to support financial assets of the elite. The idea of ‘stimulating the larger economy’ just isn’t on: NOBODY at the top CARES. They are not hurting. Their political rigged game isn’t threatened by unemployment. Policy makers are far more threatened by teetering oligarchs who would either throw their support to some other polished flunky or crash over taking down all. Thinking over four centuries of modern financial markets, we have _never_ had a condition where all major government or quasi-government actors are hellbent on flooding money to their respective wealth classes to prop up asset prices (because let’s be frank folks this is EXACTLY what is going on now). Historically, this would have caused flight from the assets involved to ‘less risky ones.’ But there’s nowhere to go with every sovereign money issuer pixelating money out the door for all they are worth.

    We don’t have financial ‘anti-gravity’ in my view. But the volume of hot air being blown can keep asset prices hovering over the abyss and societies stultified for an undefinable period of time. NOT indefinite, in my view, but I couldn’t say how long. Ten years? Twenty? (Doesn’t seem likely.) But I agree to this extent with the anonymous strategist Linden cites above: we are in a new age, truly one never before seen. Governments everywhere are acting with all the powers at their disposal to ‘save the assets’ of the rich and let societies suffocate, especially at the bottom. This isn’t about ‘stimulating investment,’ I don’t care what lies central bankers tell themselves to justify the unjustifiable. Perhaps the real notion they swap in the executive washroom is that if the wealth at the center of society is preserved, those societies can be kept intact until ‘growth’ organically returns. Or at least societies can be kept intact, no nasty revolutions or political sweep-outs or expropriations or the like as threatened or happened back when governments pretended that the situation of ‘the little people’ mattered a damn. But this new program of asset protection isn’t stimulative in intent, so forcing investment changes is not it’s primary focus. Saving the assets and the social dominance of the oligarchy IS this program’s true intent. I suspect it will be an accident or error of some kind which precipitates a catastrophic state-change of this unprecedented monetary policy. What happens then is hard to say other than that the mess will be of historically salient scale.

    We are all Japan. Employment is so 20th century. Investment is so 19th century. This is Century 21 baby, where the government just prints money and hands it to the rich, so who needs investment, employment or taxes. . . . Now I think one sees the Republican political program in capsule. Oh central bankers and policy makers say, and some of them may believe, that they are acting broadly to ‘save the larger economy,’ but this is nonsense. One sees this in how readily those same policy makers are pursuing employment _destruction_ programs, such as austerity in the EU or deunionization in the US. What we see _on the ground_ is deliberate attempts to destroy employment at the bottom while the assets at the top are propped up by all means necessary. How long can they keep this up? Five years and counting, and we’ll see from here. But let’s not delude ourselves that central banks are doing anything AT ALL other than protecting major financial assets: this is the new supra-normal.

    1. Up the Ante

      ” .. referred to as “money printing” which, although at some level is technically correct, provides a fairly deceptive view of what is actually happening and in many cases simply adds to the confusion as to what is actually going on.

      The reason these operations are referred to as money printing is because when a central bank makes purchases of financial assets it does so by adding amounts to the reserve accounts of banks .. ”

      The only thing “deceptive” is the use of the phrase “adding amounts”.

      see Hugh’s statement below, ” .. in kleptocracy it’s always about the looting. ”

      In excuse-making it’s always about the Apologists.

      http://market-ticker.org/akcs-www?post=211566

      “QE has been an abject and objective failure.

      Period. “

  4. Hugh

    Both the Fed’s QE3 and the ECB’s OMT are backdoor bailouts of banks and the rich who stand behind them. In the Fed’s case, it is banks generally but especially the TBTF. In Europe, it’s the Northern banks and their rich bondholders. The OMT is used to support the peripheral governments so those governments can continue to support the peripheral banks so that these can continue to pay back loans to Northern banks so that these can keep their rich bondholders happy.

    This is kleptocracy and in kleptocracy it’s always about the looting.

    1. bhikshuni

      Let’s not forget the known details:

      http://www.bbc.co.uk/worldservice/business/2009/09/090910_aftershock_bizdaily_pricewaterhouse.shtml

      “Steven Pearson and Tony Lomas are from the accountants PricewaterhouseCoopers.

      Last September, they were appointed as the administrators of Lehman Brothers European operations.

      Steven Evans joined them in the bank’s former London headquarters, to see how they set about salvaging something from the wreckage of the investment bank.

      Suddenly the high testosterone, go-getting bank was under the control of outsiders of a very different culture.

      First broadcast on Business Daily”

      I’d love to see respected Yves follow up and do another book with these two guys!

  5. Bill

    To Richard Kline :

    Well said and quoted ! No Koolaid in your tummy . Eyes wide open . Seeing what is unseen by the masses . There is the .01
    % that is aware ,ONTO, what is happening to the sheeple on a world scale . You are one . Good post !

  6. Jose Guilherme

    “…all reserve banks create, and destroy, reserves on a daily basis in order to maintain the interbank market rate. See here for more in this topic”.

    What happened to the link in “here”?

    Broken or missing, it should be repaired.

  8. PQS

    I’m with RKline above. This is just another tool of the oligarchs to further push down the rest of us. They. Don’t. Care. (My only tiny quibble would be that I’m not sure the 19th century middle class was as large or as “empowered” as today’s middle class in being the actual engine of the consumer economy….but it’s early and I have to go to work, so I can’t parse this out more.)

    In any event, the banks have tightened their lending standards so much (wow, how they got religion) that anyone with less than platinum credit and a job paying twice what should be expected for the loan isn’t getting ANYthiNG out of the banks, no matter HOW LOW the INT rates GO. Why Ben and the Gubmint think that lowering the rates to zero will do anything to help anyone not wearing a $3K suit, I haven’t the faintest clue.

    I will say that I do think that ONE positive to lowering interest rates even more and keeping them there (as “promised”) has, perhaps, led to a teensy uptick in commercial real estate projects. I know I’ve seen more actual multi family projects with real money behind them in the past year than I have in the past five. Slowly some are figuring out that they will NEVER have such cheap money to build things.

  9. Reverb

    Trying to refinance my mortgage. No rate drops by any of the lenders I am canvassing over the last three days despite the collapse of the MBS/10y UST spread to record lows. Transmission mechanism is busted methinks, the banks are content to keep it for themselves.

  10. JCC

    “The overall outcome of these side effects is inflationary pressures in food and energy that potentially decrease consumption and therefore reduce overall economic activity.”

    As to whether the U.S. Economy is expanding, I’m not sure about the jury still being out. All the indicators seem to be saying that we are either entering or are in another recession. Between inflation in commodities and stocks already showing in the past week, and practically non-existent positive interest rates, it’s pretty obvious to me that savers like myself are royally screwed relative to my personal “long run” prospects. Scary stuff, “money printing” or not.

  12. TC

    This analysis is flawed. In venturing to drive down interest rates is capital freed to expand systemic leverage. In so doing via today’s lender of last resort machinations is a direct effect to all concerned meted, this in a process crushing profit margins to the end of leading to the shedding of so-called “excess capacity” bringing a reduction of economic activity and raising the spector of physical shortages (refined crude oil being a contemporary case-in-point). Back in the day when the London-Wall Street axis of fraud could manufacture any number of highly prized securities, the negative impact of similar ventures expanding systemic leverage could be disguised, as freed capital went right back into the loop feeding a credit bubble that now stands exposed as a debt trap. With lenders of last resort now facilitating a hollow shell of yesteryear’s Ponzi finance, that now dead confidence game is being replaced by a rush for physical assets whose impact but facilitates wholesale shutdown of physical economic activity, and this at an accelerating rate. Thus is the danger of the “open ended” hyperinflationary commitment that, central banks of the trans-Atlantic have entered, with added debt burdens venturing to increase systemic leverage only hastening the physical economy’s shutdown, as well as consequent, increasing scarcity. Sacrificed in this process surely will be ever larger players, both in the physical and financial realms, with the latter reality making all the squealing of late for more QE from enterprises comprising the [dying] axis of fraud truly a suicidal death wish.

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