In 2002, in a speech that earned him the nickname "Helicopter Ben," then-Fed Governor Bernanke famously said that the government could easily reverse a deflation, just by printing money and dropping it from helicopters. "The U.S. government has a technology, called a printing press (or, today, its electronic equivalent)," he said, "that allows it to produce as many U.S. dollars as it wishes at essentially no cost." Later in the speech he discussed "a money-financed tax cut," which he said was "essentially equivalent to Milton Friedman's famous "helicopter drop' of money." You could cure a deflation, said Professor Friedman, simply by dropping money from helicopters.
It seems logical enough. If there is insufficient money in the money supply (deflation), the solution is to put more money into it. But if deflation is so easy to fix, then why has the Fed's massive attempts to date failed to do the job? At the Federal Reserve's Jackson Hole summit on August 27, Chairman Bernanke said he would fight deflation with his whole arsenal, including "quantitative easing" (QE) purchasing longterm securities with money created on a computer. Yet since 2008, the Fed has added more than $1.2 trillion to "base money" doing just that, and the economy is still in a serious deflationary spiral. In the first quarter of this year, the money supply actually shrank at a record annual rate of 9.6%.
Cullen Roche at The Pragmatic Capitalist has an answer to that puzzle. He says that as currently practiced, quantitative easing (QE) is not really a money drop. It is just an asset swap:
"[T]he Fed doesn't actually "print' anything when it initiates its QE policy. The Fed simply electronically swaps an asset with the private sector. In most cases it swaps deposits with an interest bearing asset."
The Fed just swaps Federal Reserve Notes (dollar bills) for other assets (promissory notes or debt) that can quickly be turned into money. The Fed is merely trading one form of liquidity for another, without raising the overall water level in the pool.
The mechanics of how QE works were revealed in a remarkable segment on National Public Radio on August 26, describing how a team of Fed employees bought $1.25 trillion in mortgage bonds beginning in late 2008. According to NPR:
"The Fed was able to spend so much money so quickly because it has a unique power: It can create money out of thin air, whenever it decides to do so. So . . . the mortgage team would decide to buy a bond, they'd push a button on the computer "and voila, money is created.'
"The thing about bonds, of course, is that people pay them back. So that $1.25 trillion in mortgage bonds will shrink over time, as they get repaid. Earlier this month, the Fed announced that it will use the proceeds from the mortgage bonds to buy Treasury bonds essentially keeping all that newly created money in circulation. The decision was a sign that the Fed thinks the economy still needs to be propped up with extraordinary measures."
"Extraordinary measures" was a reference to Section 13(3) of the Federal Reserve Act, which allows the Fed in "unusual and exigent circumstances" to buy "notes, drafts and bills of exchange" (debt instruments) from "any individual, partnership or corporation" satisfying its requirements. The Fed was supposedly engaging in these extraordinary measures to "reflate" the money supply and get credit flowing again. Yet the money supply continued to shrink. The problem, as Roche explains, is that the dollars were merely being swapped for other highly liquid assets on bank balance sheets. That this sort of asset swap will not pump up a collapsed money supply has been shown not only by the Fed's failed experiments over the last two years but by two decades of failed QE policy in Japan, an economy which remains in the deflationary doldrums. To reverse deflation, it seems, QE needs to be directed somewhere else besides the balance sheets of private banks. What we need is the sort of helicopter drop described by Bernanke in 2002 one over the towns and cities of the real economy.
There is another interesting lesson suggested by two decades of failed QE: it might actually be possible for the government to "print" its way out of debt, without triggering the dreaded hyperinflation long warned of by pundits. Swapping dollars for debt hasn't inflated the circulating money supply to date because federal debt securities already serve as forms of "money" in the economy.The Textbook Money Multiplier Model . . .
And Why It Is Obsolete
Beginning with some definitions, "quantitative easing" is explained in Wikipedia like this:
"A central bank . . . first credit[s] its own account with money it has created ex nihilo("out of nothing').It then purchases financial assets, including government bonds, mortgage-backed securities and corporate bonds, from banks and other financial institutionsin a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money, and thus a hopeful stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system."
"Deposit multiplication" is the textbook explanation for how credit expands as it circulates through the economy. In the textbook model, banks must retain "reserves" equal to 10% of outstanding deposits (including deposits created as loans). With a 10% reserve requirement, a $100 deposit can support a $90 loan, which gets deposited in another bank, where it becomes an $81 loan, and so forth, until a $100 deposit becomes $1,000 in credit-money.
The theory is that increasing the banks' reserves will stimulate this process, but both the Federal Reserve and the Bank for International Settlements (BIS) now concede that the process has not been working in the textbook way. (The BIS is "the central bankers' central bank" in Basel, Switzerland.) The futile effort to push more money into bloated bank reserve accounts has been compared to adding more apples to shelves that are already overstocked with apples. Adding more reserves to a banking system that already has more reserves than it can use has no net effect on the money supply.
The failure of QE either to increase bank lending or to inflate the money supply was confirmed in a March 24 paper by Federal Reserve Vice Chairman Donald L. Kohn, who wrote:
"The huge quantity of bank reserves that were created [by quantitative easing] has been seen largely as a byproduct of the purchases [of debt instruments] that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation."