An economics student with whom I’ve been corresponding recently relayed to me that his economics professor stated that the Federal Reserve’s policy of quantitative easing (QE) did not equate to printing money. This question causes a lot of confusion between economists and non-economists so it seemed like a good topic for a quick post.
So, should QE be considered money printing?
At first glance it should. In fact, if you Google the term “quantitative easing,” Google provides the following definition, “the introduction of new money into the money supply by a central bank.” Similarly, Wikipedia starts off its entry on quantitative easing with, “Quantitative easing (QE) is a monetary policy in which a central bank creates new electronic money in order to buy government bonds or other financial assets to stimulate the economy…”
Before we go further, let’s understand the basic mechanics of quantitative easing. In a nutshell, the Federal Reserve (or any other central bank) purchases long-term bonds from banks and other financial institutions using newly created money. Now, when we use the term “newly created money” we do NOT mean that the Fed prints a whole bunch of brand new Ben Franklins ($100 bills, for those of you reading this outside the U.S.). Instead, the Federal Reserve makes an electronic entry in its computer system, indicating brand new money.
Let’s say that the Fed purchases $1 million of bonds. On its balance sheet, the Fed records a liability of $1 million reflecting the brand new (electronic) money that it created and records an asset of $1 million reflecting the bonds it just bought. The Fed’s balance sheet is now larger by $1 million than it was prior to the purchase.
Now let’s look at the balance sheet of the bank that sold the bonds. On the asset side, the bank now holds $1 million of additional cash (in the form of reserves) courtesy of the Fed’s new money. Also on the asset side, it has decreased its holdings of bonds by $1 million. Hence, there is no change to the net value of the bank’s assets (and no change to its liabilities).
The simple answer to whether quantitative easing is printing money is clearly yes, since the Fed creates new money in order to purchase bonds. As we’ve seen, the Federal Reserve’s balance sheet increases by $1 million. The commercial bank’s balance sheet doesn’t change (the makeup changes but not the amount). So the net effect to the entire system is a $1 million increase. However, to economists, the story does not quite end here.
Economists argue that while the Fed is technically creating new money, it is not actually increasing the money supply. And here we find that the question of whether or not QE is money printing is really a semantic argument rather than a true economic argument. In essence, it boils down to whether “printing money” is the same thing as “expanding the money supply.”
The argument that economists make is that what the Federal Reserve is really doing is an asset swap. The Fed is merely swapping newly created money for bonds. The key point economists are trying to make is that once the Fed owns those bonds, they are not really part of the economy and should not be counted as part of the money supply. In essence what economists are saying is that ONLY the private sector banking system, by making a new loan, can expand the true money supply. The central bank cannot expand the money supply by creating electronic money.
Is this true? First, it depends on what your definition is of the “money supply.” There is no one agreed upon definition of the money supply and in fact economists have different measures of the money supply (e.g. M1, M2, M3). Ultimately, you must pose the question, “what is money?” The true meaning of money is equally important, complex and misunderstood and something I do not dare tackle here, but hope to in a future (and much longer) post. For now, I reiterate what I said earlier in this post, that whether quantitative easing is or is not money printing is really a semantic discussion, and not an important one.
There are much more important, and economic (rather than semantic) questions to discuss regarding QE, which we will turn our attention to shortly. However, before moving on, I want to add one point to the discussion. I would argue that when the Federal Reserve purchased bonds from the private sector financial system, it paid MORE than fair market value, given its massive size and status. Hence, by overpaying (compared to what others would have paid), QE was not exactly a one-to-one asset swap.
For example (and I’m making up numbers here) if the true market value of a bond was $80 and the Fed paid $100 then the $20 difference should indeed be considered “money printing” even if you take the position that QE is, otherwise, an asset swap. To be fair, not being a bond trader, I have no idea to what magnitude the Fed overpaid but I would bet that they did, especially for the mortgage backed securities (MBS) that the Fed purchased (the Fed purchased both US treasures and MBS in its three rounds of QE).
There’s an additional argument that some economists and commentators make with regards to QE not being money printing. They claim that even though the Federal Reserve expanded its balance sheet by trillions of dollars under QE (and ZIRP), because there was no meaningful inflation (not to mention poor GDP growth and poor employment figures), Fed policy cannot and should not be considered to be “printing money.” I’ve written previously (here) a post on why the Fed’s extraordinarily loose monetary policy hasn’t led to inflation. Briefly, however, I believe this line of argument is faulty for two reasons.
First, it is erroneous to equate expanding the money supply with inflation. This fallacy is, in my opinion, one of the reasons why the Fed (and other central banks) have caused so much damage to the world’s economies. I have and will continue to write about this topic elsewhere, but simply put, measures of inflation such as the CPI and expanding the Fed’s balance sheet are two different things. It is even less true to say that the money supply can be equated to economic growth or employment.
Second, and much more importantly is the counterfactual. How do we know what would have happened in the absence of QE? We know that the U.S. economy (and many others) was facing enormous deflationary pressure after the financial crises. This is precisely why the Fed along with other central banks resorted to unprecedented and extraordinary policy. It is certainly possible, and perhaps likely, that absent QE, the economy would have experienced substantially lower GDP, lower employment (higher unemployment) and even lower inflation (or deflation).
If true, then QE was certainly inflationary even if the CPI was ONLY 2%. In short, to state that a massive amount of QE cannot be considered inflationary (or be considered printing money) simply because the economy did not overheat is bad science and holds no water since we have no idea what would have happened without QE.
As I wrote above, I believe that the question of whether quantitative easing is technically “money printing” or not, is a semantic one and of little importance. What is important are the following three questions: 1) what was the purpose of quantitative easing, 2) did it work and 3) was it justified.
What was the purpose of quantitative easing?
At the highest level, the goal of quantitative easing was to help the economy. First, to help prevent the economy from falling into a depression and to help stave off deflation (both, real fears to central bankers after the financial crises). Second, to help expand the economy faster, to reduce unemployment, grow wages and increase inflation.
Specifically, as we’ve already discussed, the Federal Reserve was buying long-term bonds (Treasuries and MBS) in order to reduce long-term interest rates. This was a new policy because historically the Federal Reserve only purchased short-term debt in order to target short-term interest rates. However, given that targeted short-term interest rates were already at zero because of the central bank’s zero-interest rate policy or “ZIRP,” the Fed decided to target long-term rates.
The stated goal of lower long-term interest rate was to encourage borrowing. For example (in theory), lower long-term rates should lead to lower mortgage rates, which should induce more people to buy new homes. Similarly, lower rates should make it cheaper and easier for businesses to borrow to build new factories or open new stores. The end result (again in theory) being more economic activity, higher GDP, more jobs and lower unemployment rates.
There were at least two other goals of QE, both significantly less talked about by central bankers, for what should be obvious reasons. One was to help members of the banking sector “repair” its balance sheets. The idea being that an unhealthy bank is unlikely to lend. A bank with a healthy balance sheet more likely to lend, and thus aid the economy. That’s the polite way of looking at it. The more cynical viewpoint is that QE represented further bailouts to the banking sector. (One of the reasons why, as I discussed above that I suspect that the Fed was paying above market prices, especially for MBS, whose value otherwise should have been marked down).
The second less discussed goal was to directly increase the price of financial assets. This idea is known in econ-speak as the “wealth effect,” an idea in which the Federal Reserve seems to believe. Other things equal, lower interest rates raise the value of all financial assets. The wealth effect posits that individuals whose financial assets have risen in value (and therefore have more wealth) will consume more. More consumption (other things equal) naturally leads to a faster growing economy, more investment and less unemployment.
Regardless of which of the Fed’s motives you believe were more important, in all cases the intent of QE was to spur lending in order to grow the economy faster (or prevent it from shrinking). And, as I stated above, every loan that the banking sector makes is considered an expansion of the money supply. So (and this is a key point), whether or not the act of quantitative easing by the central bank is technically “printing money” or not, the INTENT of QE is clearly to expand the money supply.
Did quantitative easing work?
Remember, the purpose of quantitative easing was to lower long-term interest rates in order to induce more lending, more investment, more jobs and more economic growth. Did it work? Well, after trillions of dollars of bonds bought by central banks, the answer is…wait for it…we have no idea. On the one hand, the U.S. economy (same story for other economies that experienced QE) did not experience very strong GDP growth, employment and wage growth, nor did headline inflation (CPI) reach the Fed’s target of 2%. On the other hand, economic growth, though weak, was at least positive, the employment rate did decline significantly and the economy avoided the Fed’s worst fears of deflation.
Economics is not a science primarily for the following reason: economists cannot run experiments. That is to say, economists cannot rerun the financial crises hundreds or thousands of times with and without quantitative easing to determine whether or not QE was effective. And as I stated above, we have no idea what the economy would have looked like in the absence of QE.
Personally, I would guess the following: quantitative easing was somewhat effective in preventing the worst effects of the post financial crises deflationary pressures and had somewhat of an effect on increasing GDP and reducing employment. I would further surmise that QE was nowhere near as effective as the Federal Reserve (and other central banks) had hoped.
Was quantitative easing justified?
Up until now, pretty much everything I’ve written would be considered mainstream economics. Here, in this final section, I will deviate. The question that remains, and the most important one in my mind, is SHOULD the Fed have engaged in quantitative easing.
It has become standard economics since Keynes in the 1930’s to focus exclusively on the short-term results of economic policy and to ignore the long-term effects. I’ve already stated that I believe that QE aided the economy in the short-term by increasing GDP and lowering unemployment. To mainstream economists, that is good enough. Not to me. The question that needs to be asked (but never is), is whether the long-term negative effects of quantitative easing outweigh the short-term benefits. I believe they do, and massively.
Quantitative easing (along with ZIRP) has re-inflated an asset bubble that has been trying to burst for 30 years and delayed the inevitable restructuring that must occur. It has bailed out banks and rewarded bankers that deserve, and need, to fail. It is has subsidized “investment” in non-productive financial activity such as M&A, stock buybacks and parasitic technology companies, all which destroy jobs, at the expensive of long-term job creating real investment. It has been the primary cause of increased income inequality, which if not reversed, will destroy liberty (and lives) throughout the world.
In the near-term some of us might be better off because of quantitative easing. In the long term, we are all worse off.