A research paper featured in the 2014 Q1 Bank of England Quarterly Bulletin calls it a “misconception” that a "central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money.” It is quite clear, however, despite the research-paper authors’ protestations to the contrary, that central bankers, in practice, believe this “misconception.” Central Bankers even extoll this “misconception” with the adulatory term, “the money multiplier approach." This central bank shibboleth is at the heart of the quantitative easing (QE) policies of the U.S. Federal Reserve, the Bank of Japan, the Bank of England, the People's Bank of China and, as of last Thursday (1/22/15), the European Central Bank.
The theory of QE is easily stated: Central banks conjure money. Their black magic has succeeded, at least with electronic impulses recorded in account books, where the alchemists of old failed. Indeed, the central banks’ legerdemain is even more powerful. The alchemists at least had to start with something physical in their attempts to create gold from lesser stuff. But the central bankers create money, i.e., real purchasing power, ex nihilo, meaning “out of nothing.” And that “nothing” is exactly what backs this demon seed, but for the belief in central bankers and their omnipotence.
Once created, the new money is used by the central bank to purchase bonds (generally sovereign debt and mortgage obligations) from commercial banks. (The Bank of Japan is even purchasing stocks with their newly created yen.) Per the central banks’ theory, the commercial banks, in turn, will loan that fresh liquidity to commercial and retail borrowers. The borrowers then will deposit the loaned funds into their own bank accounts, triggering the fractional reserve “transmission system,” compounding the amount of money in circulation. The increased money in circulation is supposed to stimulate demand for both financial assets and consumer goods and services, hereby “fueling” an economic recovery, including production increases and the job creation that accompanies it.
Sounds wonderful, as the central bankers proclaim it. Problem is, it does not work.
Why? One simple reason. It is not a surfeit of credit (i.e., bank liquidity sourced from central banks) that causes good loans to be made by commercial banks. Good loans, by definition, can be made only when borrowers are able to use credit to build or purchase assets that enhance profitability, creating free cash flow with which the loans can be serviced and ultimately repaid. But a surfeit of credit, particularly credit in the hundreds of billions, shot out of central bank QE fire hoses, facilitates bad loans—and lots of them. These bad loans, or what F.A. Hayek would call “malinvestments,” ultimately result in credit bubbles that burst and wreck the economy. This is the “crack-up boom” described by Mises in his magnum opus, first published in 1949, Human Action. One need look no further than the 2008 housing bubble for proof of this chain of causation.
The genesis of the 2008 housing collapse was Federal Reserve–created, too-cheap credit forced into the economy pursuant to the political mandate of the Community Reinvestment Act (CRA). The CRA facilitated hundreds of billions of dollars in subprime home mortgages that ended up on the books of Freddie Mac and Fannie Mae, government-sponsored enterprises that had the implicit guarantee of the U.S. government. The transmission system for the guaranteed credit was the money center banks, whose managers were only too happy to push bad loans for the fees they generated, both on origination and on sale into Wall Street securitization packages. These securitized bad loans ultimately were purchased by pension funds, retirement funds, hedge funds and sovereign wealth funds worldwide.
QE, which creates bank liquidity not demanded by the real economy, is, as Keynes himself acknowledged, “pushing on a string.” The fact that banks have more fiat money to lend does not mean that firms and individuals have an economic use for that liquidity. As the late Professor Hyman Minsky pointed out, consumers and nonfinancial private-sector firms do not borrow simply because rates are low. In order to borrow, rational real businesses and rational real consumers must believe that they will be able to repay any credit they assume. In the case of businesses, they have to see the market for their goods or services as stable and likely to increase in the short to medium term. As for consumers, they have to believe that they have job security and the possibility of wage increases in the short to medium term.
For example, think about the potential first-time home-buying couple who have been experiencing stagnant wages, perhaps are experiencing higher health-care costs as a result of Obamacare’s insurance-premium increases, and who see their college-educated friends unable to find employment paying sufficient wages to service their student-loan debt. That couple, who witnessed the carnage of the housing market a few short years ago, will not be inclined to commit to a mortgage, even at a historic low rate. This is particularly true when the press reports, accurately, that housing prices are increasing as a result, not of higher individual-family demand, but as the result of central bank–funded hedge-fund purchases to turn single-family homes into rental units. Perhaps that couple also are anticipating the new carnage that will result when the hundreds of thousands of investor-owned single-family homes bought with QE funds begin to hit the resale market (as hedge-fund managers try to complete their investment cycle).
So if firms do not borrow the newly created money for profit making, self-liquidating opportunities, and if individuals do not borrow the newly created money because they lack confidence in their future economic conditions, where does all that liquidity go?
Only to bad uses. First among these bad uses is more lending to bankrupt governments—more of the “kicking the can down the road” theory of government finance beloved by politicians. Even better for the politicians is the transmission mechanism by which the newly created QE money reaches the bankrupt governments’ coffers, because that transmission mechanism means even higher profits for the politicians’ banking and financial industry cronies and more political contributions therefrom.
Here is how that logrolling works: institutional investors borrow the new money and buy government bonds. Why would they do that? It is certainly not because these investors crave the microscopic yields available on government bonds. Indeed, current government-bond yields are so low that James Grant, publisher of the iconic Grant’s Interest Rate Observer, recently quipped that there were “no interest rates to observe.”
It is certainly not because these institutional bond buyers have confidence that the currencies in which the bonds are denominated will strengthen. After all, the entire point of QE is to debase the QE currency (in a “race to the bottom” that is intended to facilitate exports.
It is certainly not because these investors believe that the bond-issuing nations’ economies are going to grow at a rate fast enough to turn government deficits into government surpluses and drive down interest rates, increasing the market value of the bonds. For example, the inflation-adjusted average growth rate of U.S. GDP between January 2009 and September 2014 was below 1.9 percent, while at the same time, the gross, on U.S. National Debt increased, on average, by slightly less than 10 percent each of those years. Even accounting for annual inflation, which averaged 1.6 percent over that period, the average increase in the U.S. National Debt exceeded 8 percent per year. (Of course, the off-budget national debt, i.e., the net present value of the unfunded liabilities of the Federal government, e.g., Medicare, Medicaid, Social Security, Freddie Mac, Fannie Mae and Federal employee pension obligations, exceeds, according to Professor Laurence Kotlikoff, $200 trillion.
Institutional investors buy these ultra-low yielding government bonds for one reason only: for the guaranteed arbitrage opportunity that is realized as the central bank, once committed to QE, immediately uses the newly created fiat money to buy these obligations. Indeed, the arbitrage opportunities are enormous. According to Fortune, “[a] recent study by a Fed economist [Zhaogang Song] and one from MIT [Haoziang Zhu] estimate that Wall Street firms may have made as much as $653 million in fees selling bonds to the Fed.”
Although the buy-sell arbitrage spreads in favor of the institutional investor may be small, when dealing with billions of dollars or euros, even a two basis point (two one-hundredths of one percent) spread can mean a profit of 200,000 dollars or euros per billion bought and sold. This is free money, earned without any risk. The arbitrage profits drop directly to the bottom lines of the arbitrageur banks and financial institutions, fattening bonuses and increasing share prices and stock-option values.