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Why the Fed's "QE3" Plan Won't Jumpstart the Economy - And What Would

What the country needs is money in the pockets of consumers and a focus on employment.
 
 
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The Fed’s announcement on September 13, 2012, that it was embarking on a third round of quantitative easing has brought the “sound money” crew out in force, pumping out articles with frighting titles such as “ QE3 Will Unleash’ Economic Horror’ On The Human Race.”  The Fed calls QE an asset swap, swapping Fed-created dollars for other assets on the banks’ balance sheets.  But critics call it “reckless money printing” and say it will inevitably produce hyperinflation.  Too much money will be chasing too few goods, forcing prices up and the value of the dollar down.

All this hyperventilating could have been avoided by taking a closer look at how QE works.  The money created by the Fed will go straight into bank reserve accounts, and banks can’t lend their reserves.  The money just sits there, drawing a bit of interest.  The Fed’s plan is to buy mortgage-backed securities (MBS) from the banks, but according to the Washington Post, this is not expected to be of much help to homeowners either.

Why QE3 Won’t Expand the Circulating Money Supply

In its third round of QE, the Fed says it will buy $40 billion in MBS every month for an indefinite period.  To do this, it will essentially create money from nothing, paying for its purchases by crediting the reserve accounts of the banks from which it buys them.  The banks will get the dollars and the Fed will get the MBS.  But the banks’ balance sheets will remain the same, and the circulating money supply will remain the same.

When the Fed engages in QE, it takes away something on the asset side of the bank’s balance sheet (government securities or mortgage-backed securities) and replaces it with electronically-generated dollars.  These dollars are held in the banks’ reserve accounts at the Fed.  They are “excess reserves,” which cannot be spent or lent into the economy by the banks.  They can only be lent to other banks that need reserves, or used to obtain other assets (new loans, bonds, etc.).  As Australian economist Steve Keen explains:

[R]eserves are there for settlement of accounts between banks, and for the government’s interface with the private banking sector, but not for lending from.  Banks themselves may . . . swap those assets for other forms of assets that are income-yielding, but they are not able to lend from them.

This was also explained by Prof. Scott Fullwiler, when he argued a year ago for another form of QE—the minting of some trillion dollar coins by the Treasury (he called it “ QE3 Treasury Style”).  He explained why the increase in reserve balances in QE is not inflationary:

Banks can’t “do” anything with all the extra reserve balances.  Loans create deposits—reserve balances don’t finance lending or add any “fuel” to the economy.  Banks don’t lend reserve balances except in the federal funds market, and in that case the Fed always provides sufficient quantities to keep the federal funds rate at its . . . interest rate target. Widespread belief that reserve balances add “fuel” to bank lending is flawed, as I explained  here over two years ago.

Since November 2008, when QE1 was first implemented, the monetary base (money created by the Fed and the government) has indeed gone up.  But the circulating money supply, M2, has not increased any faster than in the previous decade, and loans have actually gone down.

Quantitative easing has had beneficial effects on the stock market, but these have been temporary and are evidently psychological: people THINK the money supply will inflate, providing more money to invest, inflating stock prices, so investors jump in and buy.  The psychological effect eventually wears off, requiring a new round of QE to keep the game going.