“It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank, so, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.”—Chair Ben Bernanke, 03/15/2009, answering Scott Pelley’s (60 Minutes) question “Is that tax money that the Fed is spending?”
What Fed Chair Bernanke WAS NOT talking about right there was federal gov’t deficit spending (aka vertical money creation) and he WAS NOT talking about non-federal gov’t deficit spending (aka horizontal money creation) either. Ben Bernanke was talking about the Fed’s emergency rescue lending to banks (support for auto loans, student loans, money market funds, mortgages, short-term lending for small business loans)—the first $1T of Fed money creation undertaken early in the credit crisis.
There’s a big difference between a vertical money creation during federal gov’t ‘borrowing’, plus a horizontal money creation by the non-federal gov’t (by our own actual borrowing); vs. a money creation by the Fed for that kind of emergency lending in 2009, or just like for the Large Scale Asset Purchases soon afterwards (for so-called QE). To help explain the difference, let’s call any money creation by the Fed a ‘diagonal’ money creation.
First, let’s do a hypothetical…
Imagine an Authority of Roads and their agent, an Emergency Towing Department, in their bid to maintain traffic flow by employing one four measures:
1) If traffic flow is balanced, the Authority doesn’t need to do anything except observe how many small cars are being organically added on the road.
2) If traffic flow builds up in concentrated places, the Authority takes small cars from those places and redistributes them to places that don’t have as many cars at all (which doesn’t add to the total amount of cars on the road).
3) If traffic flow is getting too light, then the Authority again takes action and distributes newly-created big cars (which intentionally adds to the amount of cars on the road).
4) If traffic flow has completely seized up due to an infrastructure crisis, then the towing department of the Authority clears the damaged roads by removing big cars off the road, reimbursing the big car owners, impounding the cars inside the towing agent’s parking lot (which adds the exact same amount to the assets & liabilities on the Authority’s balance sheet, while also changing by the exact same amount, the composition of the assets of the former, big car owner’s balance sheet); until the infrastructure crisis is resolved, after which the compounded big cars are sold back and return on the road (which reverts the amount of cars on the road back to the original amount before the crisis, while both the Fed’s balance sheet and the big car owner’s balance sheet reverts back to exactly where it was before the crisis…as if it all never happened).
Authority of Roads = Federal gov’t fiscal policymakers
Emergency Towing department = Central bank
Traffic Flow = Economic growth
1) = Private sector deficit spending facilitated by banks (horizontal money creation)
Small cars = Dollars
On the road = Into the private sector
2) = Federal gov’t surplus spending
3) = Federal gov’t deficit spending (vertical money creation)
Big cars = Treasury bonds (dollars with a coupon)
4) = QE & unwind
Infrastructure crisis = Financial crisis
Emergency Towing department’s parking lot = Central bank’s balance sheet
…and then next, here’s the actual:
During any ‘horizontal’ (endogenous) creation of dollars when the non-federal gov’t is deficit spending or ‘vertical’ (exogenous) creation of dollars when the federal gov’t is deficit spending, in both instances, dollars are being added to the banking system.
Furthermore (and this is the major point of the post), those ‘endo’ and ‘exo’ creations of dollars are always going into the NON-FEDERAL GOV’T (either into the non-federal gov’t / Domestic, aka private sector; or into the non federal gov’t /International, aka foreign sector).
QE was the exception…QE is an example of money creation where the dollars are being added to the banking system WITHOUT those dollars going into the non-federal gov’t.
The Fed created $4.2T to pay for all those bonds that the Fed bought during QE, which was federal gov’t money creation of $4.2T (that added $4.2T to the banking system) BUT THOSE DOLLARS STAYED IN THE FEDERAL GOV’T SECTOR.
Like many others, the bond ‘kings’ and hedge fund ‘stars’ thought that QE looked like vertical money creation, quacked like horizontal money creation, so they figured it probably was money creation going into the private sector (which would cause inflation, a bond sell-off, yada yada), and they placed their bets accordingly.
What everybody got wrong there, was that the $4.2T in money creation by the Fed for QE (unlike ‘exo’ money creation by Congress for deficit spending or unlike ‘endo’ money creation by banks for private sector deficit spending), DID NOT get injected into the non-federal gov’t (private or foreign sectors) like all deficit spending does.
QE was NOT a money creation for deficit spending, QE was money creation for a glorified swap. The $4.2T created by the Fed during QE added dollars to the banking system BUT ONLY added dollars to the Fed’s balance sheet AND DID NOT add dollars to the balance sheets of the non-federal gov’t private / foreign sectors.
During QE, the total amounts of assets on the balance sheets of those bondholders in the private / foreign sectors never changed. For the private / foreign sectors, QE was just a wash, just a swap, just a change in the composition of dollars (from dollars with a high interest-rate coupon to dollars without a coupon), and NOT a change in the total amount of dollars in the private / foreign sectors (and why QE didn’t cause any inflation). After QE is fully unwound, both the bondholder’s balance sheet and the Fed’s balance sheet revert back to where they were before QE, as if it all never happened. In addition, if you think about it, because the Fed bought those high-coupon (high-interest paying) bonds from the banks, meaning that the Fed started collecting the interest payments (instead of the banks), that $4.2T that the Fed created and added to the banking system was actually, counter-intuitively, a dollar DRAIN from the non-federal gov’t private / foreign sectors. Which is another reason why QE ‘monetary stimulus’, didn’t (nor will ever), cause much inflation, nor much stimulus (a sugar high to stock prices as dollars seeking yield get pushed off the curve, yes; but a stimulus, no).
You (monetary policymakers) can lead the horse (aggregate demand) to water (cheaper liquid financing) but you can’t make it drink. Fiscal stimulus is a job done only by fiscal policymakers in the Authority (and not to be confused with the monetary policymakers driving the tow trucks).
Thanks for reading,