Is QE equivalent to “printing money” ?

HelicopterMoney

 

Since the launch of quantitative easing (QE) by the major central banks, numerous economic commentators and especially journalists are equating QE and “money printing”. This is of course interesting, as money is generally very precious, yet not completely understood by the public and this is troublesome, given the paramount role of ‘money’ in society.

I will try to explain here why it is misleading to equate QE with money printing, and also I will try to explain how QE induces money creation.

For these purposes we need to build a very simple model of our monetary economy. Let us first suppose that we have a Central Bank (CB), a (commercial) bank and an institutional investor (II) be it a pension fund. Moreover, we implicitly assume that there are households, firms etc. who need capital markets for financing.

First of all, let us define a couple of important concepts (simplification)

-Central bank money =commercial banks’ deposits at the central bank + notes and coins in circulation. These are liabilities of the central bank.

-Public Money = Deposits of households and firms and government at the commercial banks. These are liabilities of the commercial banks. This is nowadays what we call casually ‘money’, given that the use of cash is diminishing.

We assume that initially the commercial bank (all banks in the economy) in the economy holds 100 euros worth of bonds issued by the government and firms. The pension fund holds lets say 300 euros worth of same bonds. So the total outstanding amount of bonds in the economy is 100+300=400.

The initial balance sheet of the commercial bank is assumed to be consisting of some assets, say loans worth of 900 euros and the loans and bonds held are financed with 950 euros of deposits and 50 euros of equity. The balance sheet of the commercial bank looks like this:

Assets                                 Liabilities

Loans 900                          Equity 50

Bonds 100                          Deposits 950

The central bank then proceeds with QE. It buys the whole portfolio of bonds from the commercial bank crediting the bank’s account at the central bank with 100 euros. The balance sheet of the bank looks like this:

Assets                                Liabilities

Loans 900                         Equity 50

CB deposits 100              Deposits 950

Now the commercial bank is not happy, as the account at the central bank is costly (-0,4% p.a. in the Euro area), so it wants to compensate this negative carry by buying a lot of government bonds from the pension fund. This is the so called “portfolio (rebalancing) effect”. Do note that the sovereign bonds are “risk free” in the sense that they do not require any regulatory capital. The pension fund holds a checkings account at the commercial bank.

The bank now credits the pension fund’s account with 200 euros and gets in return 200 euros worth of sovereign bonds. Now the bank’s balance sheet looks like this

Assets                                  Liabilities

CB deposits 100                Equity 50

Bonds 200                         Deposits 1150

Loans 900

The same economic effect for the bank can be achieved by extending new credit to households and firms. It improves the net interest income and therefore the bank has an incentive to expand its balance sheet, if there is sufficient capital available. This effect is especially strong now, because of negative interest rates.

So we notice that balance sheet of the commercial bank did not increase directly due to QE and hence that the amount of public money did not increase directly due to QE. However, when the banking system is induced to buy new bonds or to issue new loans, due to rebalancing effects the amount of public money is increased as a second-order phenomenon.

In other words, QE is not “money printing” as such, because the first-order effect just increases the amount of central bank deposit money, which is not used by the public.

On the other hand, if the central bank wants to buy all/large amounts of bonds held by the bank and the pension fund, the bank needs to buy these bonds first from the pension fund in order to sell them to the CB, which creates new public money (the bank credits the pension fund’s account). On the other hand, this money is at the hands of the pension fund and as such does not create directly any additional purchasing power as the fund needs to have certain amount of assets to cover its pension-related liabilities.

Is the debt burden lower for central goverments due to QE ?

No, not really. Even though most central banks are owned by the central government, the debt is still there and if the CB decides to taper, i.e. to start divesting and let its balance sheet shrink, the maturing government debt must be refinanced by selling new bonds to private investors. Therefore QE is not about cancelling government debt. Some of coupon interest ends up cancelled because the CB profits are distributed to the central government.

Problems with QE

Even though QE might work to fight deflation, it is not particularly efficient at that. Moreover, QE creates huge amounts of central bank money, which usually causes a euphoria in the asset markets as banks want to buy bonds and stocks with their excess reserves. Over-valued asset markets might cause problems in terms of financial stability. Moreover, as QE inflates asset prices, the distribution of wealth tends to favour the rich as the rich own more assets than the poor. This is not trivial in terms of social justice. Finally, at least in the Eurozone, QE has increased the level of TARGET2 imbalances and the general level of credit risk for the central banks. This might be trouble in terms of budgetary sovereignty of national parliaments. Moreover, the solvency of various entities might be zombie-solvency, because debt sustainability might be very different with a “normal” yield curve. This is especially so as QE includes corporate bonds as well.

Therefore fiscal policies (lowering taxes/increasing public investment) would be in general more efficient and socially justifiable solutions fighting deflation. Of course in the Eurozone this is very difficult.

Conclusion:

QE in its purest form (no buying of bonds by the banks) is not equal to money printing as it only increases the amount of central bank money deposits. However, in practice because of of the portfolio rebalancing and because of the scale of QE , banks do create new money to fund their bond-buying from institutional investors.

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