Wednesday, August 24, 2011

Gov Rick Perry was Wrong

It has been over week since Rick Perry in one of his first idiotic statements as a Presidential candidate suggested the Fed Chairman Bernanke was treasonous. Part of his statement was
“Printing more money to play politics at this particular time in history is almost treasonous in my opinion.”
His apparent dislike of playing politics, which is his game, and giving it an historic perspective made it sound positively profound for a few milliseconds until he threw in treason, which carries the death penalty.
The mainstream media had a field day with his lack of Presidential perspective. But, none questioned the truth of the Fed printing money. That’s where we come in.
Clearly, Gov. Perry was referring to the Fed’s purchase of Treasuries in what has been called Quantitative Easing. QE is not “printing money,” a term used by conservatives to conjure up the specter of uncontrolled inflation. Actually, QE was ineffective as students of modern money expected.
QE and Gov. Perry’s remarks were based on an outdated understanding of old monetary theory that says bank lending is constrained by bank reserves. You may have heard of the old multiplier effect that says: If banks must hold in reserves 10% of their customer deposits, then when one deposits $100 dollars in the bank, the bank can loan out $90, when that is deposited in a bank that bank can lend $81, and the next bank 0.9 x 81= 72.9, and so on. After some more math, we conclude that the multiplier is 10. So, a total of $1000 can be loaned by the banking system.
With modern money banks are not constrained by reserves but only by their capital and the availability of creditworthy customers. So, what does this have to do with QE? Well, QE raised the level of excess reserves in the vain hope that it would encourage lending.
Previously, (here and here) we have discussed how excess reserves are converted into national debt (Treasury bonds) as the Fed tries to maintain its target interest rate and banks try to minimize their excess reserves.
Remember, Treasuries are just interest-earning savings accounts at the Fed. They don’t even come with a gold embossed piece of parchment, they are just numbers on a spreadsheet. Said Treasuries arose from the Fed selling them to drain excess reserves from the banking system. Under QE, buying the Treasuries back returns them to being excess reserves in various bank checking accounts. It is just like someone converting a Certificate of Deposit at a bank back into a checking account. The net balance of one’s wealth is unchanged except for the interest earned.
The consequence of this action is that excess reserves are no longer maintained at zero balance. The excess reserve are now large and the overnight bank rate is driven to about zero. The Fed has recently announced that it will keep that rate at zero for a couple of years. The chart below shows this increase in excess reserves graphically.
Excess reserves as a result of Quantitative Easing, which changed Treasuries back into the reserves from which they sprang.
That $1,600 billion is not new money. It is old money converted back to checking accounts.
What does this mean to you? You won’t be getting any interest on your bank savings accounts for a couple of years, because the banks can get money from the Fed at 0.25% or less. It also means that banks don’t have to charge as much on loans. So, car and house loans will carry less interest. 
Another consequence is that those Treasuries are earning no interest out in the private sector. At say 4% interest that $1,600 billion would have earned $64 billion which is now lost to the private sector. That should be a gain for the deficit hawks.
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