December 2, 2013
Response to Gulliver Travails’ Comment on “Unless the Fed Goes Cold Turkey …”
Notice that my definition of TOTAL thin-air credit is the SUM of Fed credit and depository institution (bank) credit. This is important when analyzing the effect of a Fed purchase of securities FROM the banking system. So, let's start with that scenario -- the Fed purchases $X of securities from the banking system. If the banking system then uses the reserves created by the Fed to replace the securities sold to the Fed by acquiring $X of loans/securities from the nonbank sector, then Fed credit will have increased a net $X and banking system credit will be unchanged (it sold $X of securities to the Fed and purchased $X of loans/securities from the nonbank sector). In this case, the SUM of Fed and banking system credit increases a net $X. If the banking system has made a new loan to some entity, then presumably, that entity makes a new purchase of something -- a good, service and/or asset. If the banking system acquires a newly-issued security, then the security issuer -- a household, business and/or government, makes a new purchase of something. If the banking system purchases a "seasoned" security, then the seller of that security might purchase a newly-issued security, which, again, presumably would lead to new spending on goods/services in the economy. The seller of the security to the bank, might purchase another "seasoned" security. That's still another transaction resulting indirectly from the Fed's purchase of securities. Alternatively, the seller of the "seasoned" security to the bank might decide to use the proceeds to purchase a good/service, especially in a low interest rate environment when the inducement to postpone current consumption is so low.
Now, if the banking system purchases a "seasoned" security from the nonbank public and the seller of that security to the banking system chooses to simply hold more banking system deposits, then the Fed's purchase of securities will NOT result in a net increase in spending on SOMETHING by the nonbank public. But if the nonbank public has an increased demand for deposits TO HOLD, and the Fed had NOT, purchased securities, which enabled the banking system to purchase "seasoned" securities from the nonbank public, then the net change in spending by the nonbank public would have been NEGATIVE, rather than zero. That is, if the VELOCITY of bank deposits were decreasing and the SUPPLY of bank deposits were constant, then nominal transactions would have to fall according to the
identity: MV = PT.
Now, suppose again that the Fed purchases $X of securities from the banking system. But this time, the banking system does NOT replace these securities with new acquisitions of loans/securities. Rather, the banking system chooses to hold an extra $X of (cash) reserves. In this case, the net change in the SUM of Fed and banking system credit is ZERO. Fed credit increases by $X; banking system securities decrease by $X. In this case, there is no net change in spending by the nonbank public resulting from the Fed's purchase of securities. This is akin to the decline in velocity of deposits mentioned above. In this case, there is a decline in the velocity of RESERVES. I.e., the banking system desires to hold more reserves.
If the Fed purchases securities directly from the nonbank public, then the analysis is the same as the Fed purchasing securities from the banking system and the banking system using the newly-created reserves to acquire "seasoned" securities from the nonbank public. The only difference is that "middleman", the banking system, is eliminated from the sequence. Only if the nonbank seller of securities to the Fed desires to hold more deposits, i.e., there is a decline in the velocity of deposits, will there be no net increase in spending on SOMETHING in the economy.
Now, immediately after the failure of Lehman Bros., there undoubtedly was an increased demand for federally-insured bank deposits, i.e., a decline in the velocity of deposits. I would argue that to the degree that the Fed's first round of QE increased the SUPPLY of deposits as the DEMAND for deposits was increasing, QE cushioned the negative impact on nominal spending in the economy resulting from the decline in velocity. I suspect that now, five years after the onset of the crisis, the demand for deposits is gradually decreasing. So, an increase in the SUM of Fed and bank credit would likely result in increased net nominal transactions.
I have no doubt that the increased SUM of Fed and bank credit resulting from QE has played an important role in boosting the prices of risk assets. Would it be preferable for growth in nominal spending on goods/services to be weak AND the prices of risk assets be weak, too?
Although Fed QE may now be on the edge of creating excessive growth in the SUM of Fed and bank credit, I would argue that if the Fed had NOT engaged in QE after the 2008 crisis, economic performance would have been weaker than it has been. To those who argue that QE does NOT promote faster growth in nominal spending, I would counter that without QE, growth in nominal spending would have been even weaker.
Paul L. Kasriel