We use money every day, and yet the functioning of our monetary system is still deeply misunderstood.
Without mastering the concept of money, connecting the dots in global macro is impossible.
Let's see how different forms of money impact the economy and markets.
A thread.
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Without mastering the concept of money, connecting the dots in global macro is impossible.
Let's see how different forms of money impact the economy and markets.
A thread.
1/
There are two main different tiers of money: interbank money and real-economy money.
That's your easy way to think about what operations are (at least short-term) inflationary and which ones are asset-price-inflationary only.
Who prints interbank and real-economy money?
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That's your easy way to think about what operations are (at least short-term) inflationary and which ones are asset-price-inflationary only.
Who prints interbank and real-economy money?
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Real-economy money is printed by governments and commercial banks.
If the govt spends more than it plans to collect taxes for, new money has been created.
Government spending (via deficits) increases the net worth of the private sector without adding a liability to it...
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If the govt spends more than it plans to collect taxes for, new money has been created.
Government spending (via deficits) increases the net worth of the private sector without adding a liability to it...
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...and unless households have to purchase Treasuries issued to fund the deficit spending, they now have more net worth than before.
New money has been created.
A bank making a new loan also literally creates new real-economy money...
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New money has been created.
A bank making a new loan also literally creates new real-economy money...
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...as banks don't lend reserves or existing deposits: as the Bank of England itself shows, when making new loans banks literally credit your account out of nowhere and hence create new deposits.
This is how real-economy money gets created.
Not via QE.
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This is how real-economy money gets created.
Not via QE.
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Can you see how this might be short-term inflationary?
Expansion of credit or net govt spending boosts aggregate demand: ceteris paribus and with a small lag, this pushes activity up.
2020-2021 is a prime example: massive credit creation = huge rise in nominal growth!
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Expansion of credit or net govt spending boosts aggregate demand: ceteris paribus and with a small lag, this pushes activity up.
2020-2021 is a prime example: massive credit creation = huge rise in nominal growth!
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Increase in govt or private sector credit = increase in the quantity of real-economy money.
Deficit spending (in most cases) adds net worth to the private sector w/o an attached liability, while private sector credit creation (e.g. mortgage) also adds debt to households.
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Deficit spending (in most cases) adds net worth to the private sector w/o an attached liability, while private sector credit creation (e.g. mortgage) also adds debt to households.
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Did you notice how I didn't mention Central Banks yet?
Now let's talk interbank money.
QE is a form to create interbank money: how does that work?
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Now let's talk interbank money.
QE is a form to create interbank money: how does that work?
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The Central Bank changes the composition of the asset side of the financial institutions' balance sheet: it takes away bonds, and swaps them for reserves.
The interbank system as a whole can't refuse this transaction; there is always a marginal clearing price for QE.
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The interbank system as a whole can't refuse this transaction; there is always a marginal clearing price for QE.
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In other words, it's a forceful asset swap: bonds out, reserves in.
Now, the trick is that reserves are NOT money for the private sector: they are money for banks.
Banks don't lend reserves; you can throw as many as you want to them, and it won't change their stance...
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Now, the trick is that reserves are NOT money for the private sector: they are money for banks.
Banks don't lend reserves; you can throw as many as you want to them, and it won't change their stance...
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...and Japan showed us that in the early 2000s already.
Bank reserves (red) doubled (!) in 5 years as the BoJ went on with QE, and yet bank loans (red) shrank by 25% in the same period.
With double the amount of reserves, banks lent less.
Why?
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Bank reserves (red) doubled (!) in 5 years as the BoJ went on with QE, and yet bank loans (red) shrank by 25% in the same period.
With double the amount of reserves, banks lent less.
Why?
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When lending, banks look at 3 things:
- The creditworthiness of the borrower
- The loan yield they can generate
- The capital they need to put up against the loan
If there is a good trade-off amongst these 3 variables, they lend. Otherwise they don't.
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- The creditworthiness of the borrower
- The loan yield they can generate
- The capital they need to put up against the loan
If there is a good trade-off amongst these 3 variables, they lend. Otherwise they don't.
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Hence, throwing a bazillion reserves at the banking system doesn't affect much their willingness to lend (i.e. to create new real-economy money).
QE also prints bank reserves, which are not a form of money...
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QE also prints bank reserves, which are not a form of money...
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...for the private sector, but only money for banks (i.e. interbank liquidity).
But what if the Central Bank buys from a non-bank?
New ''deposits'' are created: this must be real-economy money, right?
No.
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But what if the Central Bank buys from a non-bank?
New ''deposits'' are created: this must be real-economy money, right?
No.
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If PIMCO sold bonds to the Fed during QE, PIMCO now has deposits at a bank
PIMCO can't be spent these deposits in the real economy, but can instead be used to purchase financial assets
QE only prints money for the financial sector
Inflationary money is instead...
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PIMCO can't be spent these deposits in the real economy, but can instead be used to purchase financial assets
QE only prints money for the financial sector
Inflationary money is instead...
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...mostly represented by bank deposits held by the non-financial private sector and physical cash
Central Banks cannot print real-economy money, but instead they can print interbank money (reserves)
Remember these two tiers of money: real-economy and financial-sector money
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Central Banks cannot print real-economy money, but instead they can print interbank money (reserves)
Remember these two tiers of money: real-economy and financial-sector money
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But Alf, people can withdraw money from ATMs and banks hence must convert reserves into cash
This way, reserves can reach the real economy!
No
When somebody withdraws from an ATM, it's simply swapping bank deposits for cash: one form of existing real-economy money...
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This way, reserves can reach the real economy!
No
When somebody withdraws from an ATM, it's simply swapping bank deposits for cash: one form of existing real-economy money...
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...for another: no new money has been created.
Your checking account goes down in $$$ by the very exact amount of the physical cash you withdraw from an ATM.
Reserves DO NOT enter the real-economy.
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Your checking account goes down in $$$ by the very exact amount of the physical cash you withdraw from an ATM.
Reserves DO NOT enter the real-economy.
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20 years of QE didn't generate inflation because...well, QE is not inflationary
Credit creation instead boosts aggregate demand and it can lead to inflationary pressures
That's exactly what we have seen in 2020-2021: massive fiscal deficits & govt-sponsored bank lending...
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Credit creation instead boosts aggregate demand and it can lead to inflationary pressures
That's exactly what we have seen in 2020-2021: massive fiscal deficits & govt-sponsored bank lending...
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...ended up overheating the economy with super strong real GDP growth and inflationary pressures on top.
That real-economy money is NOT printed by Central Banks.
They instead print interbank money (reserves).
Don't mix different tiers of money up.
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That real-economy money is NOT printed by Central Banks.
They instead print interbank money (reserves).
Don't mix different tiers of money up.
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