QE stands for Quantitative Easing, which is a monetary policy tool used by central banks to stimulate the economy by increasing money supply.
This is the most common statement made in relation to QE: This injection of new money into the financial system increases the reserves held by banks, giving them more money to lend to businesses and individuals.
With more money available for lending, interest rates may be pushed lower, making borrowing cheaper and encouraging more investment and spending in the economy.
By increasing the demand for government bonds and other financial assets, QE also tends to push up their prices and lower their yields. This can encourage investors to shift their money into riskier assets, such as stocks or corporate bonds, which can also stimulate economic activity.
There are many who suggest that QE does not work because the Government, in effect, swaps one liability (Bonds) for another liability (overnight cash borrowing). If the amount of liability doesn’t change, then the net effect should be zero.
Every liability in the financial system is matched by a corresponding asset. This relationship holds true in every financial transaction. The owners of financial assets may change but nevertheless stays in existence until the corresponding liability is paid off.
This is what happens with, say a $10million Government bond, owned by a fund manager. The bond is the asset, and the liability is the indebtedness of the Government.
If a fund manager owns a Government bond, that fund manager cannot “spend” the bond easily. I say easily because the fund manager could borrow cash against the bond and make another investment. That strategy involves gearing the bond investment, so that action would not be as prevalent as spending cash in the bank.
So, the fund manager swaps a government bond asset for a cash asset. That fund manager therefore is likely to purchase another security, considering that when cash rates were zero, the attractiveness of a zero return was a least preferred option.
The mechanism of buying hundreds of billions of dollars of government securities, semi government securities and mortgage back securities had the effect of increasing bank deposits in the system by the same amount. We obviously saw the effects of the asset bubble since the Covid stimulus.
A less talked about effect of QE is the additional leveraging effect the massively increased bank deposit causes.
Lets follow the steps through:
Asset Liability
Fund Manager owns bond – $10m Government bond liability – $10m
RBA buys bond from fund manager.
Asset Liability
Fund Manager bank deposit – $10m Government cash liability – $10m
Admittedly, the RBA buys the bond with a corresponding liability in the exchange settlement account. As the RBA is a government owned entity, the net effect is the same.
Now lets look at a situation where the fund manager, rather than purchasing an existing security, they lend $10m on a new loan to XYZ Ltd (ie they create a new liability).
Asset Liability
Fund Manager bank deposit – $10m Government cash liability – $10m
Fund Manager pays XYZ Ltd – ($10m) XYZ Ltd – Loan Liability – $10m
Fund Manager bank deposit – NIL
XYZ Ltd – Bank Deposit – $10m
Net effect:
Asset Liability
XYZ Ltd – Bank Deposit – $10m Government cash liability – $10m
Fund Manager Loan to XYZ – $10m XYZ Ltd – Loan Liability – $10m
So, QE allows for an increase in money supply which allows the bank deposit holders to push up the price of a range of existing assets. Additionally, it allows for non-bank lenders to add greater credit to the financial system.
Now, lets come back to this statement:
“This injection of new money into the financial system increases the reserves held by banks, giving them more money to lend to businesses and individuals”.
Bank Deposits are assets of Households/Corporates/Fund Managers etc. They are not assets of the banks; they are liabilities of the banks. Banks can’t lend liabilities.
Do you agree with all these points? Drop me a line and let me know.
