QE for Makers - Part 1: Quantitative Easing and Money Printing Myths

In tech and entrepreneurial circles, a prevailing myth persists: Quantitative Easing (QE) is money printing. Positioned as the ultimate monetary policy weapon, the FED itself promotes the narrative that QE creates money from the press of a key. Further amplified by viral memes - money printer go brrrrr.

In the post-Covid era, misconceptions about it’s sibling, Quantitative Tightening (QT), have also emerged. With the QE money printer switched off, the FED is actively draining the liquidity it once injected into the global economy, leading to a massive de-leveraging and wealth destruction.

These opinions on money printing and the FED are increasingly prominent in tech, I suspect Digital currencies have played a strong part. In the tech world they are like a rowdy neighbor, with narratives on macroeconomics and QE spilling into broader founder and tech circles. It’s attained an almost revered status, serving as a bedrock for crypto’s criticism against central banks.

Why does this matter? In the tech landscape, misguided beliefs position startups as beneficiaries of mythical "free money”, inadvertently shaping venture capital trends and investment directions. These misconceptions are most evident during significant economic shifts or volatile tech funding periods. Misunderstandings about QE and 'money printing' add complexity, diverting founders into misguided choices.

On my I've been in discussions with priminent

In my prior article, I shared my journey during the post-COVID e-commerce surge. While I exited the fray through an acquisition, many peers grappled with shattered funding and IPO dreams due to macroeconomic misinterpretations. If you missed it, catch up here.

That acquisition journey was the driver for this series. To elevate understanding at the nexus of tech and finance. We’ll dissect the actual mechanics of "money printing”, its genuine impact on startups, and its ripple effect on the wider market landscape.

So spoiler alert: QE is not quantitative, it doesn’t ease and there's no money printed. We will learn while QE changes the composition of money, it doesn't involve or impact its creation. Moreover, there's minimal direct correlation to inflation, stocks, assets, or consumer behaviour. So, let's dive in and unravel these misconceptions.

Money creation primer

Before we delve into the intricacies of QE, we should take a detour into money creation. If you've ventured down the maze of central banking and QE, you've likely moved past the initial misconceptions about money. The widespread public belief that the government dictates the amount of money in circulation, with banks keeping our cash safe in their vaults. Banks can then lend a portion of the cash in their vault out to individuals and businesses. Perhaps also a vague image of a government-operated printing press, churning out money through some shadowy process.

In the tech neighborhood, Bitcoin is like the boisterous neighbor whose conversations about central banking, fiat, and money printing can be heard across the street. In some ways, it's understandable; how could engineers not be drawn into discussing programmable money?
What ever your thoughts are on digital currencies, having tech founders venture into discussions on latest acronyms from the FED's toolkit and pushing finance and money topics into tech is overall positive. It enhances our macroeconomic lens.

The downside is the misconceptions that follow, sidelining the complexities of banking and money. Unfortunately, these can also become entrenched mantras. So, before getting to QE, we need to clear the air on fraction reserve lending. Core to this are “reserves”.

Bank Reserves:
Bank reserves are a unique form of digital currency, distinct from the money used in the broad economy. These reserves are held by financial institutions with the Federal Reserve (FED). ~Emil Kalinowski~ aptly describes them as "interbank tokens." While these tokens are pivotal for daily operations and facilitating transactions between banks, they don't circulate in the broader economy. In essence, they are just tokens. Confined to the banking system and cannot be used for regular commercial transactions or by the general public.

This distinction of reserves and money is essential to understand. Many of the misconceptions on money, central banking, credit creation stem from here. Emil’s description of bank tokens is helpful to frame them as being distinct and separate from money. So we’ll use that term in place of reserves where we can. With this understanding that reserves are not money, but instead tokens held at the central reserve, we can more back to fractional reserve banking.

Contrary to the notion that banks are mere vaults of cash, thanks to our rowdy crypto neighbours, the pervasive thinking in tech circles has shifted. Banks, it is thought, play a multiplier role in the money creation process. Here's how it typically unfolds:

• A bank receives $100, either from customer deposits or created QE "money printing"
• Banks are required to keep 10% of this $100 in reserve. Then, with the stroke of a key, can create $90 in new money and lend another customer.
• This $90 then circulates in the economy, finding its way into other banks. These banks then create another 90% of $90 as new money ($81). This cycle continues until the loaned amounts become negligible.
• From the initial $100, a massive multiplier is achieved based on the 10% reserve requirement.

Central banks have the ability to create money, and commercial banks play a role in amplifying this effect. The outcome? A rapid increase in the money supply, loosely anchored by reserve requirements, leading to a continually expanding credit creation process. This is all underpinned by the principles of fractional reserve banking. From my experience, it's the prevailing narrative in tech and founder circles. But, it's wrong. Let's dissect these misconceptions.

Misconception 1: Banks don't need customer deposits or reserves to issue credit. That loan you secured for home improvements or a vacation? It's not sourced from other people's money. It's new money. To the bank, this new money is both a liability (the bank owes it to you) and an asset (it holds value, assuming you remain creditworthy). While the actual flow of funds in this process is more intricate (considering spending, regulatory oversight, and the involvement of various financial institutions), it's essential to understand that lending creates new money. It isn't just a redistribution of existing deposits, while keeping some back in “reserve”.

George Gammon raised this well. When was the last time you or anyone else you know went to get a loan, only to be told "sorry, we're out of reserves and deposits, try again next month". Never.

Misconception 2: Banks do not need reserves (either from customer deposits or from borrowing) to make loans based. Reserves are not a limiting factor. Instead, banks first create loans, which simultaneously create deposits. The act of lending is primarily constrained by the bank's assessment of the creditworthiness of borrowers and the bank's capital requirements, rather than its reserves. After making the loan, the bank might end up needing reserves for settlement purposes or to meet reserve requirements. If it's short on reserves, it can borrow them in the interbank market or, as a last resort, from the central bank.

Misconception 3: Reserves ≠ Money. When a bank receives a deposit, like $100, there's a widespread belief that the “reserve requirement” means earmarking a portion, say $10, as a "reserve" in a digital vault. This money is imagined to be set aside, ready for when depositors request their funds or if loans default. However, this isn't the case. It's crucial to remember that bank ~reserves~ tokens are not money, and money can’t be transform into bank reserves tokens.

Misconception 4: The traditional money multiplier model suggests that there's a direct and predictable relationship between central bank reserves and the total money supply in the economy. According to this model, if the central bank injects reserves into the banking system, it will lead to a multiplied increase in the broad money supply because banks will lend out a portion of their reserves, which will then be redeposited and relent, and so on. However, this view has been challenged, especially in light of modern banking operations. The period of excess reserves post-2008 provided empirical evidence that challenges the traditional money multiplier concept. It showed that simply having excess reserves doesn't automatically lead to proportional increases in lending. The credit supply is influenced by a myriad of factors, including banks' risk appetite, regulatory environment, and broader economic conditions, not just the level of reserves.

So what constrains bank lending? Instead, the lending process is more about the bank's confidence, the creditworthiness of borrowers, and the overall economic climate. The money multiplier effect, as traditionally taught, is thus a simplified, backwards and inaccurate representation of how modern banking systems operate.

In summary, while the regulation is onerous and complex, banks can effectively just create money as and when they want. A simple adjustment their digital ledger. We also learned that bank reserves tokens are not required initially to “finance” bank balance sheet expansion via rising excess reserves. In practice, the sequence is reversed.  Banks simply lend, create deposits and secure the necessary reserves, always supplied by the central bank. Repeat After Me: Banks Cannot And Do Not "Lend Out" Reserves. Finally, we covered the money multiplier myth and the role of bank tokens. Despite a surge in bank tokens post-2008, lending did has not increased proportionally.

With this understanding of money creation and reserves, we can refocus on QE and its alleged role as a money printer.

The Legacy of Political Deceit

Throughout history, political deceit has left indelible marks on the public's trust. From the shadows of the Watergate scandal, which was initially dismissed as a "third-rate burglary" but later unraveled into a tale of political espionage, to President Bill Clinton's emphatic denial, "I did not have sexual relations with that woman," only for the truth to surface later.

In a parallel strand of deliberate misinformation, the domain of monetary policy has also been clouded by a deliberate spread of misinformation. Consecutive Fed chairs, the highest-ranked officials at the core of our monetary system, have intentionally crafted the narrative they process a digital money printer. The ability to create dollars with force and precision across the world.

In a 2009 interview on "60 Minutes," Ben Bernanke, then the Fed chair, explained how the Fed can produce money digitally. When asked if that's tax money they're spending, he replied

It's not tax money... We simply use the computer to mark up the size of the account.

Fast forward to 2020, amidst the economic turmoil of the COVID-19 pandemic, Jerome Powell, the Fed chair further honed this message during another "60 Minutes" appearance. He confidently showcased the presence of a digital money printer and its pivotal role in the financial landscape.

POWELL: We print it digitally. So as a central bank, we have the ability to create money digitally.
….
PELLEY: Fair to say you simply flooded the system with money?
POWELL: Yes. We did. That's another way to think about it. We did.

However, once you delve into the mechanics of QE, it becomes clear not just why these statements are inaccurate, but also why the Fed wanted the public to believe in them. When a lie is repeated often enough, it starts to wear the cloak of truth. In the world of monetary policy, if people believe the central bank can and is printing money, then the effects of that belief can ripple through markets and economies, even if the underlying premise is false.

Unlike the deceptions of Nixon and Clinton, which were laid bare for all to see, these monetary mistruths persist.

Understanding Quantitative Easing

To dispel the myth of "money printing" associated with Quantitative Easing (QE) and bank reserves tokens, we next need to dive into another fundamental concepts: asset swaps. With a clear understanding of bank reserves tokens and assets swaps, we can unravel the mechanics of QE, showcasing how it doesn't create new money but rather changes the composition of existing money through specific swaps.

Asset Swaps:
An asset swap is fundamentally about exchanging one type of asset for another while ensuring the overall value remains unchanged between the parties involved. In the realm of startups, this can be likened to a company trading a portion of its equity for cash during an investment round. The startup hasn't magically generated new value; instead, it has transformed a slice of its ownership (equity) into liquid capital (cash). In a similar vein, during QE, the central bank exchanges its reserves for financial assets with other financial institutions.

Mechanics of QE through Balance Sheets

Now we understand the building blocks, we should introduce the parties involved:

• Treasury Department: The Treasury Department of the government is responsible for raising funds to cover government expenditures. They do this by auctioning off debt in the form of U.S. Treasury Securities (USTs), which are essentially government bonds.
• Primary Dealers: Primary dealers are major financial institutions selected by the central bank to participate in the UST auctions and act as trading counterparties in the central bank's open market operations. They play a crucial intermediary role between the Treasury Department and the central bank.
• Central Bank (Federal Reserve): Responsible for implementing monetary policy, which includes actions like QE. During QE, the central bank purchases financial assets, mainly USTs, from primary dealers with the goal of influencing economic conditions, particularly interest rates.

For those accustomed to startup finances, the balance sheet is a familiar tool. Using this framework, let's delve into the QE process, step by step. So now we’ve introduced the building blocks (assets swaps and reserves) our participants (the FED, Primary Dealers and the Treasury Department), we can walk through the balance sheet mechanics that lead to QE.

Balance sheets before QE

On the balance sheet of a primary dealer, these acquired USTs are classified as assets. They hold value, can be traded in secondary markets, and may generate interest income for the dealer. Alongside USTs, primary dealers typically maintain bank reserves on their balance sheets.
Again,  they may seem like "cash," they are, in fact, a distinct form of digital money that can only be used within the banking system. These reserves serve various purposes, including meeting regulatory requirements, facilitating interbank transactions, and potentially serving as collateral for various financial activities.

So, before the initiation of Quantitative Easing (QE), primary dealers hold a combination of USTs, representing government debt they've purchased at auctions, and bank reserves, which are essentially deposits held at the Federal Reserve. These assets and liabilities form a critical part of their financial infrastructure as they navigate the intricacies of the financial markets.

Important: We'll refer to bank reserves as bank tokens to clarify that they are not the same as broad economy money and to prevent any misconceptions.

On the Federal Reserve side, envision a simplified balance sheet featuring assets in the form of USTs, previously acquired through QE, alongside bank reserves on the liability side.

Starting the EQ process

As the central bank initiates QE, it effectively increases the amount of bank reserves in the system. This increase is akin to a digital ledger adjustment, a concept famously described by economist Milton Friedman as "the stroke of the bookkeeper's pen." In this case, it's not actual physical cash being printed; rather, it's an adjustment to a digital ledger maintained by the central bank.

Completing the asset swap

This alteration on the balance sheet signifies the introduction of new bank reserves (again, not money). Next, the FED swaps these reserves for USTs. The $1m of reserves are added to the balance sheet of the primary dealer in return for $1m of USTs being added to the balance sheet of the central bank.

Through the lens of balance sheets, we can distinctly observe that while the types of assets on the balance sheets have shifted, no new net money was created in the broader economy. The Primary Dealer started and ended the processes with $3m in assets.

• Start: $3m assets ($2m UST + $1m Bank Tokens)
• End: $3m assets ($1m UST + $2m Bank Tokens)

The central bank's liabilities (reserves) have increased, but these are balanced by the increase in its assets (government bonds). Likewise, while the bank's holdings in government bonds have decreased, this is balanced by an increase in their reserves at the central bank.

If no new money is truly printed through Quantitative Easing, what about secondary effects. Could the shift in the composition of assets, specifically the increase in bank tokens/reserves, compel or enable commercial banks to lend more?

Next steps

Navigating past the notion of QE as "money printing," we're prompted to investigate its other potential impacts. Could there be a connection between the vast sums involved in QE and increased bank lending and money creation? Much like the misconceptions about money creation, our journey continues. In Part 2 we'll delve deeper into the intricate relationship between QE and lending, unraveling the myths that cloud our understanding. Join us as we further demystify the world of Quantitative Easing.