Thursday, December 9, 2010

What Does “Printing Money” Mean?

When I heard Ben Bernanke on 60 Minutes Sunday, I was initially taken aback when he said that QE2 did not constitute “printing money.” Obviously it’s not physically printing money, but nobody ever uses that phrase literally. If creating bank reserves is not “printing money,” then what is? My first thought, maybe he means that the increase in base money is not expected to lead to an increase in bank deposits. But if that’s the case, why would they be doing it? It’s hard to imagine QE2 being effective without causing bank deposits to increase. Sure, they may not increase via the textbook money multiplier process, given that reserve requirements are not currently binding and reserve ratios are not expected to be stable. But that’s a cop out: the Fed is increasing bank reserves; it hopes this action will lead, by whatever process, to an increase in bank deposits. How is that not printing money?

Apparently it gets worse. I had forgotten what Bernanke said on his earlier 60 Minutes appearance, but Jon Stewart has a clip where, in reference to QE1, Bernanke essentially acknowledges that the Fed is printing money. Naturally, Jon Stewart was amused by this seeming inconsistency, as was I.

But I’ve been thinking about this a bit more, and I no longer think Bernanke’s statements are inconsistent. The problem is that the definition of the word “money” is not as clear cut as it seems. Indeed, one might argue that the whole concept of “money” is no longer useful (at least to economists) in a world where bank reserves pay interest and people pay bills with credit cards and with checks drawn on bond mutual funds.

Long, long ago, before I started graduate school, I used to think that the concept of money was fairly straightforward. There was cash (Federal Reserve notes, as well as coins), and there was money in the bank, and those were money. And OK, there were money market mutual funds, and those were “sort of” money. When I really started to think about it, I realized this framework was inadequate, especially given the concept of liquidity preference that I was trying to use, where the cost of holding liquid money was supposed to be the interest rate. (Money market funds pay interest, and they’re almost just like money, and even some bank accounts pay interest, so apparently you can hold liquid money without giving up the interest, so where’s the cost?)

At the time I had a solution: stop thinking of bank accounts and such as money and instead just think of “outside money,” money created by the central bank. This approach sort of seemed to work. If you wanted to hold “money” in this sense, you had to give up the interest, and a bank’s willingness to pay interest on deposits (no longer considered money) was influenced by the amount of actual money that the bank needed to hold in order to maintain that deposit. And policymakers actually had control over this kind of money, so the concept fit well with the simple assumption that the quantity of money is determined by policy.

But in 2008, the Fed started paying interest on bank reserves. (Some other central banks had already been doing so for a while, but, being a provincial American, I hadn’t really noticed.) To be honest, it didn’t occur to me at the time, but this change totally destroyed my concept of money. If bank reserves pay interest, then they aren’t money, because you don’t have to give up the interest in order to hold them. But surely they are money, because monetary policy consists primarily of manipulating the quantity of bank reserves. Epistemological fail!

So are bank reserves money or not? I don’t know. But here’s something to think about: what is the difference between bank reserves and Treasury securities? They both pay interest. They’re created by different institutions, but so what? They’re both ultimately obligations of the government: the interest paid on reserves comes out of the Fed’s profits which would otherwise go into the Treasury.

You might say that Treasury securities have to be paid back, while bank reserves don’t, but that’s merely a function of the banks’ willingness to hold reserves: if the banks (and their customers) want cash instead, the reserves have to be “paid back” to the banks/customers. And if Treasury security holders want to roll over their securities, then Treasury borrowing doesn’t have to be paid back. So there’s no real difference there. The maturity is different, it’s true: bank reserves have zero maturity, while Treasury securities have maturities ranging from one month to 30 years. But that’s not a fundamental difference: it just means that bank reserves are a special case, not that they’re a different kind of entity.

OK, bank reserves can be used to fulfill reserve requirements, and Treasury securities cannot, but again so what? Banks are subject to a number of regulatory requirements, which depend on various aspects of their asset structure. There’s really nothing special about the reserve requirement. Today capital requirements are closer to being a binding constraint than reserve requirements, so for most banks Treasury securities are just as good as reserves when it comes to fulfilling regulatory requirements. Maybe someday in the future banks will once again have a particular need for Fed-issued zero-maturity assets to fulfill a regulatory requirement, but I don’t see how that makes such assets a fundamentally different type. Show me junk bonds, T-bills, and bank reserves, and it seems to me that, if anything, the bonds are the fundamentally different type of asset.

I submit that bank reserves are essentially just zero-maturity government debt. You can call them “money” if you want, but the application of the term is pretty arbitrary. And if you’re going to call bank reserves money, why not call T-bills money as well? And for that matter, T-notes and T-bonds: those are just long-maturity money.

So back to Ben Bernanke. What is QE2? It’s an exchange of bank reserves for longer-maturity Treasury securities: both forms of government debt; the only substantial difference is the maturity. QE2 is not, in any important sense, “printing money” but merely a restructuring of the government’s debt.

And what was QE1? It was (largely) an exchange of bank reserves for private sector assets, essentially an exchange of government debt for private debt. It’s very important that QE1 involved “printing” substantial quantities of government debt that would not otherwise have existed. That government debt happens to be “money,” though, rather than what we usually think of as government debt. So, rather than go through a whole explanation of how bank reserves are really government debt, the simple and substantively correct way of explaining QE1 is that it constituted “printing money” in exchange for private sector assets.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.


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