How Quantitative Easing “Works” — The Mainstream Still Doesn’t Get It
Paul L. Kasriel
August 5, 2014




I’m not going to lie to you. I have had a mild case of writer’s block the past month. I have found that there is nothing better to summon my muse than to read what mainstream economic analysts/commentators are writing about current issues. Typically, I can find something they are saying that I vehemently disagree with.

Sure enough, it worked. While thumbing through my most recent copy of The Economist (August 2nd – 8th), I came across the Free Exchange section entitled “The Exceptional Central Bank.” The header on the article is: “The European Central Bank should adopt quantitative easing now rather than as a last resort.” I don’t have any disagreement with this header other than I would argue that the ECB should have adopted quantitative easing (QE) five years ago. No, what lit my fuse was the following:

“One of the main ways that QE has boosted the American economy is by lowering corporate borrowing costs. As the Federal Reserve bought Treasuries and government-guaranteed mortgage securities, pushing down their yields, investors turned to corporate bonds, in turn driving down their yields (emphasis added).”

Really? This is how QE has boosted the American economy, by lowering corporate bond yields? I disagree with this analysis on both empirical and theoretical grounds. Let’s start with the empirical evidence. Let’s observe how the yield on corporate bonds has behaved in relation to Fed purchases of Treasury coupon and agency mortgage-backed securities. These data are shown in the chart below. The Fed stepped up its securities purchases early in 2009. By the second quarter of 2010, its first phase of QE had ended. Corporate bond yields fell as the Fed ended QEI. The Fed again stepped up its securities purchases in the fourth quarter of 2010, terminating QEII in the second quarter of 2011. As the Fed initiated QEII, corporate bond yields trended higher. Following the termination of QEII, corporate bond yields plummeted. With the initiation of QEIII in the fourth quarter of 2012, corporate bond yields started rising. So, Fed purchases of securities in recent years have tended to be positively correlated with corporate bond yields. That is, when the Fed has stepped up its purchases of securities, corporate bond yields have tended to rise; when the Fed has cut back on its securities purchases, corporate bond yields have tended to fall. I guess the editors of The Economist hold to the maxim, “never let the facts get in the way of a good story”.

Except that it is not even a “good story” on theoretical grounds. Suppose one morning, all households decided to cut back on their spending by 10% and use these saved funds to purchase corporate bonds. Corporate bond yields would surely fall. For the sake of argument, assume that businesses in the aggregate increased their borrowing and spending by an amount equal to what households cut back on their spending (increased their lending). In this extreme case, the decline in corporate bond yields would elicit a net change in total spending in the economy of zero. In a more likely case in which the saving behavior of households was positively correlated with the level of interest rates (i.e., the supply curve of household lending sloped upward and to the right), all else the same, the increase in business borrowing/spending resulting from an outward shift in the household lending supply curve would be less than the cut in household spending (increase in household lending). So, a decline in corporate bond yields, in and of itself, is no guarantee of a net increase in aggregate spending on goods and services.

But what if there were an increase in credit that did not entail households cutting back on their current spending? What if some entity could create credit, figuratively, out of thin air? That is exactly what the Fed does when it purchases securities. Suppose the Fed purchases $100 worth of securities from a pension fund. The Fed pays for these securities by crediting the pension fund’s bank account by the amount of the securities purchase, $100. The pension fund has $100 more of deposits and $100 less of securities. The Fed has $100 more of securities, an asset to the Fed, and $100 more of reserves, a liability the Fed, owned by the pension fund’s bank. The pension fund’s increase in deposits and the increase in reserves owned by the pension fund’s bank were created by the Fed, figuratively out of thin air. If the pension fund decides to purchase some securities to replace those it sold to the Fed, then it will be using funds created by the Fed out of thin air to increase the supply of credit.

Assume that the pension fund purchases $100 of newly-issued corporate bonds to replace the $100 of securities it sold to the Fed. Further assume that the corporation issuing these bonds uses the proceeds of the bond sale to purchase $100 of new equipment. In this case, the increase in credit will result in a net increase in aggregate spending on goods and services because the increase in credit was created out of thin air, not as a result of households cutting back on their current spending in order to purchase the newly-issued corporate bonds.

The main way QE has boosted the American economy has been by the Fed creating credit out of thin air, enabling some entities to increase their current spending without requiring any other entities to cut back on their current spending. Contrary to what the editors of The Economist and many mainstream economic analysts assert (but don’t verify), QE has not boosted the American economy by lowering corporate bond yields.

Note: The views expressed in this commentary solely reflect those of Econtrarian, LLC.


Paul L. Kasriel
Econtrarian, LLC
1 920 818 0236
Senior Economic and Investment Advisor
Legacy Private Trust Co., Neenah, WI

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

8 Responses to “How Quantitative Easing “Works” – The Mainstream Still Doesn’t Get It”

  1. VennData says:

    The Economist has devolved into a simpletons spinner of nostrums. The NY Post of Money.

    They should just sell out to Rupert Murdoch and be done with it.

  2. Misho Iliev says:

    Not sure you are right about corporate bond yields. Have a look at the HQM for corporate bonds here:

    You can observe that as QE2 ended corporate yields with two years maturity rose from 1.18 in Jun 2011 to 1.81 Oct 2011. Similarly, you can observe that the lowest yields of 0.77 were reached in Mar – May 2013 during QE3. So it might be a bit naive to assume that if during the month when QE is announced yields drop that means that QE’s effect is to raise yields. First, there can be other factors at play, and second QE boosts confidence so it might have the effect of a short-lived boost. You need to do more work to prove your point.

    As for the creation of credit out of the thin air, that is not new. In a way a big part of credit is created ‘out of the thin air’. You can check on the internet or in a textbook on monetary economics how banks create money (i.e. credit) out of the thin air.

    In your article you seem to mix up the Fed high powered money (deposits at the Fed) with the “ordinary” money we use for exchange. The Fed is paying for the bond purchases with reserves at the Fed.

  3. OC Sure says:

    Also, QE actually lowers government borrowing costs since whatever the Federal Reserve “earns” from the spread on the notes and bonds’ interest received and the interest paid on reserves eventually gets sent back to the The US Debt Department. (It really isn’t the US Treasury Department anymore since there is no treasure left to manage.)

    Most importantly, when ever you say “created money out of thin air,” then what you are saying is that the currency is counterfeit. It represents the exchange of nothing for something and this is theft. So, whomever exchanges the counterfeit for debt, stocks, commodites, industrial equipment, or Billy’s lemonade down on the street corner is stealing real goods and services from the economy of productive work.

    Therefore, a very strong argument can be made that QE actually slows down the economy much more then if it was never implemented. So, why do it? Counterfeiting, QE, “works” best for the thieves.

    • Misho Iliev says:

      @OC Sure

      Your arguments apply to all money, most of which is in the from of deposits, i.e. a pure balance sheet operation.

      If a commercial bank has sufficient reserves at the Fed it can create new deposits that didn’t exist before. What is behind this money are the promises of the debtors to create enough “stuff” that the market will valuate sufficiently for the borrow to reply the debt. This is all a bit abstract… But this is how the system works. It’s also a bit counterintuitive and it does give the impression that something is created out of nothing. Though that is not really the case.

    • willid3 says:

      well government borrowing costs have been extremely low. mainly cause every other ‘asset’ is now viewed with suspicion as to whether it really is an asset, because they really arent ‘safe’.

    • willid3 says:

      not sure that its stealing, since it seems like almost every thing you point to being exchanged for money is evidently being done willingly

      • Rookie says:

        Willingly . . . interesting choice of words. The government is ‘managing’ our money (and money supply) – they are making the rules, running the printing presses, moving money from one pocket to the next, etc. We have no choice but to use this medium of exchange.

  4. DeltaV says:

    While I am in agreement with the author, there are multiple positive effects from QE, including removal of toxic debt (MBS). Interestingly, William Dudley& head of the FRBNY, has said he doesn’t know how QE works, even though he has voted for it on multiple occasions.

    And of course the negative effects are still to be determined.