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September
15
2020

Money Creation Mechanics
Steven Saville

Since the Fed implemented its first Quantitative Easing (QE) program in 2008-2009, many analysts have claimed that QE adds to bank reserves but does not increase the money supply (bank reserves aren’t counted in the money supply). Such claims are patently wrong.

Anyone who bothered to do some basic calculations would see that when the Fed monetises securities, as it does when implementing QE, it adds to the economy-wide supply of money. Specifically, if you add-up the increases in the dollar amounts of demand and savings deposits within the commercial banking system during a period in which the Fed ran a QE program and subtract from this the amount of money loaned into existence during the period by commercial banks, you will find that the difference is approximately equal to the net dollar value of securities purchased by the Fed.

The fact is that when the Fed buys X dollars of securities from a Primary Dealer (PD), either as part of a QE program or a non-QE open market operation, it adds X dollars to the PD’s deposit at a commercial bank AND it adds X dollars to the reserve account at the Fed of the PD’s bank. Another way to look at the situation is that the Fed’s purchases of securities add covered money (money in commercial bank deposits covered by reserves at the Fed) to the economy.

The process is described at the top of page 6 in the Fed document linked HERE. Some parts of this document are out of date in that it was written well before the Fed started paying interest on reserves and before commercial banks were able to reduce their required reserve amounts to zero via the process called “sweeping”, but the mechanics of the Fed’s direct money creation haven’t changed.

The persistent claims that the Fed’s QE doesn’t boost the money supply are not only wrong, but also dangerous. The creation of money out of nothing distorts relative prices, leading to mal-investment and slower economic progress. Consequently, the failure to identify the direct link between QE and money-supply growth makes the QE seem far less harmful than is actually the case.

I have been a fulltime professional speculator since 1998 and the owner of a subscription-based web site about the financial markets since 2000. The web site is called “The Speculative Investor”, or “TSI” for short.

In an average week, TSI subscribers receive two reports: a Weekly Market Update on Sunday and an Interim Update on Thursday morning (NYT). The Weekly Update typically has 4000-4500 words and 15-20 charts, while the average Interim Update is about half that size. As well as containing information about the gold, currency, stock, bond and commodity markets, these reports regularly include discussions about macro-economics. The economics-related discussions are from an “Austrian” perspective, because I’ve found that the Austrian School is the only school of economics that is consistently logical and explains how the world really works.

TSI subscribers also get access to a list of stock selections. The TSI stock selections have provided very good long-term returns; however, due to the highly speculative nature of the stocks I tend to focus on, my year-to-year returns have been ‘lumpy’, to put it mildly. For example, since 2000 my own equity portfolio, which comprises many of the stocks covered at TSI, has had six triple-digit years (years when the portfolio was up by at least 100%, without using any debt-based leverage and maintaining a cash reserve of at least 20%) and two years of 50%+ losses. The year-to-year ‘lumpiness’ of the performance that goes hand-in-hand with my focus on relatively risky (by traditional standards) equities will make the TSI stock selections unsuitable for many people.

The price of a TSI subscription is US$240/year or US$25/month.

The TSI Blog was created in 2014, mostly for fun, but also to promote the TSI subscription service and to be a venue for me to make public comments that for one reason or another aren’t suited to the subscription service.

tsi-blog.com