The Federal Reserve's "QE2" ended with a whimper on June 30. The Fed's second
round of "quantitative easing" involved US$600 billion created with a computer
keystroke for the purchase of long-term government bonds. But the government
never actually got the money, which went straight into the reserve accounts of
banks, where it still sits today. Worse, it went into the reserve accounts of foreign
banks, on which the Federal Reserve is now paying 0.25% interest.
Before QE2 there was QE1, in which the Fed bought $1.25 trillion in
mortgage-backed securities from the banks. This money too remains in bank
reserve accounts collecting interest and dust. The Fed reports that the
accumulated excess reserves of
depository institutions now total nearly $1.6 trillion.
Interestingly, $1.6 trillion is also the size of the federal deficit - a
deficit so large that some members of congress are threatening to force a
default on the national debt if it isn't corrected soon.
So here we have the anomalous situation of a $1.6 trillion hole in the federal
budget, and $1.6 trillion created by the Fed that is now sitting idle in bank
reserve accounts. If the intent of "quantitative easing" was to stimulate the
economy, it might have worked better if the money earmarked for the purchase of
Treasuries had been delivered directly to the Treasury. That was actually how
it was done before 1935, when the law was changed to require private bond
dealers to be cut into the deal.
The one thing QE2 did for the taxpayers was to reduce the interest tab on the
federal debt. The long-term bonds the Fed bought on the open market are now
effectively interest-free to the government, since the Fed rebates its profits
to the Treasury after deducting its costs.
But QE2 has not helped the anemic local credit market, on which smaller
businesses rely; and it is these businesses that are largely responsible for
creating new jobs.
In a June 30 article in the Wall Street Journal titled "Smaller Businesses
Seeking Loans Still Come Up Empty", Emily Maltby reported that business owners
rank access to capital as the most important issue facing them today; and only
17% of smaller businesses said they were able to land needed bank financing.
How QE2 wound up in foreign banks
Before the Banking Act of 1935, the government was able to borrow directly from
its own central bank. Other countries followed that policy as well, including
Canada, Australia, and New Zealand; and they prospered as a result. After 1935,
however, if the US central bank wanted to buy government securities, it had to
purchase them from private banks on the "open market". Former Fed chairman
(1934-48) Marinner Eccles wrote in support of an act to remove that requirement
that it was intended to keep politicians from spending too much. But all the
law succeeded in doing was to give the bond-dealer banks a cut as middlemen.
Worse, it caused the Fed to lose control of where the money went. Rather than
buying more bonds from the Treasury, the banks that got the cash could just sit
on it or use it for their own purposes; and that is apparently what is
In carrying out its QE2 purchases, the Fed had to follow standard operating
procedure for "open market operations". It took secret bids from the 20
"primary dealers" authorized to sell securities to the Fed and accepted the
best offers. The problem was that 12 of these dealers - or over half - are
US-based branches of foreign banks (including BNP Paribas, Barclays, Credit
Suisse, Deutsche Bank, HSBC, UBS and others), and they evidently won the bids.
The fact that foreign banks got the money was established in a June 12 post on
Zero Hedge by Tyler Durden (a pseudonym), who compared two charts: the total
cash holdings of foreign-related banks in the US, using weekly Federal Reserve
data; and the total reserve balances held at Federal Reserve banks, from the
Fed's statement ending the week of June 1. The charts showed that after
November 3, 2010, when QE2 operations began, total bank reserves increased by
$610 billion. Foreign bank cash reserves increased in lock step, by $630
billion - or more than the entire QE2.
In a June 27 blog, John Mason, Professor of Finance at Penn State University
and a former senior economist at the Federal Reserve, wrote:
essence, it appears as if much of the monetary stimulus generated by the
Federal Reserve System went into the Eurodollar market. This is all part of the
"Carry Trade" as foreign branches of an American bank could borrow dollars from
the "home" bank creating a Eurodollar deposit. ...
Cash assets at the smaller [US] banks remained relatively flat . ... Thus, the
reserves the Fed was pumping into the banking system were not going into the
smaller banks. ... [B]usiness loans continue to "tank" at the smaller banking
The real lending by commercial banks is not taking place in the United States.
The lending is taking place off-shore, underwritten by the Federal Reserve
System and this is doing little or nothing to help the American economy grow.
Tyler Durden concluded:
. . . [T]he only beneficiary of the reserves
generated were US-based branches of foreign banks (which in turn turned around
and funnelled the cash back to their domestic branches), a shocking finding
which explains ... why US banks have been unwilling and, far more importantly,
unable to lend out these reserves ...
... [T]he data above proves beyond a reasonable doubt why there has been no
excess lending by US banks to US borrowers: none of the cash ever even made it
to US banks! ... This also resolves the mystery of the broken money multiplier
and why the velocity of money has imploded.
Well, not exactly.
The fact that the QE2 money all wound up in foreign banks is a shocking
finding, but it doesn't seem to be the reason banks aren't lending. There were
already $1 trillion in excess reserves sitting idle in US reserve accounts, not
counting the $600 billion from QE2.
According to Scott Fullwiler, Associate Professor of Economics at Wartburg
College, the money multiplier model is not just broken but is obsolete. Banks
do not lend based on what they have in reserve. They can borrow reserves as
needed after making loans. Whether banks will lend depends rather on (a)
whether they have creditworthy borrowers, (b) whether they have sufficient
capital to satisfy the capital requirement, and (c) the cost of funds - meaning
the cost to the bank of borrowing to meet the reserve requirement, either from
depositors or from other banks or from the Federal Reserve.
Setting things right
Whatever is responsible for causing the local credit crunch, trillions of
dollars thrown at Wall Street by congress and the Fed haven't fixed the
problem. It may be time for local governments to take matters into their own
hands. While we wait for federal lawmakers to get it right, local credit
markets can be revitalized by establishing state-owned banks, on the model of
the Bank of North Dakota (BND). The BND services the liquidity needs of local
banks and keeps credit flowing in the state. For more information, see
Concerning the gaping federal deficit, Congressman Ron Paul has an excellent
idea: have the Fed simply write off the federal securities purchased with funds
created in its quantitative easing programs. No creditors would be harmed,
since the money was generated out of thin air with a computer keystroke in the
first place. The government would just be canceling a debt to itself and saving
As for "quantitative easing", if the intent is to stimulate the economy, the
money needs to go directly into the purchase of goods and services, stimulating
"demand". If it goes onto the balance sheets of banks, it may stop there or go
into speculation rather than local lending - as is happening now.
Money that goes directly to the government, on the other hand, will be spent on
goods and services in the real economy, creating much-needed jobs, generating
demand, and rebuilding the tax base. To make sure the money gets there, the
1935 law forbidding the Fed to buy Treasuries directly from the Treasury needs
to be repealed.