Question:
I would like to ask you a basic question of not understanding quantitative easing. I understand the mechanics but I don't understand why this is considered pumping in "fresh" money, since the FED is just buying up Bonds that were purchased before. They are NOT just giving away absolutely free to BANKS. I know it's wordy but the below elaboration details my confusion. Hope you can help. Thank you!In quantitative easing, the process of US Fed Bank buying bonds from Banks in order to increase money supply is pretty straight forward but no one seems to be able to explain my particular question or I guess confusion. I even posted on the US Fed open market website but they just gave me the typical answer I already knew.
Again, I'm aware that the FED can pretty much "print money" out of thin air and "inject" it into system but when I look closer at the details of what is happening, I still have trouble describing the process of injecting "fresh" money into an economic system because it looks as though they are limited by putting back the money that was spent to buy the bonds in the first place by banks.
So, to elaborate what I'm trying to say is that if you have a situation of the FED just giving away cash or call it a credit on their ledger for various banks out of the blue. Now that is exactly what I would call injecting fresh money because the banks didn't have to do anything or exchange anything in order to receive that money, just like if I were walking down the street and a complete stranger just came up to me and handed me cash. Now that scenario is what I would understand as injecting fresh money on top of a system.
But what is really happening is that under open market operation for quantitative easing, the US FED is buying up all the bonds that banks are holding at a given moment. Those bonds were purchased at an earlier time by various banks by giving money to the FED or other government agencies, so it looks at best to be putting all the money back into a system in which those monies were extracted from the system before, therefore it's not a "fresh" injection of new money. So it's just putting equal money back into system that was taken out at earlier time? Isn't it?
In other words, let's just say for simplicity that all US Banks spent $1 Trillion to buy bonds 5 years ago (so 5 years ago, $1 Trillion was taken out of an economic system) And now, 5 years later the FED is buying up those bonds from the banks(putting $1 Trillion back into system) The net effect is no new fresh money.
Put it another way, if you add up all the bonds that banks are holding, let's say it comes to $1 Trillion, the FED even though they want to inject $2 Trillion into system over time, they can not do that because all the bonds that are out there doesn't equal $2Trillion; they can only purchase back up to $1Trillion. So the saying, the FED can "print" money as much as they want into a system is not possible, at least in this example of how they do it now in the real world.
I'm sorry for such wordiness but you won't believe how much misdirected answers I get even from professionals. I'm really hoping you can shed some light on my confusion.
Answer:
Let me try to answer your question by breaking it down.
“In other words, let's just say for simplicity that all US Banks spent $1 Trillion to buy bonds 5 years ago (so 5 years ago, $1 Trillion was taken out of an economic system)”.
First of all, $1 trillion was NOT taken out of the system. $1 trillion worth of bonds were issued by the Treasury to use the proceeds (whoever may have purchased those bonds, banks or private individuals) to finance infrastructure or fight wars, implying that $1 trillion went towards payment for goods and services generated by households in the economy. This $1 trillion stays in the economy and continues to circulate for all time.
“And now, 5 years later the FED is buying up those bonds from the banks (putting $1 Trillion back into system) The net effect is no new fresh money.”
To understand what happens 5 years later, consider the following balance sheet for the banking system as a whole. I have switched to smaller units (100 million instead of 1 trillion) to reduce the number of zeros.
Bank Assets, 5 years later:
T-bonds: $100 m
Cash reserves: $10 m (10% of checkable deposits as mandated by law)
Total assets = $110 m
Bank Liabilities, 5 years later:
Checkable deposits: $100 m
Other deposits: $10 m
Total liabilities = $110 m
Suppose now that the FED buys back all the T-bonds from the banks. The new balance sheet looks as follows:
Bank Assets, after sale of T-bonds:
Cash reserves: $110 m ($10 m it had previously + $100 m that it gets from selling the T-bonds to the FED)
Total assets = $110 m
Bank Liabilities, after sale of T-bonds:
Checkable deposits: $100 m
Other deposits: $10 m
Total liabilities = $110 m
The banking system now has more cash than it needs to sustain its level of checkable deposits. It will use this extra $100 m cash in more profitable ways – namely, to provide loans to businesses who will use the funds to finance their projects. Thus $100 m new money has been pumped into the system. (The new money creation process does not stop here, but that is a different story)