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Forget Tapering, The Fed Will Increase QE

November 08, 2013 / Greg Simon Back in September establishment Wall Street economists ate a healthy portion of humble pie when against their overwhelming consensus expectations of the Fed tapering QE, no QE taper materialized. Of course I was not surprised, as I have written numerous times since the actual day QE began five years ago (and here and here, etc) the Fed can not only never stop QE or even reduce QE, but it can never stop increasing QE. One would think these economists looking down on us from their ivory towers might consider the possibility of a flaw in the economic theories they have applied leading them to be so wrong for so long. Sadly, it appears they have failed to do so. Once again, the intellectual elites are now telling us a Fed taper is coming in March of next year. They will be wrong, again. But where are they getting it wrong?
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Wall Street economists naively believe the Federal Reserve's goal with QE is to stimulate economic growth in the US economy. The Federal Reserve has two stated mandates: minimize unemployment and maintain a target price inflation rate. As is usually the case with central planners, the truth and what we are led to belief are often not the same thing. The Fed could care less about the rate of unemployment. I also propose it could care less about real economic growth in the USA. All the Fed cares about is protecting stability of the banking system which requires a steady controlled growth in the money supply. Let me explain why I have come to believe this.

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Money is Debt The money we use is in reality debt. Yes, as bizarre as this may sound to you the paper money in your wallet and the digital money in your bank account are both debt. The paper money in your wallet is debt issued by the Federal Reserve bank. The digital money in your bank account is debt issued by a commercial bank. In both cases you have lent money to these corporations and you have received in exchange for that loan an IOU - either a paper Federal Reserve Note IOU or a digital commercial bank account IOU.

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Money can only come into existence by issuing new debt If you think that is crazy, it gets better. Not only is our money debt, but the money we use can only come into existence by the creation of new debt by a bank. Let me say this again: in our current banking system money

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can only come into existence if new debt is created by a bank. Most of us have been led to believe from our education in school the opposite is true, or the lending out of money is how debt is created. What we were taught simply is not true. To know the truth we have to unlearn what we were taught. If a bank does not create new debt, new money cannot come into existence. Let us use a simple example to learn why. Say you have a great business idea to start selling lemonade on the street corner. Excited with your business plan in hand you go to the bank to ask for a loan for funding to buy your stand, sign, lemons, sugar, pitcher and cups. The bank listens to your idea and agrees it is a great idea. People love homemade lemonade and you are likely to generate profits. The bank decides to lend you $100 to start your business. Now, here is the accounting that follows that decision:

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Bank lends you $100 t o st art a lemonade st and Credit : $100 t o t he bank s liabilit y account demand deposit s. This is money t he bank owes t o you now. It represent s an asset t o you and a liabilit y t o t he bank . Debit : $100 t o t he bank s asset account Loans out st anding. This is an invest ment for t he bank it believes will generat e profit s for it in t he fut ure.
You see, you have not been lent money the bank already had to start your lemonade stand. The bank simply punched a few keystrokes on a keyboard and magically created new money to give to you. The bank has just lent to you something it never possessed itself

before you walked into the door.

Debt comes with interest expense The debt that has been created comes with interest expense. When we borrow money we not only have to pay back the money we borrowed but we also have to pay back some interest to the lender. This interest paid is in exchange for the lender giving up the utility of having that money in its possession for the period of time we are borrowing it (even though ironically the bank never really possessed the money in the first place). This process of a bank creating money it does not have out of thin air to lend is called Fractional Reserve Banking. It is fractional because the bank only has a fraction of its total IOUs (savings and checking accounts to us) held in its real reserves. Each dollar the bank actually possess in its reserves can be lent out multiple times in this creating money out of thin air magic by that bank. In the process it is leveraging and it is creating something of an inverted pyramid of debtmoney on top of the base of actual money it possesses in reserves.

There is never

enough money to meet debt and interest obligations All money in circulation can only come into existence by the issuing of new debt. But what about the interest expense on that debt? Where does the money required to pay this come from? The answer to this question exposes to us the inherent instability of the entire fractional reserve banking system. The money we use comes into existence by the issuing of new debt, but the money we need to pay the interest expense on that debt does not. At any point in time, total debt outstanding plus the interest expense on that debt will always exceed the total supply of money in circulation. As existing money is used to pay interest expense the total supply of money will decline by that amount. As the supply of money declines the price of money, or interest rates, will rise. With the burden of paying the now higher interest rates and therefore higher interest expense, the amount of money consumed to pay interest expense will rise while the rate of decline in the total supply of money will accelerate. This in return will cause interest rates to rise further, and around and around we go. This death spiral of money supply deflation will feed upon itself until all the debt-money has gone bad and the fractional reserve system is delevered down to 1x leverage, or to the money base. This is the worst case scenario for the Fed and all other central banks. The central banks will do anything, anything to avoid this money supply deflation scenario. So far we have learned our money is in reality debt, that money can only come into existence by issuing

new debt, all debt comes with interest expense and there is never enough money outstanding to meet both the debt obligations and the interest expense on that debt. These four facts are all we need to know to understand why the Fed can not only never taper but must increase QE forever.

QE can never end To prevent the above scenario of uncontrollably rising interest rates and a collapse of the fractional reserve banking system, the Federal Reserve must ensure there is always a sufficient rate of newly created money entering the system. This creation of new money is called money supply inflation. Inflating the supply of money causes the value of each unit of money to decline. This decline in the value of each unit of money is manifest in the economy as rising prices. The Federal Reserve and the armies of PHD economists have successfully indoctrinated us into believing the reason the Fed targets inflation is to stimulate consumption. To any logically thinking person this is a ridiculous assertion. If people are paying more for the things they are buying they cannot buy more things because the purchasing power of their money is falling. They buy less things because they can only afford to buy less things. Prices of electronics fall every year because of human innovation. Have sales of smartphones, laptops and flat screen TVs suffered as a result of falling prices driven by human innovation? Of course not. On the other hand, falling prices do facilitate increased consumption. If people are paying less for the things they are buying they can buy more

things because the purchasing power of their money is rising. They buy more things because they can afford to buy more things, or they save more. Either way, it is clear an individual consumer is financially better off in an environment of price deflation, not price inflation. So, if price inflation is harmful to the individual consumer why does the Federal Reserve only care about inflation so much? The Fed does not care about PRICE inflation, it cares about MONEY SUPPLY inflation. It must, absolutely must, continue to inflate the money supply, for reasons we saw above. Nothing is more important to the Federal Reserve in protecting the stability and survival of the fractional reserve banking system than a perpetual and steady inflation of the money supply. Of course it does not want us to know this. That is why it conveniently defines inflation as price inflation, rather than money supply inflation, even though a simple exercise of logical reasoning shows us aggregate price inflation in an economy is entirely a function of money supply inflation and has nothing to do with the supply or demand for individual goods, as we explained in this June 27th note titled, "What Is Inflation?" By deflecting our attention to price inflation, away from money supply inflation, the Federal Reserve can successfully convince us inflation is rising prices, and that the Fed's mandate is to target price inflation, not money supply inflation. It is smoke and mirrors to manipulate reality and keep us in the dark from what is really going on and why. Without the Fed's QE the US dollar money supply would not be growing at a sufficient enough rate to maintain the current artificially low interest rates. In

the five years since October 2008 the US M2 money supply has increased by $3.2 trillion from $7.7 trillion to $10.9 trillion. Over the same time period the monetary base has increased by $2.75 trillion from $850 billion to $3.6 trillion. The monetary base is a component of the broader M2 money supply. We can see almost all of the increase in the broader M2 money supply since 2008 has come from the increase in the monetary bases, and therefore is entirely a function of QE. What if we adjust M2 for this increase in the monetary base growth? If we extract the impact from QE, over the last 5 years the M2 money supply has increased by $3.2 - $2.75 = $450 billion. Over a five year period this averages out to an annual increase in M2 ex-QE of $90 billion. Let us compare this $90 billion annual growth in the M2 money supply ex-QE over the last five years to previous yearly YoY increases in the M2 money supply prior to QE:

2007 +$400 billion 2006 +$340 billion 2005 +$300 billion 2004 +$360 billion 2003 +$255 billion 2002 +$325 billion 2001 +$490 billion 2000 +$380 billion 1999 +$240 billion 1998 +$280 billion 1997 +$195 billion 1996 +$170 billion 1995 +$150 billion 1994 +$16 billion

(Source: Federal Reserve)

If the US economy is recovering, why is the M2 money supply ex-QE growing at the slowest pace in 19 years? Because the US economy is not recovering. It will not recover until the debt is liquidated. The Federal Reserve will not allow the debt to be liquidated because debt is money. Liquidating the debt means liquidating the money, or allowing for money supply deflation. Ironically, the solution is the very thing the Federal Reserve itself exists solely to prevent. If the Fed ever tapers QE the rate of money supply growth will slow and interest rates will rise causing a deflation of the

fractional reserve money supply. Additionally, as the total supply of debt-money increases the effectiveness of $85 billion of QE each month declines. This is why QE3 is bigger than QE2 which was bigger than QE1. This also is why we have recently seen interest rates rising despite ongoing QE.

QE3 is losing it's effectiveness against the increasing size of total money supply outstanding. The total money supply

outstanding must perpetually grow, forever.

In summary, money is debt. Money can only come into

existence from the issuance of new debt. Debt comes with interest expense. There is never enough money to meet both debt and interest obligations outstanding. There is no longer real growth in the US economy and it is unlikely there will be real growth again in the US economy unless the excessive debt is liquidated. The Federal Reserve will never allow to the debt to be liquidated because debt is money and liquidating the debt means money supply delfation. If the Fed ever were to taper the rate of money supply inflation would slow, interest rates would rise and the money supply would deflate. Money supply deflation would result in an uncontrolled collapse of the fractional reserve banking system. The Fed can never taper QE. The Fed can never end QE. Just to maintain the current level of interest rates the Fed must perpetually increase QE, forever. Forget taper, the Fed will increase QE.

My name is Greg Simon. I am an independent thinker and world traveler.

1 Comment \ Ec onomic s, Financ e Y QE, Taper, Federal Reserve, Inflation

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Jose Velez
about 2 days ago

Interesting thoughts, but I don't necessarily agree with you on the prospect of QE never ending. I do agree that the folks at the Fed and academics who continue to believe QE is working are massively underestimating the negative externalities hitting the global markets because of QE. QE must end because it simply is not sustainable and the folks who have most benefited from QE (whether it was intended or not) are already experiencing diminishing returns as a result. The mechanics and consequences of printing money needs no introduction (from an economic or historical perspective) and QE essentially is an attempt to print money on an unprecedented scale. QE will end whether the Fed wants it to or not because the market will eventually begin to price in (devalue) the dollar to compensate for such dismal returns.

I have written my own thoughts on QE at my blog - Jose L. Velez

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