The Great Canadian QE Myth – Part 3

While the previous post in this series had originally been intended to serve as the final article of a two-part series concerning QE in Canada, there would appear to be considerable confusion remaining regarding the precise mechanism by which BoC asset purchases transmit inflation to the broad economy. Part 3 of this series is therefore meant to address, under the current financial system, precisely how the QE process can either create inflation or remain price-level neutral and why it is generally incorrect to assume that the “money-printing” used to fund BoC asset purchases is inherently inflationary. This is a fallacy that even trained economists continue to propagate, and will almost certainly be parroted by mainstream media outlets in the event that QE is undertaken by the BoC in response to a pending Canadian downturn in the residential real estate market.

When the BoC purchases assets from the commercial banks, it does so by crediting the reserve accounts that commercial bank hold with the BoC. Reserve accounts are used by banks to settle payments with one another and are part of a closed system by which reserves are transferred, borrowed and lent solely within the Canadian payment system (called the LVTS). To illustrate how reserves are used by commercial banks to settle payments with one another as part of normal operations, imagine a scenario where Bob were to initiate a money transfer of $100 from his checking account held at Bank A to another checking account held at Bank B. In this case, Bob’s $100 deposit would simply be transferred electronically from Bank A to Bank B, and Bank A would subsequently enable the transfer of funds in question by wiring $100 from its reserve balances held at the BoC to Bank B’s reserve account held at the BoC. In this manner, banks settle payments as part of their normal operating procedures through the transfer of reserves amongst one other, but this money is not “spent” within the private sphere to purchase assets or make loans in the way that most people today are conditioned to think when discussing money in the more conventional manner.

While it is therefore true that money was simply conjured into existence by the BoC to pay for its newly purchased bonds, it is incorrect to believe that these funds can be used by the banks at their discretion to make loans, purchase stocks, or speculate in financial markets. Reserves are simply money held captive in the Canadian financial payment system by banks for the purpose of settling balances, with virtually all power to both add and remove funds to or from this closed system residing almost exclusively at the feet of the BoC. The only exception to this rule is the right bestowed on chartered banks by the BoC to convert their bank reserves into real spendable physical currency at any time they so desire. While this mechanism is meant to be used by commercial banks to satisfy the general public’s economic demand for physical currency, it is also the only practical method by which newly created bank reserves would be able to escape into the broad economy to bid up the prices of goods and services. While it is therefore technically correct to say that the central bank is “printing” money, in reality these newly-created funds are trapped within the Canadian payment system and can only be utilized in very limited ways which will tend to greatly hinder its inflationary impact on the broad economy.

And yet many commentators who are quick to acknowledge that the BoC is merely adding to bank reserves still tend to erroneously sound the inflation alarm in one of two ways. In the first place, they often cast dire warnings that reserves will “leak” out into the economy and subsequently bid up the prices of existing assets, thus causing a general inflationary increase in the overall prices of goods and services. But this ignores the fact that central banks generally have near-complete control over the reserve balances within the banking system, and have various mechanisms at their disposal to prevent large quantities of reserves from being converted to physical currency and hence escaping into the economy at large. For example, in certain countries central banks have adopted a process of paying interest on reserves, which causes commercial banks to voluntarily maintain larger reserve balances than they otherwise would have elected to hold if interest on reserves was not being paid at all. In other countries, such as Canada, large injections of bank reserves undergo a process of “sterilization” to remove excess bank reserves from the payment system (as previously described in Part 1 of this series). This explains why the near-$40 billion of bank reserves injected by the BoC during the 2008 Great Financial Crisis were virtually guaranteed not to be converted into physical currency by the commercial banks in response to the sudden large infusion of excess reserves into the financial system. While it is very likely the case that Canadian commercial banks had no intention of converting $40 billion of reserves into physical bank notes in the first place (and the government had no intention of issuing $40 billion of new bank notes to facilitate this conversion), the sterilization process nevertheless assured virtually zero direct inflationary impact from reserves leaking out into the Canadian economy.

The second misnomer often propagated by financial pundits is that the addition of bank reserves would still be inflationary since they set the money-creation machine into overdrive as commercial banks now have more reserves to back new loan creation. It is important to understand that when commercial banks make loans they do so with money created out of thin air – money which constitutes the majority of new money creation in the Canadian economy. As is often explained in traditional economic textbooks, commercial banks are said to have a “reserve requirement” by which they must maintain a certain percent of outstanding loans in the form of bank reserves held in their accounts at the BoC. In this way, bank reserves are meant to place somewhat of an upper limit on new loan growth and the process of money creation in the Canadian economy. As the reasoning goes, the act of increasing reserves functions to increase the “backing” of new money creation and serves to expand the amount of money that banks are subsequently able to conjure into existence. The only problem with this line of thinking is that in today’s world the reserve requirement imposed on banks no longer actually exists. The concept of reserve requirements has long since been abolished as commercial banks in most modern monetary systems are never actually reserve-constrained in their ability to extend new loans to credit-worthy borrowers. Indeed, in the Canadian financial system, the present-day reserve requirement has officially been reduced to zero, meaning that no reserves held by Canadian banks are ever officially “required”.

Yet if reserves themselves do not constrain Canadian banks from extending new loans to their customers, what then is to prevent commercial banks from creating new money with reckless abandon and thus triggering high inflation or hyperinflation throughout the broad economy as they run rampant with greed and the desire for higher profits? The answer, of course, is both capital requirements and the credit-worthiness of borrowers. When banks identify profitable lending opportunities, they extend new loans first regardless of their given level of reserves and subsequently acquire any necessary reserves later on through the inter-bank market or by borrowing reserves directly from the BoC. Contrary to popular opinion, the amount of reserves created by the BoC will not suddenly entice commercial banks to lend in either a deflationary environment or in the midst of a deep recession if they cannot identify sufficient investment opportunities by which to satisfy lending criteria and generate necessary profits. Asset purchases performed by the BoC in this manner, then, do nothing to increase business lending via the addition of new commercial bank reserves, and it certainly does nothing to add directly to the Canadian money supply.

But if the process of the BoC purchasing assets in exchange for bank reserves does nothing to increase the money supply, does this then mean that the process of QE is never directly inflationary? No, because QE can happen in a second way which not only adds to the bank reserves of Canadian banks, but also adds directly to deposit money held in checking and savings accounts within the banking system. When QE is performed by the BoC through the purchase of bonds from non-bank entities (as opposed to directly from the banks themselves) such as pension funds, insurance companies, security dealers, or the Federal Government, it writes a check against itself made out to the seller of the asset. When the seller deposits this check into their account at a commercial bank, new deposit money is created in the seller’s account at the bank and therefore becomes a debt owed by the bank to the depositor. The bank, in order to acquire a corresponding asset to offset this liability, subsequently presents this check to the BoC which then credits the bank’s reserve account at the BoC with newly created funds. In this manner the BoC has created “covered money” by adding an equal amount to reserve balances in the interbank market as it does to deposit balances in the private sector. This is similar to the process described in Part 2 detailing how the Government of Canada’s “Prudential Liquidity Management Plan” (PLMP) was directly funded with new spendable deposit money simply created out of thin air and added to the GoC’s deposit account at the BoC (rather than simply adding to new reserve balances of the commercial banks). Were the GoC to have actually spent this money into the broad economy, the PLMP would have been directly inflationary and would have served as the closest thing to genuine QE that has ever been experienced by Canada since the 2008 Great Financial Crisis.

Whether or not QE is directly inflationary, therefore, depends entirely on its precise method of implementation which has historically been somewhat variable between countries. In the United States, for example, QE involved assets being purchased directly from Primary Dealers which are legally classified as non-bank entities in the US. The manner by which QE was implemented in the US therefore served to increase both deposit money and reserve balances at the commercial banks and is the reason why money supply growth in the United States accelerated strongly upwards shortly following the 2008 financial crisis. While a similar implementation of asset purchases was likely also likely pursued by both the ECB and the UK as part of their own QE programs following the crisis, the relatively anemic money supply growth in Japan suggests that Japanese QE was predominantly pursued through direct purchases of assets from the banks directly.

All of this, of course, begs the question – from whom exactly will the BoC be buying assets from in the event it is forced to engage in QE in response to a collapse in the Canadian residential housing market? Or asked a different way – will the BoC be adding money directly to the economy through the purchase of assets from non-bank entities, or merely adding to reserve balances through the direct purchase of assets from Canadian chartered banks? Unfortunately, it is highly unlikely that we will be able to answer this question until well after the QE process eventually begins, as current BoC literature on the subject merely refers to its framework for QE as “purchases of financial assets through the creation of excess settlement balances” (reserves are called settlement balances in Canada).

Barring complete disclosure by the BoC, the best we will likely be able to do is look towards the money supply for a direct correlation between checking/savings deposit growth and BoC asset purchases. If the money supply spikes in direct response to BoC asset purchases, then it will be QE rather than bank lending which will serve as the primary transmission mechanism by which inflation is ultimately transmitted through to the the broad economy. If not, then it will be unlikely that QE will be successful at achieving its inflationary policy goals, as merely adding to bank reserves has historically not proven to be an effective method of increasing bank lending in an environment where both business and personal balance sheets have become significantly impaired.