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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

hereandhere, 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 th eir ivory towers might consider the

possibility ofa 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 n ow telling us a Fed taper is

coming in March ofnext year. They will be wrong,

again. But where are they getting it wron g?

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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. TheFederal Reservehas

two stated mandates: minimize unemployment and

maintain a target price inflation rate. As is usually th e

case with central plann ers, the truth and what we are

led to belief are often not the same thing. The Fed could

care less about the rate ofunemployment. I also

propose it could care less about real economic growth

in the USA. All the Fed cares about is protecting

stability ofthe banking system which requires a steady

controlled growth in the money supply. Let me explain

why I have come to believe this.

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.

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 ofnew 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 ofus have been led to believe from our

education in school the opposite is true, or the lending

out ofmoney 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. Ifa 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

busin ess plan in han d 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 busin ess.

Now, here is the accounting that follows that decision:

Bank lends you $100 to start a lemonade stand

Credit: $100 to t he banks l iabilit y account

demand deposits. This is money the bank

owes to you now. It represents an asset to you

and a liability to the bank.

Debit: $100 to the banks asset account Loans

outstanding. This is an i nvestment for the

bank it believes will generate profits for it inthe 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

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before you walked into the door.

Debt comes withinterest 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 ofhaving

that money in its possession for the period oftime we

are borrowing it (even though ironically the bank

never really possessed the money in the first place).

This process ofa bank creating money it does not have

out ofthin air to lend is called Fractional Reserve

Banking. It is fractional because the bank only has a

fraction ofits 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 andit is creating somethin g of an inverted pyramid of debt-

money on top ofthe base of actual money it possesses

in reserves.

There is never

SOURCE: FEDERAL RESERVE


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enough money to

meet debt and

interest obligations

All money in circulation can only come into existence

by the issuin g ofnew debt. But what about th e interest

expense on that debt? Wh ere does the money required

to pay this come from? The answer to this question

exposes to us the inh erent instability ofthe entire

fractional reserve banking system. The money we use

comes into existence by the issuing ofnew 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 th e total supply ofmoney in circulation.

As existing money is used to pay interest expense the

total supply ofmoney will decline by that amount. As

the supply ofmoney declines the price ofmoney, or

interest rates, will rise. With the burden ofpaying th e

now higher interest rates and therefore higher interest

expense, the amount ofmoney consumed to pay

interest expense will rise while the rate ofdecline in the

total supply ofmoney will accelerate. This in return

will cause interest rates to rise further, and around and

around we go. This death spiral ofmoney supply

deflation will feed upon itselfuntil all the debt-money

has gone bad and the fractional reserve system is de-

levered 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 anyth ing,

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


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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. Eith er way, it

is clear an individual consumer is financially better off

in an environment ofprice deflation, not price

inflation.

So, if price inflation is harmful to the individual

consumer wh y 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 protectingthe stability and survival ofthe fractional reserve

banking system than a perpetual and steady inflation

ofthe money supply. Ofcourse it does not want us to

know this. Th at is why it conveniently defines

inflation as price inflation, rather than money supply

inflation, even though a simple exercise oflogical

reasoning shows us aggregate price inflation in an

economy is entirely a function ofmoney supply

inflation and has nothing to do with the supply or

demand for individual goods, as we explained in this

Jun e 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


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the five years since October 2008 th e US M2 money

supply h as increased by $3.2trillion 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 ofthe 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 ifwe adjust M2for this increase in the

monetary base growth? Ifwe extract the impact from

QE, over the last 5 years the M2money supply has

increased by $3.2 - $2.75 = $450 billion. Over a five year

period this averages out to an annual increase in M2ex-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 billion2006 +$340 billion

2005 +$300 billion

2004 +$360 billion

2003 +$255 billion

2002 +$325 billion

2001 +$490 billion

2000 +$380 billion1999 +$240 billion

1998 +$280 billion

1997 +$195 billion

1996 +$170 billion

1995 +$150 billion

1994 +$16 billi on


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(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 th e debt to be liquidated because debt is

money. Liquidating the debt means liquidating the

money, or allowing for money supply deflation.

Ironically, th e solution is the very thing the Federal

Reserve itselfexists solely to prevent.

If the Fed ever tapers

QE the rate ofmoneysupply growth will

slow and interest

rates will rise causing

a deflation of the

fractional reserve money supply. Additionally, as the

total supply ofdebt-money increases the effectiveness of

$85 billion of QE each month declines. This is why QE3

is bigger than QE2which 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 supplyoutstanding. The

total money supply

outstanding must perpetually grow, forever.

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




10/12

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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. Ifthe Fed ever

were to taper the rate ofmoney supply inflation would

slow, interest rates would rise and the money supply

would deflate. Money supply deflation would result in

an uncontrolled collapse ofthe fractional reserve

banking system. The Fed can never taper QE. The Fedcan never end QE. Just to maintain th e 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.

www.knowmadiclife.com

www.facebook.com/gregory.loren.simon

[email protected]


11/12

Interesting th oughts, but I don't necessarily

agree with you on the prospect ofQE 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 ofprinting money needs nointroduction (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 n ot

because the market will eventually begin to

price in (devalue) the dollar to compensate for

such dismal returns.

Preview Post Comment

Jose Velez

about 2 days ago


12/12

I have written my own thoughts on QE at my

blog - http://investcafe.org/the-fed-continues-

monetary-policy-of-accommodation

Jose L. Velez

investcafe.org

- E E

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money is debt

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