by Daniel Nevins, CFA, Nevins Research
We’ve produced some research over the years that we’d love to see the powers-that-be react to, but none more so than our look at financial flows during the QE programs.
By netting all lending by banks and brokers-dealers and then comparing it to the Fed’s lending, we stumbled upon a chart that seemed to show exactly what QE does or doesn’t do. But “doesn’t,” not “does,” was the story, and it couldn’t have been clearer. Or shown a more stimulating pattern. To geeks like us, our Excel click on “Insert, Line” was like stepping from a shady trail to a sunny vista.
Here’s the updated chart, which we dubbed the “argyle effect” and looks even sharper than it did when we first produced it in 2014:
We like the chart because we’re just as confirmation-biased as the average human—anything that confirms our QE skepticism is cognitively satisfying. And the chart appears to show that QE was largely irrelevant. It merely replaced growth in privately financed credit with growth financed by the Fed. The Fed grabbed the credit-growth baton for QE laps and returned it to the private sector for QE pauses, and whoever didn’t have the baton more or less stood still. As we concluded in 2014, QE is a substitution story, not an addition story.
Many pundits told the addition story as QE was underway. They expected banks to “multiply up” reserves by aggressively expanding their loan books. But reserves never significantly multiplied. We think there are five reasons why the “money multiplier theory” failed:
- High-quality borrowers don’t emerge mysteriously from cracks in the Eccles Building and parade zombie-like to bank loan desks. In other words, credit demand was probably about the same with or without QE.
- QE’s effects on bank balance sheets aren’t quite as distorting as they’re often depicted. Consider that new reserves are typically matched by new deposits, because dealers offering bonds to the Fed get paid for those bonds through their accounts at commercial banks. In other words, QE adds a similar item to both sides of bank balance sheets, which you might not appreciate if your information comes from those who call for banks to “lend out” reserves. That’s impossible—reserves can’t be “lent out”—and it often leads to exaggerated statements about the implications of excess reserves.
- To a significant degree, banks can neutralize excess reserves (and the corresponding “excess” deposits) with financial derivatives and other balance sheet adjustments. They can rearrange exposures to mimic a balance sheet of equal risk that’s not stuffed with reserves.
- Just as importantly, excess reserves flow naturally from banks that don’t want them to banks that don’t mind them nearly as much. Consider that Fed data shows a disproportionate amount of QE’s extra reserves landing at U.S. branches of foreign banks. Those foreign banks might have sound reasons for holding excess reserves.
- The money multiplier theory is inconsistent with real-world reserve management practices. The Bank of England has called it “reverse” to how bank lending and reserve management work in the real world. And the gap between theory and reality is so large that you don’t even need the four reasons above to reject the money multiplier—you just need a healthy skepticism about mainstream theory.