Collateral Damage: QE3 and the Shadow Banking System

By Ellen Brown
Global Research
July 23, 2013



Rather than expanding the money supply, quantitative easing (QE) has actually caused it to shrink by sucking up the collateral needed by the shadow banking system to create credit. The “failure” of QE has prompted the Bank for International Settlements to urge the Fed to shirk its mandate to pursue full employment, but the sort of QE that could fulfill that mandate has not yet been tried.

Ben Bernanke’s May 29th speech signaling the beginning of the end of QE3 provoked a “taper tantrum” that wiped about $3 trillion from global equity markets – this from the mere suggestion that the Fed would moderate its pace of asset purchases, and that if the economy continues to improve, it might stop QE3 altogether by mid-2014. The Fed is currently buying $85 billion in US Treasuries and mortgage-backed securities per month.

The Fed Chairman then went into damage control mode, assuring investors that the central bank would “continue to implement highly accommodative monetary policy” (meaning interest rates would not change) and that tapering was contingent on conditions that look unlikely this year. The only thing now likely to be tapered in 2013is the Fed’s growth forecast.

It is a neoliberal maxim that “the market is always right,” but as former World Bank chief economist Joseph Stiglitz demonstrated, the maxim only holds when the market has perfect information. The market may be misinformed about QE, what it achieves, and what harm it can do. Getting more purchasing power into the economy could work; but QE as currently practiced may be having the opposite effect.

Unintended Consequences

The popular perception is that QE stimulates the economy by increasing bank reserves, which increase the money supply through a multiplier effect.  But as shown earlier here, QE is just an asset swap – assets for cash reserves that never leave bank balance sheets. As University of Chicago Professor John Cochrane put it in a May 23rd blog:




Cochrane discusses a May 23rd Wall Street Journal article by Andy Kessler titled “The Fed Squeezes the Shadow-Banking System,” in which Kessler argued that QE3 has backfired. Rather than stimulating the economy by expanding the money supply, it has contracted the money supply by removing the collateral needed by the shadow banking system. The shadow system creates about half the credit available to the economy but remains unregulated because it does not involve traditional bank deposits. It includes hedge funds, money market funds, structured investment vehicles, investment banks, and even commercial banks, to the extent that they engage in non-deposit-based credit creation. Kessler wrote:


That explains what he calls the great economic paradox of our time:


Fractional Reserve Lending Without the Reserves

The post-textbook form of money creation to which Kessler refers was explained in a July 2012 article by IMF researcher Manmohan Singh titled “The (Other) Deleveraging: What Economists Need to Know About the Modern Money Creation Process.” He wrote:


Like the reserves in conventional fractional reserve lending, collateral can be re-used (or rehypothecated) several times over. Singh gives the example of a US Treasury bond used by a hedge fund to get financing from Goldman Sachs. The same collateral is used by Goldman to pay Credit Suisse on a derivative position. Then Credit Suisse passes the US Treasury bond to a money market fund that will hold it for a short time or until maturity. Singh states that at the end of 2007, about $3.4 trillion in “primary source” collateral was turned into about $10 trillion in pledged collateral – a multiplier of about three. By comparison, the US M2 money supply (the credit-money created by banks via fractional reserve lending) was only about $7 trillion in 2007.  Thus credit-creation-via-collateral-chains is a major source of credit in today’s financial system.

Exiting Without Panicking the Markets

The shadow banking system is controversial. It funds derivatives and other speculative ventures that may harm the real, producing economy or put it at greater risk. But the shadow system is also a source of credit for many businesses that would otherwise be priced out of the credit market, and for such things as credit cards that we have come to rely on. And whether we approve of the shadow system or not, depriving it of collateral could create mayhem in the markets. According to the Treasury Borrowing Advisory Committee of the Securities and Financial Markets Association, the shadow system could be short as much as $11.2 trillion in collateralunder stressed market conditions. That means that if every collateral claimant tried to grab its collateral in a Lehman-like run, the whole fragile Ponzi scheme could collapse. That alone is reason for the Fed to prevent “taper tantrums” and keep the market pacified. But the Fed is under pressure from the Swiss-based Bank for International Settlements, which has been admonishing central banks to back off from their asset-buying ventures.

An Excuse to Abandon the Fed’s Mandate of Full Employment?

The BIS said in its annual report in June:


For “adjustment,” read “structural adjustment” – imposing austerity measures on the people in order to balance federal budgets and pay off national debts. The Fed has a dual mandate to achieve full employment and price stability. QE was supposed to encourage employment by getting money into the economy, stimulating demand and productivity. But that approach is now to be abandoned, because “the roots of the problem are not monetary.” So concludes the BIS, but the failure may not be in the theory but the execution of QE. Businesses still need demand before they can hire, which means they need customers with money to spend. QE has not gotten new money into the real economy but has trapped it on bank balance sheets. A true Bernanke-style helicopter drop, raining money down on the people, has not yet been tried.

[Continued...]

Check out the member blogs, videos, and discussions @ http://12160.info