An Explanation of Quantitative Easing For The Uninformed – And Mr. Armstrong

It is now 7 years after the Fed began its first quantitative easing process, yet there are many who still do not understand how it worked, or, rather, will not work.  Recently, Mr. Martin Armstrong and I have gone back and forth in our own public forums regarding this issue in a very indirect manner, so allow me to present how quantitative easing works for all those that do not understand the process. While Mr. Armstrong questioned “I do not know how in the world someone can say the Fed created debt but not cash,” I believe this article will explain it to him and many others.  And, being a lawyer and accountant by training, I will attempt to take you through my thought process in a logical step by step progression.

What Constitutes “Money?”

Before we begin, please understand that this entire discussion is centered around the definition of “money.”  And, within the term “money” is included BOTH physical cash (“greenbacks”) and credit. 

Moreover, according to modern economic theory, the more “money” moving through our system, the more pressure is placed upon the goods and services being sold, which then “should” lead to inflation.  (As an aside, I have noted “should” since I believe that “modern economic theory” will eventually be proven as completely wrong in its own right).  So, increasing either the amount of “greenbacks” in the system or increasing the amount of utilized credit in the system are two ways many believe that we can see pressure on the price of goods and services being sold, which “should” lead to inflationary pressures.  The main reason is that when there is more available “money” (greenbacks or credit) to be able to buy the good and services available for sale, then the price of those goods and services “should” rise.

Lastly, understand that simply printing physical greenbacks is a direct manner in which the Fed can attempt to control inflation/deflation forces.  However, in order to increase the utilized credit side of the definition of money, there are two aspects upon which we will have to focus:  there must be more debt made available (supply), AND there must be increased demand for that additional available debt.

It is through this secondary method (the debt side of the equation), in which the Fed attempted to control the inflation/deflation forces in our system through its QE process. The demand side of that equation is not within the Fed’s control, whereas the ability to increase the available supply certainly is. 

Has The Fed Focused On “Greenbacks” or Credit?

Next, allow me to present a question to you.  If the Fed has at its discretion the ability to print actual greenbacks as a primary and direct tool in fighting deflation and attempting to create inflation, why would we need a quantitative easing process? 

If you understand the logic behind this question, you must conclude that there is clearly something about quantitative easing which is different than simply printing greenbacks.  You see, as mentioned above, quantitative easing targets the credit side of the money definition whereas printing additional greenbacks targets the physical side of the money definition.  Clearly, they are not one and the same as so many have erroneously suggested.  This begins to answer Mr. Armstrong’s question about QE not being the same as creating “cash” or, as it is also known, “greenbacks.”

Therefore, we may conclude that the more direct deflation fighting tool at the Fed’s disposal is printing actual greenbacks, whereas the secondary tool at the Fed’s disposal is much more indirect, and is called quantitative easing.  And, my claim that quantitative easing is not a process through which the Fed prints actual greenbacks, and floods the system thereby, is the premise upon which many have disagreed with me, including Mr. Armstrong.  But, it is quite clear that these are two very different methods through which the Fed will attempt to fight deflation, yet too many have incorrectly and inaccurately lumped them together as one and the same, erroneously calling it all “printing.” 

How Does The Fed Attempt To Control The “Credit” Side of Money?

The primary manner in which the Fed has been attempting to affect the monetary base over the last decade is through machinations that make available additional credit to the system rather than printing actual greenbacks. They do this by a process termed "monetization of debt."  

Allow me to explain how this process works, and why I say it is an indirect method at attempting to fight deflation, as compared to the direct method of simply printing greenbacks and flooding the system.

First, the Fed approaches its member banks, and acquires Treasury issued debt instruments in the open market from these banks.  Rather than sending newly “printed greenbacks” to their member banks, the Fed issues the seller bank a "credit" on its books for the acquisition price in its Fed account. In effect, the Fed simply creates a book credit for the seller bank that did not exist before. This is how they seemingly create money “out of thin air.” But, it does not send cash to the bank, as no additional greenbacks have been printed in this process. Moreover, since it never retires the Treasury debt instruments it acquires, it is simply adding available credit to the monetary base by these acquisitions and extensions of credit to the seller banks. 

When we follow the flow of “money” through these transactions, we can understand the process a little better.  First, the Treasury issues its bonds to the market.  This is the debt created and owed by the United States government.  That debt is sold to the public.  When the Fed goes into the market and buys these bonds from its member banks, it never retires the initial Treasury bond debt, so that debt still remains outstanding, as it sits on the Fed’s balance sheet. 

When the Fed issues a credit to the seller member bank for its purchase of the underlying Treasury bonds, it has now created an almost equal amount of further debt (beyond the underlying Treasury bonds) out of thin air. This additional credit issued by the Fed to the seller bank is the additional debt the Fed has made available for the bank to use in its lending business. And since the underlying Treasuries have never been retired, this method basically uses the same initial debt instruments (the original Treasury bonds) to create double the amount of credit in our monetary system.  Yes, indeed, this is the key stroke through which our Federal Reserve attempts to create “money” out of thin air through an increase in credit being made available to the public, not cash.

The problem with an attempt at creating inflation through an available credit expansion method such as QE is that there has to be not only a willingness to issue credit, but also a willingness to maintain or even accept further credit expansion by the public. For if the public is deleveraging at the same time that the Fed is attempting to expand the credit base, or if the member banks are unwilling to lend out those credits they acquired from the Fed in the debt monetization transaction, then the Fed is fighting an uphill battle it cannot win.

Therefore, the government's attempt to "impose" inflation by attempting to inject additional credit into the system cannot, by definition, work in a society that is in the midst of a debt deleveraging trend, either by choice (not accepting further debt, or reducing its current debt load), or by force (default). So, as long as the consumer at large is not commensurately "buying" the additional credit available (in the form of taking on new loans to purchase goods and services), then the credit available does not make it into the system to put pressure on inflationary forces, which is why quantitative easing will ultimately be viewed as a failure.  This leads us to the main “technical” reason that QE has not “caused” inflation, and that is because this lack of additional credit utilization has not led to a significant increase in the velocity of money through the system.

Avi Gilburt is founder of