QE is debt reduction

QE is not a liability transformation – it is debt reduction

The remuneration of bank reserves has been a source of significant analytical confusion among economists. This arcane technicality matters far more than it should [1]. The two most significant implications are: 1) public sector debt across the developed world is around 30% lower than typically estimated, and 2) central banks have limitless power to meet their inflation mandates, without veering into fiscal policy. As an aside, it also follows that the entire debate about central bank ‘equity’ is a distraction, and the widespread belief that monetary and fiscal policy are blurred is incorrect. There is a crystal clear distinction between monetary and fiscal policy, which is why we have independent central banks.

Recognition of these facts would aid policy substantially. We need to rethink the tools of monetary policy – not the objectives – and there is far more fiscal space than conventional analysis assumes.

The conventional argument now seems to be that QE simply converts fixed rate government liabilities into liabilities at overnight rates [2][3]. This appears obvious to a US-centric economist because the Fed ‘pays’ the target overnight interest rate on reserves. Reserves are treated in central bank accounts as ‘liabilities’, so one liability – a government bond with a fixed coupon – has simply been swapped for another liability which pays the overnight interest rate.

It shouldn’t need repeating, but accounting convention is just that – accounting convention. And accounting convention has not been static. Financial liabilities – the obligation to make a payment at a future date or in contingent circumstances – are real, but identifying and measuring them accurately in accounting terms is hard (if in doubt, read Warren Buffett’s shareholder letters), or this shorter take.

Unsurprisingly there is a thoughtful, albeit small, literature which considers the accounting treatment of central bank reserves, most of which concludes that they do not have the simple characteristics of liabilities, and are almost certainly not liabilities at book value. This superb paper by Bank of England researcher, Michael Kumhof, and others, is probably the most insightful.

Why might we doubt the accuracy of accounting convention for reserves? The first obvious point is that notes and coins are not financial liabilities. A financial liability is the obligation to make a future payment – there is no such obligation with physical cash. Physical cash is the means of payment. Given that bank reserves are really just the electronic equivalent of notes and coins it would seem odd that the simple shift from physical to electronic form should transform something which is not a liability into a liability.

This is where the remuneration of reserves becomes paramount. But first let’s clarify the unique properties of reserves when compared to government bonds. Government bonds are traded in the open market, and their price (yield) is determined by the market exchange of bonds. When governments issue bonds the private sector is under no obligation to buy them. It does so at a price of its willing. To be clear, none of this really changes with QE. The outstanding stock of government bonds remains vast despite central bank holdings, and most developed government bond markets are therefore highly liquid, so if the private sector wants to change the yield, it can. For this reason, most estimates of the impact of QE on bond pricing are unsurprisingly negligible.

Either way, reserves are created in a completely different manner to government bonds, they are not subject to a potential private sector funding constraint. Because they are the electronic form of money between banks, and the central bank is the monopoly producer, the central bank can buy things with newly created money at will. Indeed the very process of creating reserves (buying assets or making transfers) already distinguishes reserves from bonds which are sold into a market.

To put it simply: you buy things with money, but you have to sell bonds to someone. Reserves are therefore qualitatively different to government bonds. This should be macroeconomics 101, as it is the basis of the distinction between fiscal and monetary policy, both theoretically and institutionally.

The crux of the matter therefore seems to be the remuneration of reserves. Bank reserves are not simply electronic notes and coins because central banks pay interest on them. This of course was not always the case, but it is currently. Does the payment of interest on reserves fundamentally change their nature? An immediate reason for scepticism is that the payments made to holders of bank reserves (regulated commercial banks) is not an ‘interest rate’ as we typically think of one. It is a percentage payment on the notional value of the reserves, but typically an interest rate is a necessary compensation (a price) required to create a voluntary market exchange between an issuer of a bond or loan and the buyer of a bond or provider of a loan. This is not the case with bank reserves. The central bank can remunerate however much it wants (positive or negative) without affecting the quantity outstanding. That’s because reserves are money.

So why do central banks pay ‘interest’ on reserves? Interestingly, the answer is entirely independent of all of these issues, and rests on a practical matter of how to control money market interest rates – the rates at which banks lend to each other, and which act as a benchmark for the pricing of loans and deposits across the financial system. Recent innovations in reserve management have rendered this need redundant. It is no longer the case that a positive or negative IOR is necessary to control money market rates. By paying different interest rates on required reserves and excess reserves – as a number of central banks now do – the central bank can now pay whatever ‘interest rate’ they want on reserves, independently of the money market rate they are targeting. If the central bank is targeting a negative money market rate, it pays a positive rate on required reserves, netting to zero. Conversely, if the money market rate is positive, the rate on required reserves would be negative.

This begs an obvious question: how much should banks be compensated for holding reserves? As is always the case when we think of a general equilibrium model with competition, it may not matter very much. If banks are ‘penalised’ for holding reserves, capital should leave banking and margins should rise – i.e. the rest of the economy will pay more for banking services, so everything nets to zero. There may be truth in this framing, but it feels unsatisfactory and clearer guidance would seem helpful.

There are very strong grounds for paying a zero interest rate on reserves. The most obvious is that banks are taking zero credit risk. Reserves are electronic money. Base money has no credit risk, but is required for the functioning of the banking system, and is created under a monopoly by the central bank. What is true is that holders of base money – either in its electronic form (bank reserves) or its physical form (notes and coins) – are exposed to inflation risk. If we impose the costs of inflation on banks’ holdings of base money, this cost will presumably be passed on to some extent through the bank system. The challenge with targeting a zero real return on reserves, although it may be ideal, is that inflation is imperfectly measured and we are almost certainly overstating it. In a world where central banks are targeting less than 2% inflation, zero nominal remuneration seems reasonable. After all, central banks are providing a services to the commercial banking system – reserves on demand – which it seems fair to charge commercial banks something for. (Interestingly, if the Fed was to be consistent with its own philosophy on this it would average a rate of interest equal to inflation. It is intriguing that following the shift to IOER targeting, no US economists have argued that the Fed should offset the effects of the transfer to banks with a change in the IORR).

A competing rule worth considering is that the central bank should target zero net profitability. Again, this trivial feature of central bank accounting, which results in transfer payments of “profits” to governments has confused many economists, not just opponents to the ECB’s bond purchases, that there is a blurred line between monetary and fiscal policy. An easy way to do this under the current accounting regime of course would simply be to provision away any net income surplus. There would be obvious distributional consequences within the financial sector in targeting zero net income, which is another reason to abandon asset purchases as the main means of trying (failing) to stimulate demand. Direct transfers to households are hands down more efficient, with no impact on bank profits or fiscal positions under a regime of zero interest on reserves.

My suggestion is that monetary policy can, and should, be implemented by providing a net remuneration of zero at any point in time to commercial banks holding reserves at the central bank. At its simplest, central banks could operate with two tiers, required reserves and excess reserves. Excess reserves – which can be loaned to money markets would be remunerated at an interest rate consistent with policy objectives – and the interest rate on required reserves would be calibrated so the net compensation is zero.

This is not only appropriate given banks are taking no credit risk and cannot control the stock of reserves. It helps in both directions: when central banks are targeting negative interest rates in money markets commercial banks are not penalised for holding a quantity of reserves determined by the central bank. Similarly there is no ‘gift’ to banks when interest rates are positive.

But the major benefit it seems is to clarify a dangerous but widespread error – public sector debt is not high, and central banks can do a lot more. Why does this follow? First, we can simply net off holdings of public sector debt by central banks, while being cognisant that this could reverse in future. Secondly, central banks can make transfers via dual rates and perpetual loans which permit them to meet their inflation targets without any impact on accounting equity or institutional transfers to the fiscal authorities.

Analytical confusions dissipates, central banks can do their jobs, and fiscal policy is liberated to focusing on much needed (and high returning) capital investment.

[1] See this crystal clear Eco Notepad from the Banque de France. “There is nothing magic in central bank money.”

[2] This paper by Robert Hall and Riccardo Reis is a good example, it even describes money printing through reserve creation as ‘borrowing from commercial banks”, by the same linguistic rule you would say central banks are ‘borrowing from the general public when then issue notes and coins’ – which doesn’t even make sense. This is a good example of the problems economics faces in using natural language to describe objective diverse phenomena. As occurs frequently in natural and unscientific languages, economists have a terrible habit of using the same terms to identifying distinct phenomena. It often starts as a metaphor – signalled by inverted commas – and morphs seamlessly into a (false) identity. Base money is the purest form means of payment, which is created at will by the central bank and defines monetary policy – no one does any borrowing or lending, as this short note will make clear.

[3] This UK economics commentary from Robert Peston illustrates the political risks associated with these category errors.

About The Author

Eric Lonergan is a macro hedge fund manager, economist, and writer. His most recent book is Supercharge Me, co-authored with Corinne Sawers. He is also author of the international bestseller, Angrynomics, co-written with Mark Blyth, and published by Agenda. It was listed on the Financial Times must reads for Summer 2020. Prior to Angrynomics, he has written Money (2nd ed) published by Routledge. He has written for Foreign AffairsThe Financial Times, and The Economist. He also advises governments and policymakers. He first advocated expanding the tools of central banks to including cash transfers to households in the Financial Times in 2002. In December 2008, he advocated the policy as the most efficient way out of recession post-financial crisis, contributing to a growing debate over the need for ‘helicopter money’.

14 Responses

  1. Subhash

    Hi Eric,

    I have several questions on this blog post based on my understanding and would like to know your thoughts as well, as much to make sure that I am not misinformed.

    1. The first obvious point is that notes and coins are not financial liabilities – I believe they ARE financial liabilities. They are a “promise to pay”. They are a medium of exchange (means of payment) because they are accepted as legal tender in exchange of services rendered and for taxation and they are backed by the full faith of the US treasury. Deposit money is a financial liability by virtue of the process of credit creation – banks lend which results in an asset (loan) and a liability (deposit) in the account of the bank and an opposite asset (deposit) and liability (loan) in the account of the borrower. If the borrower decides to withdraw cash, then an asset swap from deposit to notes/coins takes place in the B/S of the borrower.

    2. On treasury yields and QE – The difference between QE and conventional OMO is that in OMO, the counterparties are narrower and HAVE to have an account at the Fed and the money that is created or traded in the interbank market is monetary base/narrow money and the asset underlying it is invariably treasuries. In QE, a broader range of assets beyond treasuries can be purchased, the ultimate counterparties include those that do not have accounts at the Fed and therefore cannot participate in the interbank market. Therefore, the money that is created is NOT monetary base but broad money. Reserve money can only be used in transactions with the CB or in the interbank market or payment settlements while broad money can be used for anything. Therefore, QE effects prices/yields of much broader asset classes than just US treasuries.

    3. My understanding of the need for IOER is again driven by the limitations of reserve money – can only be used in transactions with the Fed or interbank market or payment settlement. Treasuries on the other hand can be used as collateral in a wide variety of transactions and with a wide array of counterparties. So, in stable market conditions, banks would not willingly hold reserves beyond their preference. They would rather hold liquid treasury securities. That can create problems in the fed funds market in an excess reserve environment.

    • Eric Lonergan

      1) Liability = obligation to make a payment. Liabilities are real things. If you can’t meet the obligation you default. ‘Default’ = fails to make a payment. Money = ‘means of payment’. ‘An obligation to make a payment’ ≠ ‘the means of payment’ – by definition. What is written on notes and coins, what money is used for as a means of payments (for example paying taxes), changes none of this, because money = ‘means of payment’ and not ‘obligation to make a payment’. What about deposits? Deposits *are* liabilities, because they are an obligation to make a payment. The fact that they can also function as money is independent of this fact. Many deposits are not money – but all are liabilities. Indeed, to the extent that they are liabilities, this can prevent them being money. For example, if I attempt to make a payment and my bank defaults, my deposit stops functioning as money. So, the property ‘money’ is distinct from the property ‘liability’ – which is also why we have distinct terms.

      2) Base money is created by QE, as well as broad money. The effect is negligible because from the private sector side our assets don’t change (we lose a government bond and gain a deposit) and from the governments side the stock of net debt doesn’t affect spending.

      3) ECB and others is operating with tiered reserves without any significant problems.

  2. Oliver

    Is this the reason you changed the name of your blog? Simmel was not a monetarist…

    Simmel, Philosophy of Money: “When barter is replaced by money transactions a third factor is introduced between the two parties: the community as a whole, which provides a real value corresponding to money. The pivotal point in the interaction of the two parties recedes from the direct line of contact between them, and moves to the relationship which each of them, through his interest in money, has with the economic community that accepts the money, and demonstrates this fact by having money minted by its highest representative. This is the core of truth in the theory that money is only a claim upon society.”

    This is Simmel’s description of money as social credit = debt. I.e. a real, public debt which consists of the obligation of the public to provide goods (real value) and not just ‘the obligation to make a payment at a future date’, as you put it. In this sense, which is the only siginificant sense of the term imo, an exchange of public debt held by the public for money held by the public is very clearly NOT a reduction of debt. It is an exchange of public debt under one name for the same piblic debt under another, with slightly differing conditions. The difference between the two disappears completely if, as you seem to be suggesting, you add a provision that all risk / rewards associated with public debt does not accrue to treasury (fiscal effect of monetary policy / zero net profitability) but is passed straight back to the banking sector.

    That provision is also at odds with the other suggestion you seem to be making, namely that the efffect of OMOs be neutral wrt to the banking sector. You can have either one or the other, but certainly not both.

    So, your assertion that the CB can print as much money as it likes, i.e. may extend ist balance sheet at will to purchase existing public debt, while true, is insignificent in light of the above definition(s) of debt. No amount of balance sheet acrobatics changes the amount of debt in public hands. Or only at the margin if you allow for a fiscal effect of monetary policy. If you provision that away as well, you willingly neuter monetary policy.

    • Eric Lonergan

      Hi Oliver, the blog is still called Philosophy of Money. I’m not a great fan of Simmel’s work. He desperately needed an editor. Also, he never really nails down the origin of the value of money. Hume is the best philosopher of money, because he gets the idea of an externality. The crux to understanding money is here, I think – it’s closest analogue is not a social ‘debt’, but language. Also, you might find this interesting on the philosophy of economics – it is a very common error in a lot of economics to start with a metaphor and end with a false identity. In this area, the word ‘debt’ is used metaphorically and then assumed to be an identity. If we clearly define our terms we can avoid these errors.

      • Oliver

        Hi Eric,
        Thanks for your reply. Re Simmel: I see, I guess I was puzzled by the fact that you would quote his famous work but defend a viewpoint that could not be further from his. I haven’t read the whole thing in depth, I admit. Long and winding, as with all German writing of that time. Concision hadn’t been invented, yet. But that doesn’t necessarily make it wrong, even if he does not quite nail it. The second post you link to is also purely metaphorical, btw.. Not that I completely disagree with it.

        Anyway, I read both posts you linked to. In fact, I commented on the first post in 2016. My views have evolved slightly since then. If you’re interested, I & my co-author actually discuss this very post in the draft paper linked to in my name.

        See p. 19 “Puzzle 2: Is fiat money a net asset?” & Footnote 47, where we come to the conclusion that both your view and Wray’s can be improved upon.

  3. Andrea G. Tosato

    Hi Eric, thank you for sharing your thoughts.

    I haven’t made up my mind yet when it comes to CB money being debt or not. I found your arguments appealing (indeed, CB money in inconvertible) but I still think that it is redeemable as maintained by the MMT crowd. Could you explain me your views on redeemability and/or point me to some refences?



    • Eric Lonergan

      Thanks Andrea. I think these issues are resolved by a clear definition of ‘liability’. It’s an obligation to make a payment. There is no such obligation with reserves. It’s the means of payment for banks and the CB. It’s that simple.

  4. Daniel Baeza

    Hi Eric, big fan of your work, specially dual rates. I recently published an economic proposal for the Costa Rican Central Bank based on dual rates.

    I didn’t quite follow the following part of your article, would you mind sharing a bit of light?
    If the central bank is targeting a negative money market rate, it pays a positive rate on required reserves, netting to zero. Conversely, if the money market rate is positive, the rate on required reserves would be negative.

    • Eric Lonergan

      Thanks Daniel – and good work with the paper. I am suggesting that it might be best if the central operates policy by paying commercial banks an average interest rate of zero across required and excess reserves. By remuneration required and excess reserves at different interest rates, central banks can determine whatever money market rate they want while maintaining an rate of zero as the average across all reserves.

  5. Brent

    I have recently heard podcast featuring Raul Pal. While much of what he talks about seems rather extreme he brought up an interesting point on the mystery of “no” inflation. He contends that our classical measure of inflation is inadequate. That if one looks at fixed asset class value we see significant inflation. He uses the example of gold and bitcoin, but also draws in stocks. He creates a curve trending SP 500 vs USDs (total) and draws a rather flat curve. Essentially making the point that the rise in stock prices trends the “true” value of money. As the number of dollars increases the so do stock prices.
    This raises a bunch of problems including the fooling of the middle class and given that labor is increasingly not a fixed asset, global labor prices will likely continue to fall, meaning more of gap between the financial and labor classes.
    I admit I am a rank amateur but this sounds scary.

    • Eric Lonergan

      Thanks for the comment Brent and apologies for not replying sooner. Have you got a link to the Raul Pal podcast? ‘It shows up in asset prices’ is a very old line, and not very insightful imo. The S&P500 has significantly risen with earnings (there’s also been some PE expansion, but not comensurate with the decline in real interest rates). Also, the performance of other stock markets is very varied, ie Europe. The reality is there has been almost no inflation in goods and services, and the performance of asset prices varies hugely by geography and type.

  6. Kingsley Lewis

    Government bonds, cash and bank reserves are all similarly debts owed by the government.

    Debt = “money owed or due”.
    Every debt has a creditor and debtor.
    A “creditor” is a person or organisation which to whom the money is owed.
    A “debtor” is a person or organisation which owes the money.

    In the case of a bond issued by the government, the bondholder is entitled to be credited with interest and redemption payments from the government.
    So the bondholder is the creditor and the government is the debtor.

    In the case of cash (notes and coins) issued by the government, the cashholder is entitled to be credited by the government with tax credits or credits against other debts owed to the government.
    So the cashholder is the creditor and the government is the debtor.

    Likewise in the case of a bank reserves held at the central bank, the banks are entitled to be credited by the government with tax credits or credits for other debts owed to the government.
    So the banks are creditors and the government is the debtor.

    Thus government bonds, cash and bank reserves are all similarly credits to the private sector and debts owed by the government.
    So QE is NOT debt reduction. It merely reduces a government’s liabilities from bonds with a corresponding increase in liabilities from cash and bank reserves.

    • Eric Lonergan

      Hi Kingsley, thanks for the comments. There are lots of posts on this blog explaining why that line of reasoning is false. Money = means of payment. Debt = a claim on something. ‘Means of payment’ ≠ ‘a claim on something’. I am afraid this is logic. See ‘Money is not a cigarette’ for chapter and verse, or many others.


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