QEasy time: How Banks create money by lending it. Or "If I had known that I would have gone into banking instead of cooking meth".

When people think about banks they think of a big pot of money (like a Scrooge McDuck bathing vault) that holds all the deposits that the bank then turns around and lends.  But that's not quite right because the first thing the borrower does when he gets his loan is use that money in a way that results in it being deposited back in the bank. In other words now the bank 'has' the money it's loaned to you as an asset but because the car dealer put the money he got from you back in the bank the bank still has the money to lend again while you have a car.  So there's something new that has been made by this transaction, namely: money. It is your decision to borrow money - because you believe you will get a return in excess of the rate you will pay (reliable transportation) - and the bank to lend it to you because they think you're good for the loan that creates most new money.  Thus it is the 'animal spirits' of the economy (got a job, need a car) that inflates the money supply and a fall in that confidence in the future (might lose my job, fix the old car) that causes people to save and pay down their debts that causes the money supply to shrink.

The central bank, by lending money to banks at preferential rates is a supplier to a process driven by the animal spirits.  They don't 'control' the money supply, rather they supply that which is demanded which results in an asset at the central bank and a liability at the commercial bank which is then turned into matching assets and liabilities all on down the line.  They can influence the pace of money creation by either refusing to lend to banks when they ask (what happened in the Great Depression in the US) or by varying the rate of interest that they charge on reserve loans to banks.

This is why central banks undertake Quantitative Easing: because they find themselves in a situation where they can't make banks borrow money from them (they can't push rates below zero) because investors won't borrow money from them unless the animal spirits are such that they believe the extra funds will yield a return. So stymied by pessimism that they believe is unjustified (why they are qualified to determine what is justified or not is beyond me) they bypass the banks and go directly to asset holders like pension funds or hedge funds and purchase assets - usually government securities but also mortgage backed securities in America to directly push more money into the economy.  Because the pension fund will turn around and buy another on average (because the central bank sits on what it buys) higher yielding asset.

By buying up more and more of the low risk financial assets in the economy in exchange for cash, QE tends to raise the price of other, higher risk, higher yielding assets - which is why they're doing it:  The QE faith is that more money leads to rising asset values leads to a rise in 'animal spirits' or the level of faith in the future which leads borrowers to demand more money and makes lenders more willing to lend it.  It's this 'con' game - slipping the economy a financial mickey that inflates asset values in the hope it will change the underlying assessment of the economy's fundamentals and so lead to a real change in the economy's rate of consumption and investment in productive assets and innovations (which of course are the only real ways to accelerate real economic growth and real wealth) - that is the whole point of QE.

Thus by utilizing quantitative easing central bankers have just appointed themselves economic shrinks who use the unique abilities of a Central bank to 'buck up' an economy that is 'discouraged' and 'down on its luck'.  Think of QE as financial Paxil.  Taking it doesn't change objective reality but by changing perceived reality, the Doctor of Financial Feelgood hopes to change everything.  And we're running a global experiment on just what putting financial anti-depressants in the economic water supply does to reality.

Because what if the reason that investors are 'pessimistic' is more fundamental?  What if the accumulated regulatory, tax and fiscal policies of the country have gotten objectively worse for wealth creation and/or based upon news reports and political realities, people expect that they're going to get worse in the future?  If this is the case then the cause of the low 'animal spirits' and the tendency of people to pay down debt rather than undertaking new, higher risk projects has nothing to do with being in a 'funk' it has to do with the math in the spreadsheets for new investment projects no longer adding up at the old rates of interest.  In other words, the 'hurdle rate' for investments at all levels of risk has risen because their underlying economics have worsened for whatever reasonor because the increased uncertainty about economic outcomes raises the level of asset volatility.  We don't know what to expect so we charge more for taking the risk.

If this is what is going on rather than some sort of financial glandular hypotrophy as the QE'ers argue, then the impact of the Fed buying a boatload of financial assets from fund managers will just be to raise the equilibrium value of boatloads of financial assets and raise the wealth of those who hold boatloads of financial assets (the fearsome 'capitalist' and vile 'one percent') relative to the other, less asset rich participants (the downtrodden 'prole' and virtuous '99ers').* Which is cool if you're bread is buttered by Toffs like the guys who run the Fed's is but it doesn't help the underlying economy's ability to create real wealth through innovation and investment.  Indeed by pathologizing the nation's mood rather than finding the fundamental cause of the funk and treating the symptom rather than the underlying condition, Dr. FeelGood puts off necessary change and risks the patient's well being by giving him a false glow of health while his insides continue to rot away.

Here's a little piece by the B of E on what money really is and their spin on QE.  It's shot in the bank's gold vaults which is a nice contrast - the very real gold gleaming heavily, dully in all its splendor versus the frothy insubstantiality of 'money' in an electronic age.  Ain't reality grand?

*An even worse outcome would be if the QE provoked an asset bubble and led to a crash which would have real economic effects.  Really bad ones.  This risk doesn't seem to be well understood or realistically factored into the calculations of the government's economic policy team.  Kind of scary, huh?