"that they do understand the banking system and that it is inaccurate of you to say that they don't - of this I am sure because I have read and listened to both gentlemen for many years, years after I personally learned how the banking system works."
No, I do not think they do. They don't understand how the banking system works, as I will explain below.
"1. How can you say that QE doesn't add dollars to the general economy?
Clearly, it does."
If this is so clear, why has inflation been so low since QE was started?
"When the Fed purchases bonds from a primary dealer they do so with funds that didn't previously exist."
"Sure, they can remove those funds by selling the bonds (provided that they can get the same price, which they won't be able to do if interest rates rise)"
"but the process of purchasing the bonds not only creates money out of thin air"
No, this is where you are wrong. When the government spends money, regular money, then it is actually adding money to the economy. Money that you and I spend. When the government purchases bonds from the banks, it is merely changing the structure of their assets. It is giving them a short-term, non-interest-bearing asset in exchange for a longer-term, interest-bearing one. The funds that the federal reserve gives to the banks goes to their reserve account at the fed. They can't "loan them out". They can loan it to other banks, use it to meet their liabilities (where QE is the government allowing them to bypass the natural decline in their assets if they had to unload them quickly), or use it to meet reserve requirements.
The way that QE is connected to money creation is, that, let us say, banks in general saw a lot of credit-worthy customers, but didn't have enough liquidity to meet reserve requirements(which are nowadays miniscule) or their liabilities. Instead of forcing the banks to sell off assets(and therefore having to accept reduced value), the federal reserve exchanges their assets for reserves, which they can then use to meet the above two things. Then, the bank will be able to make the loan, thereby raising the effective money supply (causing inflation).
As you can see, the QE has a tangential effect on the money creation process. In fact, the reason that QE is/has generally failed, is because Berneke himself doesn't understand the banking system. Because ultimately, QE takes assets OFF the books of banks...they are in fact losing interest in exchange for short-term reserves. In the case where the government buys bank-issued bonds in exchange for reserves, the banks have just exchanged a short-term liability for a long-term one. Essentially, they've been given extra liquidity, but their books are still in terrible balance.
Moreover, banks cannot find enough credit-worthy customers in order to create money and improve their financial state. QE doesn't change that...reserve requirements and even short-term liquidity are hardly a bother to banks if they feel that they have a credit-worthy customer they can make a profit on.
"Do you not see that the Fed's actions enable overspending politicians, and if you do see, do you not see this as problematic?"
Fundamentally, the government doesn't "have" to sell debt. It would be like, in a game of gin rummy, getting angry when the dealer awards you points without having taken them from someone else first (best analogy I could think of in a short notice). He's the dealer...he gets to make points out of then air.
The reason that government sells debt, fundamentally, is to alter the short-term interest rate. Government spending naturally increases the reserve level of banks. As reserves get larger, short-term interest rates drop...the reason being, that with so many reserves, banks do not have to think about the risk of having to borrow money from the Fed, redemption of banknotes, meeting reserve requirements, etc. The short-term interest rate heads towards zero. Moreover, government debt provides the market with, what has generally been, a safe, risk-free, good-interest bearing asset. Typically, one that beats inflation.
If short-term rates get too low, THEN you have the fear of bad credit being created. Now, if the banks "do nothing", they aren't even going to be beating inflation. The risk-reward curve gets altered, and banks will take more risk to get reward. You can kind of see how government debt pushes interest rates up...why would a bank give you a 30-year mortgage at 3% when they can buy a 30-year government bond and get 3%?
In fact, my opinion is that the government might have to crush reserve levels in order increase interest rates, because government debt is too-good of an investment...uncertainty is dropping government debt to such low rates, that the general rate is dropping too quickly for banks to make profit quickly enough to improve their financial situation. Normally, banks would counter this by going for higher-risk investments; this is something else we want to avoid. We aren't getting this because the banks are so terrified of risk (rightfully so). The Fed is worried that if they crush reserves, and perhaps use other tools to raise interest rates (like perhaps artificially set rates on government bonds), you'll kill investment since the interest costs go up. But, I would argue that lowering rates isn't going to increase the pool of credit-worthy customers. Increasing the rates might decrease that pool, but it may also give the financial sector more valuable(higher profit) assets.
"You said that the government doesn't need to issue debt. But in the real world today it clearly does."
I hope I clarified this, above.
"politicians will overspend, and in order to fund the overspending they must borrow. The alternative is raising taxes, and since the livestock doesn't like that politicians avoid this funding method in favor of borrowing."
If government really does "overspend", this will cause inflation. As much as they need to destroy that inflation, they don't need to borrow, they need to tax. Taxation takes money out of deposit accounts, which would have been spent, and directly influences inflation; borrowing CAN take money out of deposits if issues to the public, but when issues to the central banks, borrowing simply reduces reserves.
"Eventually, as the borrowing grew lenders would demand higher and higher interest rates"
A real-world counter point to this, might be that government borrowing has exploded since 2007, and interest rates have only gone south. Higher interest rates, at face, would likely attract more investors. It is just that higher rates usually come because of a decrease in the attractiveness of the underlying asset. Just to clarify.
"But as long as the Fed is there to pick up the slack with new money created out of thin air, politicians can continue to overspend until something happens to stop the process."
Look, if this is true, then why wouldn't people make investments knowing that only this new money creation is funding government borrowing? Why do they seem to be unworried about something "stopping" the process?
"taxed via the inflation tax"
1) Inflation is like, what, 1.5%?
2) Inflation is typically covered by wage growth.
3) Inflation lowers the debt burden.
Plan for eliminating the national debt in 10-20 years:
Specific cuts; defense spending: http://rolexian.wordpress.com/2011/01/03/more-detailed-look-a
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