tl;dr — Understanding quantitative easing did not cure me of my 26 years of virginity or solve my small pp problem.
The journey starts on a cold winter night in January. It is my birthday and in my drunken stupor, I proclaim to my friends that this will be the year I enlarge my small pp, get over my fear of woman and lose my virginity. Thus, I embarked on the journey of trying to understand what quantitative easing is. My hope was that understanding this magic term would lead me to great wealth that would cure me of my small pp and virginity. Spoiler alert, I do not have great wealth, my pp is the same size and I'm still a virgin.
So help me God
For those of you who wish to also know this useless knowledge that I have obtained, buckle up because this is a long one.
To start, we first need to understand "how does the banking system works?"
A bank has a balance sheet. On one side we have the banks assets and on the other, the liabilities. Here is a simple balance sheet:
Deposits are liabilities because the bank owes you that money. On the asset side, the bank holds securities (short term government debt, usually 1-3 months), loans (money to be paid back with interest) and reserves which is basically just cash (digital or physical). A simple way to calculate reserves is to do D – S – L = R. Works most of the time.
One other key concept, is the reserve ratio. This is a magic number set by central banks. If the reserve ratio is 10, that means that banks must have a minimum of 10% of the total deposits as reserves. So if I have 10,000 dollars in deposits, I must have 1,000 dollars in reserves.
Now, banks have a special power that allows them to create more money. They use reserves as collateral to create a loan, which in turn creates a deposit, hence creating more money! Let's take the following example:
In this example, Alice deposits 10,000 dollars into Bank A. Mr. John, in need of a pp enlargement surgery, takes out a 9000 dollar loan, which gets deposited into Mr. John's bank account at Bank A. Now, Mr. John takes out that money and gives it to Doctor Big D, who performs the surgery and puts that money into Bank B. So, let's walk through the balance sheets! Aren't we having fun??!?!?!?
Bank A: Alice deposits 10,000 dollars
Bank A: Mr. John takes out a loan for 9,000 dollars
Now at this point, Bank A has just created 9,000 dollars of new money. Because the money was put into Mr. John's bank account, the total amount of reserves at this bank, have not yet decreased. In addition the reserve requirement went from 1000, to 1,900 dollars.
Bank A: Mr. John withdraws the 9,000 dollars for pp enlargement surgery
Since Mr. John. withdrew this money, we now only have 1,000 dollars left in reserves (D – S – L = R), meaning Bank A can no longer create any new money through the creation of loans because they have no excess reserves (amount of reserves over the reserve requirement).
In the meantime Doctor Big D will deposit the 9,000 dollars at Bank B (Thanks for the op Doctor Big D!). These 9,000 dollars will become reserves that Bank B can use to create more loans and expand the amount of money in the system.
Bank B: Doctor Big D deposits the 9,000 dollars
So what have we learned? Well, the banks use reserves as collateral to create loans, which create deposits, thus increasing the amount of money in the system. As the money works its way back into the banking system, those new deposits become reserves which can be used to create more loans. Depending on what the reserve requirement is, changes how much the money can be "multiplied" by. So a reserve requirement of 10, means we can multiple the base reserves in the system by a factor of 10 (theoretically). If we have 1,000 dollars of base reserves, it could eventually be turned into 10,000 dollars.
"So how do base reserves get created?" We'll look at that in the quantitive easing section but first let's look at what happens when Mr. John starts paying back his loan. Then we'll look at the security part of the bank's balance sheet. After that, it is onward to the credit cycle, and quantitive easing.
Loans are a sneaky son a bitch and help create demand for money because the loans have to be paid back with interest. This is one way, money derives its value (i.e. more demand, more valuable something is). Now when a loan is paid back, it destroys the amount of deposits in the banking system, thus lowering the amount of money.
So let's say, after Mr. John get his pp enlargement surgery, he finally has the balls to ask his manager for a raise due to the new found confidence from having a big dick. Due to this new raise, Mr. John starts paying back his loan to Bank A.
Bank A: John gets a 1,000 dollar paycheck
Bank A: John pays 1000 dollars back on his loan with 100 dollars going to interest
So what happened here? Well, 900 dollars were removed from circulation since they are no longer deposits. Im addition, 100 dollars were paid as interest to bank A. As the bank pays their expenses with those 100 dollars, the 100 dollars just end up back in the banking system as deposits.
This leads to an important concept. As the amount of loans grow in the system the amount of money will expand and as those loans are paid back the amount of money in the system decreases. Or in male monkey talk, the more ass and boobies, pp expands, the less ass and boobies, pp contracts.
Okie dokie, securities are not any different from loans. Banks need to pay interest to depositors (although this is pointless today), so when banks can't find people to give loans to (only so many pp enlargement surgeries to be had), they instead buy short term government debt.
Let's say in the example above, AOC thought it was unfair some males had a small pp and other had a big pp. Thankfully, AOC, being the progressive she is, passed the bill, equal pp sizes for all. This bill reimburses men afflicted with the curse of a small pp. So back to the balance sheets.
Bank A: Starts off with 10,000 dollars in reserves
Bank A: Buys 9000 dollars of government securities
Bank A: The government reimburses Mr. John for the 9,000 dollar pp enlargement surgery by depositing the money into Bank A
In this example, the money that the government borrows will work its way back into the bank system, thus increasing the total amount of deposits by 9,000 dollars, thus increasing the total amount of money. Much wow, very cool. For Americans this means we all own US debt ^.^.
Now that we understand the basics of banking and how the money is created, let's move on to the next step, the credit cycle.
The Credit Cycle
You've made it this far, and we still have a ways to go. Take a break, watch a youtube video, engage in that late modernity cest pool of dopamine. I certainly did at this point.
The creation of new money through debt is usually referred to as the "expansion of credit." As we expand the amount of credit in the economy, more and more debt is being taken on. Eventually, something is gonna go, wrong, very wrong. You see, Doctor Big D had a boom in business after AOC passed the equal pp sizes for all bill. So Doctor Big D took on lots and lots of debt to expand the number of clinics he ran. However, eventually the pp enlargement business faced a great bust. There was simply not enough pps left to enlarge!
Everything starts going south. Doctor Big D, unable to pay back his debt, blows his brains out. His business, "Big Ds for All" goes under. His army of 10,000 pp enhancers all lose their jobs. No longer can they make their debt payments. Banks across the nation panic as mortgage default rates start increasing. They tighten up their lending standards. Companies, start panicking and cutting cost by laying off workers. Suddenly those workers don't have money to pay back their debts. More defaults! The economy enters free fall as everyone cuts spending, hordes dollars, and pray they'll have enough money to service their debts in this credit contraction.
Yikes! Now, who the fuck wants to live through that? Not me AND ESPECIALLY NOT BOOMERS. So this is where where the FED (or whatever the fuck your central bank is called) comes in with its big bad ass weapon, quantitive easing.
You can skip this part, and go to quantitive easing but if you want to see how a bank goes insolvent during a credit contraction, we gotta look at the balance sheet. FUCK, I hate these things.
Bank B: Life is good
Let's say this is Bank B, before Doctor Big D kills himself and Big Ds for All goes under. They've loaned 70,000 of that 90,000 to Big Ds For All.
Bank B: Big Ds for All defaults
O dingis in my kungbunghole! Bank B, now only has 50,000 dollars in assets but 120,000 dollars in liabilities. They'll never get enough money back in the form of loan repayments to pay back their depositors. This is how a bank enters insolvency.
Shit, this has taken all morning. My brain is shot… Here, I made a video on my anal abscess https://www.youtube.com/watch?v=SPu8rvk3QZc. I gotta pretend to work for a bit.
Okay, where did I leave off, ahh yes! Quantitative Easing. So remember that question you had, "So how do base reserves get created?" Well, this is where central banks come in. They're the bank for the banks. Thus central banks also have their own balance sheet (GOD DAMMIT).
In order for central banks to get some juicy assets, they go to their respective commercial banks and swap out commercial bank assets and in return give them reserve notes. From here, I'll just refer to central banks as the FED because I'm too retarded to think generically.
Here is a simple digram:
And in balance sheet shenanigans:
Bank A: Has 90,000 dollars of U.S. treasuries
Now the FED comes in and takes those 90,000 dollars of treasuries and gives Bank A 90,000 dollars of reserves.
Here's the thing, the FED just increased the base reserves in the system, making it easier for banks to give out loans. Thus this is referred to as making credit cheaper. At the same time, Bank A, still gave the U.S. government 90,000 new dollars that will work its way back into the banking system as 90,000 dollars of deposits thus increasing the amount of reserves again, by 90,000 dollars!
In the meantime the FED balance sheet has become this
Historically the FED has engaged in this mechanism through what is called the target Federal Funds Rate. There's quite a bit to this actually but the key takeway here is when the FED lowers the federal funds rate, one action they take is swapping short term securities from banks for reserves. When they raise the federal funds rate, they sell the securities back to the banks and take the reserves. Here is a chart of the Federal Funds Rate over time. (Note, these securities are so short in duration, the FED only has to wait 1 to 3 months for the US government to pay them back and thus, destroy the reserves)
As we can see, the federal funds rate has been mostly declining since the 1980s and every time we enter a credit contraction in the credit cycle, we massively cut the federal funds rate. This blunts the credit contraction by increasing bank reserves, lowering interest rates and resuming the increase in credit and debt. Low and behold the graph below.
This means, we keep kicking the can down the road and never letting the credit cycle complete. But remember, no one, and especially boomers wanted to go through a full contraction of the credit cycle. Today, it would be global suicided.
So, in 2008 (or if your Japan 2001), eventually the federal funds rate hits zero and it is time to get serious. Quantitative Easing (QE) is the next step. QE simply allows the central banks to swap what ever they want from a bank's balance sheet for reserves. For example, QE has allowed the FED to gobble up mortgage backed securities. The result is banks loan at lower interest rates in order to get home buyers to take out more/new loans. This result occurs because when a central bank engages in a swap with the bank, the bank loses an asset it was gonna make money on. Now the bank needs to create that asset again.
So QE helps keep the credit cycle going by increasing reserves, lowering interest rates and ultimately increasing the amount of credit/money in the system. Now for reasons in a different post, consumer price inflation has remained low despite this all this. However it has arguably caused massive asset inflation, contributing to an ever increase of wealth concentration.
To end it all, let's get back to the story of Doctor Big D and his clinic Big Ds for All. Let's imagine, instead of Doctor Big D having to kill himself and his life work going under, the FED in it's all mighty power comes in, engages in huge amount of QE, lowering interest rates for all! Big D is able to refinance, keep his business solvent and see his business recover as more zoomers come of age and get pp enlargement surgery. A happy ending for the day. Happy Thanksgiving.
but alas, Doctor Big D doesn't exist, my pp is small and I'm still a virgin.
So help me God.
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