Money for Nothin’ Writing Checks for Free

When coming from PIMCO, alarm bells should be going off.

Mr. Bernanke never provided additional clarity as to what he meant by “no cost.” Perhaps he was referring to zero-bound interest rates, although at the time in 2002, 10-year Treasuries were at 4%. Or perhaps he knew something that American citizens, their political representatives, and almost all investors still don’t know: that quantitative easing – the purchase of Treasury and Agency mortgage obligations from the private sector – IS essentially costless in a number of ways. That might strike almost all of us as rather incredible – writing checks for free – but that in effect is what a central bank does. Yet if ordinary citizens and corporations can’t overdraft their accounts without criminal liability, how can the Fed or the European Central Bank or any central bank get away with printing “electronic money” and distributing it via helicopter flyovers in the trillions and trillions of dollars?

Well, the answer is sort of complicated but then it’s sort of simple: They just make it up. When the Fed now writes $85 billion of checks to buy Treasuries and mortgages every month, they really have nothing in the “bank” to back them. Supposedly they own a few billion dollars of “gold certificates” that represent a fairy-tale claim on Ft. Knox’s secret stash, but there’s essentially nothing there but trust. When a primary dealer such as J.P. Morgan or Bank of America sells its Treasuries to the Fed, it gets a “credit” in its account with the Fed, known as “reserves.” It can spend those reserves for something else, but then another bank gets a credit for its reserves and so on and so on. The Fed has told its member banks “Trust me, we will always honor your reserves,” and so the banks do, and corporations and ordinary citizens trust the banks, and “the beat goes on,” as Sonny and Cher sang. $54 trillion of credit in the U.S. financial system based upon trusting a central bank with nothing in the vault to back it up. Amazing! Continue reading