FT Alphaville " Don't call it money printing, rubiks cube edition Last week FT Alphaville drew attention to the fact that HSBC had joined the cohorts of the "don't call QE money-printing" brigade. We thought this was a great positive for the mainstream analyst community. Moreover, we thought their explanation was really good. That didn't, however, stop the money-printing cohorts from bombarding us (and some of the people we named in the post) with the following sorts of Tweets. We don't want to name and shame, so we've blanked the respective party. We have thought long and hard about how to respond to this because it's clear from the above that the message is being lost somewhere. It's also clear that Twitter is not the best platform to engage in this sort of debate - at least not without generating diminishing Tweet returns. At first we thought of doing a video response... But then we received this: A delightful request and one we couldn't be more happy to reply to. So here's our attempt. In one short snappy MS Paint graphic here is the key reason why QE is not pure money-printing: This, we fully appreciate, is a rather Keynesian (and MMT) view of the world. But it's also a view that's been repeatedly proven right (especially in Japan). There's also good reason to believe that it's the view that Bernanke holds. In our diagram the economy is represented by a rubiks cube, which accounts for all the stuff available for purchase today, as well as all the money that's in circulation. "Today money" is made up of any exchange unit that is accepted by the economy for exchange of physical goods, assets or services. In our block it is represented by the light green colour. It can be bank credit, IOUs, currency notes, privately issued points, coupons or even pebbles. It really doesn't matter. As long as the economy accepts the tokens for exchange and redemption of physical goods, it counts as "today money." It's important to note that "today money" represents a ration of wealth that has already been created by the economy and is therefore already there for the taking. The work to create those goods has already been done. The money is a credit that allows the economy's wealth to be shared out amongst the economy. The amount of "Today money" thus sets the clearing price for all goods and services. Now, if there was only "today money" in circulation and no "tomorrow money" at all then the value of "today money" would almost certainly be proportional to the amount of it that's in circulation relative to the amount of stuff that's available for purchase in the economy. This state of affairs is summed up beautifully by Milton Friedman's classic quote: Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. Yet, the Friedman quote fails to account for the effects of "tomorrow money." And here we turn to Keynes's General Theory, which explored the role and impact of "tomorrow money" (also described as savings) in great depth, especially with regards to its effect on interest rates, equilibrium and prices. The amount of "tomorrow money" in circulation is directly proportional to the economy's need and want for more stuff, as well as its fears about scarcity in the future. If the economy feels there will not be enough goods tomorrow, it is compelled to holdback on spending and consumption today - just like Joseph and the pharaoh - and recycle ever more "today money" into "tomorrow money." The process essentially involves suspending one's right to redeem today's goods until tomorrow, while redirecting today's redemption rights to a third party who promises to use the goods and services in such a way that adds to overall output. The person who gives up the redemption rights becomes the investor. He is compensated by the third party with a bonus redemption right in the future, on the premise that there will be more output to share at that point. The greater the need for more stuff tomorrow (and the greater the fear of scarcity), the greater the bonus payment demanded. Every time redemption is delayed by someone in this manner, it adds what we've called "tomorrow money" into the system. This is the right to redeem a certain amount of output in the future. One other important distinction... "tomorrow money" can either be privately generated or government generated - depending on who is doing the investing. The QE swap So our concluding point is this: when the Fed does QE it only swaps "tomorrow money" for "today money." It does not, however, add to the overall quantity of money. By taking "tomorrow money" from the system, the Fed forces the real rate of interest lower by adding to the amount of "today money" that ends up chasing "tomorrow money." The swap is supposed to encourage a certain portion of money (redemption rights) - which is already in existence - to be spent on (or redeemed for) available goods today, rather than be saved until tomorrow and/or deployed on efforts designed to create yet more unprofitable output. The overall message being: save less and redeem goods and services (output) today. This is very different from the Fed sprinkling additional quantities of "today money" into the system without taking out respective blocks of "tomorrow money" at the same time. It's also very different to the private sector printing up ever more blocks of its own "today money" to redeem an ever smaller portion of real output - the situation which applied to Weimar. In our next post we'll tackle how the Rubiks cubes have changed throughout this crisis. Related links: Money Multiplier Fallacy - Delusional Optimism A time of hoarding and inflation fears, 1930s edition - FT Alphaville The decline of "safe" assets - FT Alphaville On the transfer of risk and the mystery of low yields - FT Alphaville The "high-powered money" problem - FT Alphaville This entry was posted by Izabella Kaminska on Tuesday, October 2nd, 2012 at 17:01 and is filed under Capital markets, Commodities. Tagged with Deflation, inflation, money printing.