(Updates with quotes from Paul Sheard in new 9th paragraph.)
Billionaire hedge fund manager Ray Dalio’s half-hour video animation How the Economic Machine Works has gotten more than half a million hits on YouTube since it went live in September, which is pretty good for a piece with no kittens. It’s a clear description of how over-borrowing leads to booms and busts. According to the New York Times, former Treasury Secretary Henry Paulson has been sending the link to friends, and former U.S. Federal Reserve Chairman Paul Volcker is a fan.
But the founder of Bridgewater Associates gets one thing wrong—not once but repeatedly—and it leads him to a wrong conclusion about how the economy can recover from busts.
Dalio says central banks such as the Federal Reserve can lift an economy out of a rut by printing money. In a 210-page document (PDF) on the Bridgewater website that’s a kind of companion to the video, he writes: “This ‘printing’ of money takes the form of central bank purchases of government securities and non-government assets such as corporate securities, equities and other assets.” In other words, quantitative easing.
Dalio isn’t going out on a limb here, to be sure. This is a widely held view that has been expressed by such luminary economists of the right and left as Martin Feldstein of Harvard University, John Taylor of the Hoover Institution, Allan Meltzer of Carnegie-Mellon University, and Alan Blinder of Princeton. (For references, see endnote 2 here [PDF]). It is, however, incorrect.
Quantitative easing isn’t “printing money.” If it were, the supply of money would have soared and the U.S. would have either much more economic growth or much more inflation—or probably some of each. Instead, the Fed’s purchases have merely managed to give the banking system a huge increase in unneeded reserves.
The way to increase the amount of money—and get the Bureau of Engraving and Printing to rev up its presses—is for banks to make more loans. Borrowers will put most of the money on deposit, but they will take some of it out to spend. That will increase the amount of money being passed around between buyers and sellers—i.e., in circulation. That process is largely beyond the Fed’s control.
An excellent explanation of how money works is Repeat After Me: Banks Cannot And Do Not ‘Lend Out’ Reserves (PDF). It’s by Paul Sheard, chief global economist of Standard & Poor’s Ratings Services (MHP). Sheard may not be a billionaire like Dalio, but he has had an illustrious career in finance at Nomura (NMR), Lehman, and Baring and in academia as a professor at universities in Australia, the U.S., and Japan.
Dalio’s video makes Fed easing seem like a guaranteed solution to deflation, the only worry being that the central bank might be too successful in turning things around and accidentally cause inflation. But as Sheard writes, “One should not put much store in monetary policy’s stimulatory potential in a deleveraging environment once the central bank has cut the policy rate to or near to zero and still needs to ease policy more.” Which is the situation we’re in now.
I asked Sheard about Dalio’s video. He responded by email today that he hadn’t seen it so he couldn’t comment. He wrote, “The main point I would make about the ‘money printing’ view of QE [quantitative easing] is that it is a misleading term.” Yes, the Fed injects more reserves through QE. But it simultaneously removes bonds from circulation. So it’s really just changing the composition of the private sector’s balance sheet.
There is no printing press in the basement of the Fed. Not literally, of course. Not conceptually, either.