Stock-Flow Accounting And The Coming $10 Trillion Loss In Paper Wealth by John Hussman, Hussman Funds.
Many of the misconceptions that investors hold about the economy and the financial markets can be clarified by understanding the relationship between the “flow” and “stock” of various quantities in the economy.
Before going further, let’s take a minute for some background. The total quantity of currency and bank reserves in the economy – what’s known as the “monetary base” – is uniquely determined by the Federal Reserve, and is equal to the stock of Treasury and mortgage securities on the Fed’s balance sheet. Once the Fed creates a dollar of monetary base (which the Fed does by purchasing a government security and paying for it with Fed-created base money), that dollar remains in the form of base money until that dollar is retired by the Fed. Monetary base is retired when the Fed sells a government security, or receives payment at maturity. In both cases, the assets on the Fed’s balance sheet are reduced by the amount of government securities it no longer owns, and the liabilities on the Fed’s balance sheet are reduced by the amount of base money it takes back in. To see that a dollar bill is a liability of the Fed, read the top line of any bill in your pocket.
Again, base money, once created, cannot take another form. It must remain in the form of either currency or bank reserves, and must be held by someone in the economy at every point in time. From a “flow” perspective, it can only change hands until it is retired. One can use it to buy something else – stocks, bonds, apple pie, chinchillas – but the base money simply changes hands and becomes the property of the seller. It doesn’t “go into” stocks, bonds, apple pie, or chinchillas – unless the cash is actually baked in the pie or eaten by the chinchilla.
The same is true more generally. Every security that someone views as an asset is also a liability to someone else in the economy. Every share of stock that is issued must be held by someone in the economy, in the form of a stock certificate, until that stock is retired. Every bond that is issued must be held by someone in the economy until that bond is retired. In aggregate, stocks can’t “go into” bonds. Cash can’t “go into” stocks. Bonds can’t “go into” cash. They are all pieces of paper that remain in the form in which they have been created until they are retired by the issuer.
So how does the total volume of securities in the economy ever change? Simple. Securities are evidence of something very specific: the past saving of one person that is transferred (intermediated) to someone else. Securities are evidence that somebody earned money, had the option of spending it on consumption, and decided instead to save it and transfer it for use by another economic participant. New securities are created in the economy each time some amount of purchasing power is transferred to others, rather than consuming it.
Decker, Bessie, Joe and you
Consider a simple economy. You use wood from your back yard to produce lumber, which you sell to Decker for $100 of currency (which Decker holds as evidence of past saving he has done). At the same time, Bessie produces milk on her farm, which she sells to Joe. But Joe needs currency to pay Bessie, and instead has a few shares of stock (which embody past saving that Joe has done). At current prices, Joe can get $100 by selling one share of stock to you in exchange for your currency. He then pays Bessie for the milk, and drinks it. Bessie is a cash cow, and adds the $100 to her stack of currency that embodies her past saving. We can assume that there are many others in the economy who have currency, stocks, and bonds that embody their past saving, but we don’t need to name them for this example. On the security side, you now own $100 of stock that used to be held by Joe, and Bessie has $100 of currency that used to be held by Decker.
On the real side, the economy has produced $200 of wood and milk, but only $100 of that output has been consumed. So there’s $100 of new saving in the economy. On balance, you and Bessie produced without consuming, and Joe consumed without producing, so you and Bessie are the savers, and Joe is the dissaver in the current period. Given $100 of overall saving, there must be $100 of new real investment. Who’s got it? Decker, in the form of unused wood inventory. Decker has neither produced nor consumed – he’s just traded his prior saving for current investment. Has there been any new security issuance? No, because neither you nor Bessie has intermediated your savings for someone’s use. The stock trade just represented existing securities changing hands.
Now suppose that Decker uses the wood to build a small stairway for a government building, for which he sends a bill to Uncle Sam for $150. If the government goes into deficit to pay that bill, it has to sell $150 worth of bonds to someone, in return for $150 of currency. Who has currency? Bessie, and she uses $150 of currency to buy $150 of freshly printed Treasury bonds. The government uses the $150 of currency to pay Decker. If you account carefully, the whole set of transactions has now produced $150 of real investment (the stairs) on balance, so the economy must have produced $150 in net new saving: your $100 and Decker’s unspent $50 profit. Yet in this case, $150 of new securities have been created in the economy, while there were no new securities created in the previous paragraph. That may not make sense until you realize that that’s the amount of savings that Bessie intermediated to the government. The net acquisition of securities is still zero, because the bonds that Bessie counts as an asset are the same bonds that the government counts as a liability.
If the Fed now launches QE, it does so by purchasing Treasury securities from Bessie, and paying for them with newly printed currency or crediting Bessie’s bank account with reserves (base money). Does that inject new purchasing power into the economy? No, it does not. It just changes the form of government liabilities held by the public, from bonds to base money. Is Bessie more likely to consume just because her savings take the form of cash instead of bonds? No – not if she didn’t have spending plans already, and not unless the economy was otherwise constrained by a lack of currency.
Now, there’s a central issue we have yet to address, which relates to changes in the value of existing securities. Once issued, all of these pieces of paper can vary in price later, so the saving that someone did in a prior period, embodied in the form of some paper security, may be worth more or less consumption in the current period than it was initially. That’s really the main effect QE has – to encourage