In discussions with the ever thoughtful HBL (which I now think stands for “♥s Bank Liabilities”), he asked where in H.4 data we would see bank bond liabilities increasing in response to an increase in CB bond acquisitions. And the answer is that you may not see it.
First, we are concerned with the financial sector as a whole (which I’ve defined as all financial sectors in Flow of Funds data except for retirement funds, insurance, CEFs, Mutual Funds, and ETFs). So “finance” is not just banks but also includes ABS issuers and money market mutual funds. Recall that “bonds” are foreign and domestic corporates, munis, treasuries and agencies.
Second, we are not concerned with just the CB. The issue is bond supply of the non-household sector versus bond demand of this sector. If the CB is buying bonds but the foreign sector is selling, then there is no need for the financial sector to adjust its net bond supply.
Third, what matters is the net bond supply, not the quantity of financial sector bond liabilities. This sector has traditionally held more bonds on the asset side of balance sheet than the number of bonds on the liability side.
What matters is the net position, not the gross position. If a bank sells an agency to a household, this operation is just as effective at reducing household deposit holdings as if the bank issued a new bond to households. It doesn’t matter whose liability the bond is — the financial sector supplies bonds to households by selling bonds to them, regardless of whether it is incurring a new liability or selling a third party liability.
All About Elasticities
Now the larger debate whether the non-financial sector will decrease borrowing as a result of QE. I think borrowing demands will be a function of expectations of return and interest rates. I don’t see a channel from quantity adjustments by the CB to a decrease in borrowing that is not an interest rate channel. And the effects of operations like QE on interest rates are extremely small, and go in the opposite direction of what you would expect if you assume households will borrow less to offset the increase in deposits created by the CB.
Roughly speaking, the Keynesian position is that investment, which is often or primarily funded by borrowing, is going to determine the level of savings.
My claim is that the allocation of household savings among bonds and deposits will be whatever this sector wants, conditional on the overall level of savings and interest rates, and that the other sectors aren’t going to have a lot of say on what that allocation happens to be.
The financial sector will transform the maturity of assets in such a way as to counter any maturity transformations being done by the CB (or other sectors), at the expense of a (small) change in rates.
The change in rates will not substantially alter household portfolio demands.
This is an elasticity argument, based on the assumption that the interest-elasticity of savings demands and the interest-elasticity of investment is substantially less than financial sector interest-elasticity of bond supply.
The reason for this difference in elasticities is that the financial sector operates via leverage, converting small spreads into large profits. In theory, with infinite leverage, the elasticity of supply of bond supply will be infinite. Of course it is not infinite, nevertheless the financial sector is sufficiently more sensitive to rates so that small changes in yield make it profitable for this sector to undo any attempts by the CB to transform the maturity of assets held by households away from what the household sector wants. Households need only offer a small premium to get back to their ideal savings allocation.
Therefore we might as well assume that the household sector is always able to allocate its savings among bonds and deposits however it wants, so that our concerns should be focused on the overall level of savings rather than the allocation of that savings.
Interest rate policy — if it can encourage more investment, or income policy — to directly supply savings — are what is important. Portfolio shifts are not important, moreover they do not succeed at changing the portfolio holdings of households.
Update: fixed some typos.