Thursday, May 23, 2013

The Fed and Shadow Banking

The WSJ has a fascinating Op-Ed by Andy Kessler, "The Fed Squeezes the Shadow-Banking System" Andy thinks that Quantiative Easing has the opposite, contractionary effect.

QE is just a huge open market operation. The Fed buys Treasury securities and issues bank reserves instead. Why does this do anything? Why isn't this like trading some red M&Ms for some green M&Ms and expecting it to affect your weight?  (M&M of course stands for "Modigliani Miller" if you didn't get the joke.)

The usual thinking is that bank reserves are "special." They are connected to GDP in a way that Treasuries are not.  In the conventional monetary view, MV = PY.  Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.

In Andy's view (my interpretation), that is turned around now. Now, Treasuries supply more "liquidity" needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.

Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don't do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don't make a difference to anything. More treasuries, according to Andy, we can do something with.

More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can't push on a string, as the saying goes. Much "constraint" economics forgets that once the constraint is off, the relationship doesn't hold any more.

Andy describes the repo market and the sense in which Treasuries are "special" in providing low-haircut collateral. Lots of academic research is now viewing Treasuries as special or liquidity-providing in the shadow banking system.

So, this is at least a gorgeous possibility: In a frictionless world, open-market operations, buying one kind of government debt (Treasuries) and issuing another (reserves)  have zero effect on anything, by the M&M theorem. Monetary economics thinks the M&M theorem is violated, because one kind of government debt (M) is connected to nominal GDP and the other is not.

But financial systems change. When the textbooks were written, banks mattered a lot, so bank reserves, leveraged to loans and checking accounts, were the "special" asset. In today's market, and given today's glut of reserves, Treasuries, leveraged to mortgage backed securities and money market funds through the repo market and "shadow banking system,"  might be the "special" asset connected to nominal GDP. In that case, the effects of open market operations might have the opposite sign. As Andy says,
... the Federal Reserve's policy—to stimulate lending and the economy by buying Treasurys..—is creating a shortage of safe collateral, the very thing needed to create credit in the shadow banking system for the private economy. The quantitative easing policy appears self-defeating, perversely keeping economic growth slower and jobs scarcer.
I'm not totally convinced, though this story and the alleged enormous demand for Treasuries is being bandied around as established fact. I'm also not convinced that this is all a good idea. Maybe the Fed should starve the shadow banking system.

You repo a security so that you can borrow against it. For example, you might buy a mortgage-backed security, then leave (repo, really) that security as collateral for a loan, which you used to buy the security in the first place. But what sense does it make to repo-finance a Treasury? You can't borrow at lower interest rate to make money on a Treasury! You could, possibly, if it's a long term Treasury and you're borrowing short, betting that interest rates don't rise. But I would think an interest rate swap or future would be a cheaper way to make that bet, and anyway betting on the slope of Treasury yield curve doesn't add up to the necessary GDP-linked lending that Andy has in mind.

In short, if you have money to buy a Treasury, why do you need to borrow? For any of this to get off the ground, you have to have some other, not totally rational,  reason for buying the Treasury, and then you want to borrow against the Treasury  so you can buy the risky asset that you really wanted all along. Who is that? Why is this such a necessary part of our financial system? Can't we fix things so they just buy the MBS with their initial cash?

Andy points out that repos are re-hypothecated. You use your Treasury as collateral against a loan, then the guy you gave it to uses it again as collateral to get the money to give to you. So one Treasury is used as collateral against two or three loans. Hmm. As the money multiplier creates run-prone structures, so using the same thing as collateral two or three times is a lot of what makes banks "too big to fail." If we all go down, who has the collateral?

A system awash in all kinds of liquidity, following the Freidman optimal quantity of money, seems a lot safer to me. I'd rather we expand the "bank reserve" concept -- fixed-value, floating-rate, electronically-transferable Treasury debt, and lots of it, washing the shadow banking system in liquidity and putting the run-prone structures out of business. Of course, open market operations would then have no effect in my world either, as I have removed the liquidity constraint in the shadow banking system just as Mr. Bernanke has removed it in the conventional banking system. But violations of M&M always mean the system can be made better.

If you want to comment and explain shadow banking, please use little words that the rest of us can understand.

32 comments:

  1. "The Fed buys Treasury securities and issues bank reserves instead. Why does this do anything?"

    Because the Fed is also paying interest on reserves and the interest rate that it is paying on reserves can differ from the market interest rate that Treasury securities are paying.

    Question: Can Treasuries (being a globally traded asset) be overbought to the point that they interfere with the ability of monetary policy makers to set interest rates?

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    1. Prior to 2008, the theory was -- reserves did not pay interest, and loans did pay interest. So, if the Fed bought Bank X's trearies, increasing thier reserves, the bank would write a loan againt those reserves, which would drive real economic activity.

      But if the Fed pays IOR, then the bank just lets the reserves sit at the Fed with no increase in lending.

      Delete
    2. Anonymous,

      And by paying interest on reserves, the Fed gains control of the credit origination process. If credit expansion is fueling inflation AND putting downward pressure on interest rates through trade imbalance, the Fed can hit the breaks by paying a higher interest rate on reserves than the market is requiring for private credit.

      Hence, reserves are retained by banks rather than being lent out.

      Delete
  2. "A system awash in all kinds of liquidity, following the Freidman optimal quantity of money, seems a lot safer to me."

    Friedman's optimal quantity of money does not allow for a gloabalized financial system. The U. S. federal reserve is not the only game in town.

    "...the Federal Reserve's policy—to stimulate lending and the economy by buying Treasurys..—is creating a shortage of safe collateral, the very thing needed to create credit in the shadow banking system for the private economy."

    It is the borrower that requires safe collateral to obtain the loan not the lender (shadow banking system). The collateral is what is borrowed against by the borrower not what is used to hedge with by the lender.

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  3. John--a quick observation. Primary dealers in Treasury securities have to finance their purchases. That's what led to the creation of the Treasury repo market in the first place. The dealers repo out the securities as they work off the inventory. It's a crucial part of funding the deficit you admire so much. Of course, the repo market has gotten much bigger than that now.

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    1. Thanks. That's a helpful detail. Of course that source of repo can't be large or long lasting, no?

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    2. Typically, the Repo peroid is 1 day. This is why Lehman had a liquidity crisis turn into a solvency crisis. Not only was it levered 40-1 at the peak, but most of that 40 was refinanced every single day.

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  4. When journalists write that there is "excess demand for safe collateral" and that their solution is to "put out more safe collateral", you know they haven't paid attention in economics 101 where we learn that demand is a function, not a value.

    There is excess demand for safe collateral at a certain interest rate. At 0% nominal interest rate, there is excess demand for nominal assets right now.

    It should manifest itself in the form of deflation, but that's somewhat muted by:
    1) Government spending (One ginormous irrational consumer trying to make up for all the other rational consumers that aren't spending as much)
    2) Nominal wage rigidity which turns the deflationary pressures into unemployment (although inflation is still quite low)

    There is not really a way to "produce" new safe assets and I believe demand is fairly elastic anyway, so this wouldn't help much. The right thing to do isn't to move quantity, it's to move the variable that determines quantity demanded, in this case interest rates. i.e., interest rates need to be moved into the negative range (plug the money-under-mattress hole of course) so that the money market can be brought back in equilibrium and the government can shrink back to a decent size.

    The distinction that's made between Treasuries and bank reserves is unwarranted. One can be turned into the other for a handful of basis points in the repo markets.

    If truly there was massive excess demand for Treasuries (because somehow they can be used in ways that reserves cannot be), Treasuries would be repo'ing massively special. That is, the spread between the Treasury repo rate and Fedfunds would be massively (100bps+) negative. (This phenomenon occasionally happens on certain specific bonds when they're cheapest to deliver in the futures contracts and everyone tries to get their hands on them.)

    If that were the case, the Fed would probably step in and loan out its treasuries. That would reduce MBase (which has no effect on anything anyway) but the treasuries would still be on the Fed's books.

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    1. You are right. How can we expect significant lending from traditional banks when rates are at all time lows, and they are being rewarded for not lending by interest on their reserves?

      So the Fed pumps up liquidity but nothing happens with banks. Sounds like a different approach is needed.

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    2. Three gems in these comments:

      *The distinction that's made between Treasuries and bank reserves is unwarranted. One can be turned into the other for a handful of basis points in the repo markets

      *If truly there was massive excess demand for Treasuries (because somehow they can be used in ways that reserves cannot be), Treasuries would be repo'ing massively special.

      *If that were the case, the Fed would probably step in and loan out its treasuries.

      Delete
    3. Are you implying that the rest of my comments aren't gems? :)

      Delete
  5. You are grumpy... and insightful. My takeaway, monetary policy has raised the opportunity cost of safe assets, but then what? Starve or feed the shadow banking system?

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  6. It seems to me that Kessler's argument is fundamentally flawed.

    The $3 trillion in bank reserves mentioned would support a tremendous amount of lending (including repos), if creditworthy; far more lending than the shadow banking he claims has vanished due to QE.

    There is no law of economics that makes bankers dumb and shadow bankers smart. They all lend the same green money.


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    1. Bankers and shadow bankers are the very same people.

      The banks create shadow banks when it becomes economically viable to do so.

      Delete
  7. Kessler apparently isn't aware that the Fed uses the tri-party repo system. Those assets of the Fed are being lent out all the time. There is no shortage of collateral.

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    1. Anonymous: You have to expand this comment. The Fed is obviously not repoing (borrowing against) its treasuries as that would undo the expansion of reserves. It sounds as if you're saying that the Fed directly lends its Treasuries, as one would lend a stock to a short-seller. Is this true? Do you know where one sees that on the Fed balance sheets? You failed the "use small words" request!

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    2. The Fed lends its securities (reverse repo) quite regularly to primary dealers. Data are available at http://www.newyorkfed.org/banking/tpr_infr_reform.html

      Delete
  8. Since seignorage is negative (t-bill yield < interest on reserves), there's a sense in which there's a base money glut. This is dumb because it unnecessarily adds to the government deficit (compared to lowering IOR and reducing reserves). But is it a macro problem? No.

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    1. That's right, it's a housekeeping issue which can be fixed in half a second by moving IO(E)R well below the Funds target.

      Delete
  9. http://www.time.com/time/photogallery/0,29307,1947816_2013204,00.html Notice to basketballs http://www.time.com/time/photogallery/0,29307,1947825_2013232,00.html Notice the backboard
    This can only be done through extreme dedication And focus. And a lot of time. Very impressive.

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  10. Shouldn't we be able to look at how markets react to QE pronouncements in order to determine if they're contractionary or not? Granted, we'd have to know what the previous expectation was so we could adjust for how much new information is being learned, but it doesn't sound insurmountable.

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  11. "Can't we fix things so they just buy the MBS with their initial cash?"

    You don't actually need any cash to buy, MBS. Most MBS investors never pay for them. The settlement process for MBS is specialized, and expensive.

    The MBS investor calls his bank/broker and declares his interest in buying MBS. He sketches the characteristics of the MBS he wants to buy, and the Broker makes a commitment to deliver securities that meet the criteria of the trade at some agreed upon future date. On settlement day, the broker will deliver the MBS, and the buyer will deliver his cash. The broker works with his originators to source mortgages that meet the criteria of the trade.

    A few days before the settlement date, the buyer calls up the broker and says, rather than sending the those MBS next week, why don't we push off settlement for a month. I'll hold onto my cash, and you hold onto the securities. You can collect the first month’s payment, and you can pay me for the privilege. Usually, the broker is thrilled to do this, because he has committed to sell more MBS than he was actually able to source by that delivery date.

    Technically, the buyer sells the bonds back to the bank, and opens a new buy for the future settlement date. Functionally, this, too, is a REPO.

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  12. Scott Sumner at the Money illusion.com

    "Tyler Cowen links to a John Cochrane post, which discusses a WSJ piece by Andy Kessler:

    The usual thinking is that bank reserves are “special.” They are connected to GDP in a way that Treasuries are not. In the conventional monetary view, MV = PY. Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.

    In Andy’s view (my interpretation), that is turned around now. Now, Treasuries supply more “liquidity” needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.

    Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don’t do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don’t make a difference to anything. More treasuries, according to Andy, we can do something with.

    More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can’t push on a string, as the saying goes.

    It makes me a bit dizzy seeing John Cochrane using the Keynesian “pushing on a string” metaphor that Milton Friedman discredited decades ago. More seriously, there are several fallacies in this argument. Let’s assume for the moment that reserves and T-bills are both non-interest-bearing; why would monetary policy have any impact? The answer is simple; markets don’t expect interest rates to be at zero forever.

    OK, but why does that make base money special now, when T-bills also pay no interest? Because base money is the medium of account, whereas T-bills are not. In the future a change in the supply of T-bills will not (significantly) change the price level, it will merely change the nominal price of T-bills. In contrast, a change in the supply of base money can never affect the nominal price of base money, which is always one. Instead, the price level and NGDP adjust to changes in the market for base money. None of this has anything to do with the lending channel.

    Some might argue that this will only work if the central bank has credibility, if investors believe that QE will raise the future level of the base, and hence future NGDP. But we know for a fact that investors do believe this, as markets react violently to even tiny hints of changes in QE. And they do so in a way that clearly indicates that QE is expansionary. That’s why we know for certain that Milton Friedman and the MMs are correct, and John Cochrane and Andy Kessler are wrong. As a fellow Chicagoan, I strongly urge Cochrane to dump the Keynesian pushing on a string metaphor, and go back to the Chicagoan monetarist tradition."

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  13. Professor Cochrane, I would be curious to hear your thoughts on the reply that Scott Sumner has put on his blog (http://www.themoneyillusion.com/?p=21263#comments), this answer comes after quoting your paragraph 3 to 6 :

    "It makes me a bit dizzy seeing John Cochrane using the Keynesian “pushing on a string” metaphor that Milton Friedman discredited decades ago. More seriously, there are several fallacies in this argument. Let’s assume for the moment that reserves and T-bills are both non-interest-bearing; why would monetary policy have any impact? The answer is simple; markets don’t expect interest rates to be at zero forever.

    OK, but why does that make base money special now, when T-bills also pay no interest? Because base money is the medium of account, whereas T-bills are not. In the future a change in the supply of T-bills will not (significantly) change the price level, it will merely change the nominal price of T-bills. In contrast, a change in the supply of base money can never affect the nominal price of base money, which is always one. Instead, the price level and NGDP adjust to changes in the market for base money. None of this has anything to do with the lending channel.

    Some might argue that this will only work if the central bank has credibility, if investors believe that QE will raise the future level of the base, and hence future NGDP. But we know for a fact that investors do believe this, as markets react violently to even tiny hints of changes in QE. And they do so in a way that clearly indicates that QE is expansionary. That’s why we know for certain that Milton Friedman and the MMs are correct, and John Cochrane and Andy Kessler are wrong. As a fellow Chicagoan, I strongly urge Cochrane to dump the Keynesian pushing on a string metaphor, and go back to the Chicagoan monetarist tradition."

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    1. For what it's worth, I put in my response to Sumner's post..

      http://www.themoneyillusion.com/?p=21263&cpage=1#comment-249740

      Delete
  14. repos and treasuries are not interchangeable because they can have different accounting treatments, buying financed tbills increases your regulatory assets, providing the financing for the bills decreases your assets so it looks like you have less leverage (lehman did this). There may be no economic difference as you say but the regulatory difference is huge and in fact repo rates can be less than tbill rates for this reason.

    The bigger issue is that our system is so unbelievably complicated, nobody can divine exactly what's going on, meaning the odds of the Fed getting things right are essentially zero

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  15. So far, despite peevish commentary from all quarters, no one seems to come up with any complaints about QE that make me want to stop it. I wish the Fed would do a few trillion more in QE (though limit their buying to Treasuries).

    Sheesh! We are paying down federal debt, but the trillions, and giving people cash instead. And inflation is dropping. Dropping!

    What is not to like about this? Listen, I have as much Puritan- and morals-based baggage as the next guy, but the economy is not a person. There is no need to suffer for suffering sake.

    Any business operator in America, told he could eliminate debt without much in the way of negative effects, would leap at the opportunity.

    And inflation: We are at record lows. And going down.

    Repeat: We can pay down federal debt through QE, and inflation is dead. What should we do?

    BTW, here is what Bernanke told Japan to do in 2003. So, I am nit crazy, or if I am, then so is Bernanke.

    My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt–so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent. …

    Isn’t it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ’s purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan’s fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.

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    1. "My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own."

      Given.

      "Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt–so that the tax cut is in effect financed by money creation."

      Consider a tax cut for households and businesses that is sold by the federal government. Similar to a government bond it would have a fixed duration and rate of return. In this case the tax cut sold by the government is the means of financing the government deficit while simultaneously reducing the federal debt.

      "Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent. …"

      Bernanke jumps to the conclusion here that there is a direct one for one correlation between the money stock and the price level. This is not necessarily the case.

      "Isn’t it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio."

      Selling the tax break instead of giving it away would go further in reducing the debt to GDP ratio since it would not rely on changes in individual / business decisions. The debt would certainly go down even if there were no change in GDP.

      "The BOJ’s purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending."

      Assuming the money in the public hands was spent instead of say - reducing private debt.

      "Indeed, nothing would help reduce Japan’s fiscal woes more than healthy growth in nominal GDP and hence in tax revenues."

      Ugh. A person / business has "fiscal woes" - not a sovereign.

      Delete
  16. The main effect of QE is to reduce the net interest income of the financial sector. The Fed is replacing higher-yielding treasuries with lower-yielding bank reserves. It is a very convoluted way for the Federal government to finance deficits at 25bps: issue treasuries yielding 2% to 3% and buy them back with reserves yielding .25%. How does this "stimulate" the economy? Intriguingly, this requires the assumption that if you depress the earnings of the banking sector (by reducing their net interest income) you will encourage banks to take more risk and lend more ... this might actually be true!

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    1. Incubus and SuccubusMay 25, 2013 at 11:59 AM

      Treasuries are riskier than reserves because while current inflation can nip at reserves, long term inflation expectations can take a big bite out of the long bond when marked to market.

      To maintain a risk profile, the financial sector can mop up the reserves with riskier stuff such as but not limited to : treasuries.

      Delete
  17. I still don't see how re-hypothecating a t-bill increases the money supply.

    1) Individual #1 borrows $1 million from individual #2 with a t-bill for collateral.

    2) Individual #2 borrows $1 million from individual #3 with the same t-bill for collateral. This just makes individual #2 whole. He obviously had $1 million before transaction 1), and now has $1 million again.

    3) repeat as many times as you want.

    At the end of the chain, ONE person has the collateral, at the front of the chain, ONE person has $1 million bucks, and every body in the middle of the chain has as much money as they started with, plus a small fee for the transaction. Person x in the middle of the chain HAD $1 million to start with, lent it out for the collateral, and then borrowed a replacement $1 million from person x+1, and passed on the collateral to person x+1. No matter how long the chain is, no money is created. All that happens is that the $1 million is passed along step by step from the person at the end of the chain to the person at the beginning of the chain.

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  18. Professor Cochrane, Consider the following line of argument: money and government debt are not identical. In the abstract, money is the means of payment, the purest form of liquidity. Money is not a liability (think cigarettes in prison): the issuer of currency is a provider of the service "legal tender". Government debt is a liability, it usually pays interest, and it must be repaid. In the real world, the two ends of the spectrum are dollar bills - which in no meaningful sense are "debts" (there is no promise to repay) - and 30year treasuries, interest bearing and price-volatile liabilities of government. However, also in the real world, the distinction between the "means of payment" and "government liability" is a blurred continuum between these extremes. Just as cigarettes can become cash, high quality/liquid securities can become collateral, ie quasi-cash. And cash can pay interest (ie bank reserves), ie a quasi-liability. Now the really interesting conclusion is not that QE is ineffective (I think we all know it is!). Much more important is that if treasuries are not just debts, but also a means of payment, the federal government's NET debt is much lower than we think. If treasuries provide services (liquidity/collateral etc.), they are no longer simply liabilities - the monopoly issuer is actually creating value! It seems clear to me that "money" - as I have narrowly defined it, should not be considered a debt, it is a service, "the means of payment". It follows logically, that QE is reducing the stock of net government debt. But it also follows that if treasuries are not just liabilities, but also quasi-money, there is a lower stock of net debt, but a higher stock of money. Is this inflationary? I still think you need a multiplier ...

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