Why QE and QT No Longer Work

The Broken Plumbing of Monetary Policy

The world’s monetary policy is no longer functioning as designed. As central banks struggle to manage inflation and steer the business cycle, their levers—Quantitative Easing (QE) and Quantitative Tightening (QT)—are failing to transmit into the real economy with predictable traction.

This breakdown stems from a structural failure in three areas: Measurement, Transmission, and Theory. We argue that the root cause of this failure is the rise of a pervasive, uncounted financial system: Shadow Liquidity.

The more nations shift to a Crypto Bypass like the Argentina’s experience (The Republic on Two Chains), the more central banks are left mistaking optical contraction for genuine liquidity destruction.

Why Money Supply M2 is Misleading

Central banks rely on the Money Supply M2 (M2) as a broad proxy for household and Small and Medium-sized Enterprises (SME) cash available for spending and saving. However, M2 is built only on fiat banking rails and is fatally incomplete in an era of Exchange Traded Funds (ETFs) and stablecoins.

Mechanisms that Distort Official M2

• Deposit Leakage: Household and SME balances shift out of traditional deposits and into Money Market Funds (MMFs), ETFs, or directly into stablecoins. This reduces the measured M2 balance without reducing the user’s spending capacity.
• Shadow Multiplier: M2 ignores the fact that token collateral, once on-chain, can be leveraged and rehypothecated across Decentralized Finance (DeFi) protocols. This creates an exponential expansion of purchasing power that M2 does not record.
• On-Chain Velocity: M2 velocity is slow-changing and implicit. Stablecoins on Layer 1/Layer 2 (L1/L2) networks settle 24/7 with far higher turnover, meaning the effective money supply is expanding at a rate M2 cannot capture.

The Transmission Failure—The Sixth Channel

Monetary policy historically transmits via five reliable channels. The emergence of Shadow Liquidity introduces a sixth, uncounted channel that creates a breakpoint in all five traditional ones.

The Five Traditional Channels and Where They Break:

1. Interest Rates: Policy rates set by the central bank fail to reach wallets.
   • Breakpoint: Wallet-based finance (stablecoins, tokenized cash) prices credit off protocol rates and market spreads, not policy benchmarks. Rate sensitivity fades.
2. Credit Channel: Bank lending capacity shrinks, reducing credit.
   • Breakpoint: Deposits migrate to stablecoins, shrinking bank capacity even as on-chain credit (collateralized DeFi loans) expands. Substitution undermines the tightening signal.
3. Wealth Effect: Asset prices alter consumption.
   • Breakpoint: Token prices, buybacks, and on-chain airdrops create wealth effects that Consumer Price Index (CPI) / Gross Domestic Product (GDP) surveys are blind to. QT cools listed equities while crypto-wealth remains resilient, sustaining spending for bypass cohorts.
4. Exchange Rate Channel: Higher rates strengthen the currency, reducing imported inflation.
   • Breakpoint: Stablecoins create synthetic dollar exposure off the official Balance of Payments (BoP). Capital can flee or arrive off the official ledger, causing leakage that mutes transmission.
5. Expectations Channel: Forward guidance shapes behavior.
   • Breakpoint: Crypto-native cohorts anchor expectations to protocol yields, funding rates, and network fees—not central bank rhetoric. Signaling becomes fragmented.

Shadow Liquidity: The Sixth, Uncounted Channel

Shadow Liquidity operates as a full-function money (store of value, medium of exchange, unit of account) for its users, but is off traditional measures like M2. Its mechanisms—stablecoin base, 24/7 velocity, and leverage ladders—provide credit elasticity and payment rails that policy cannot directly tighten.

The Theory Failure—Phillips Curve and War Shocks

The post-pandemic breakdown of the Phillips Curve is not a mystery—it is a measurement and modeling failure (Gillian Tett’s “black hole” theory, The Black Hole of Monetary Policy). The simple wage-unemployment trade-off no longer explains inflation because the dominant explanatory power has shifted to two primary drivers:

Driver 1: Supply Shocks and Geopolitics

The Russia-Ukraine war provided a critical overlay to the inflation surge, forcing central banks to tighten policy even as price pressures were largely non-monetary and non-demand driven.

• Energy & Food Shocks: War-driven energy disruptions and constraints on grain/fertilizer exports injected a geopolitical premium into input costs, raising prices independent of domestic labor slack.
• Balance-Sheet Optics vs. Real Effects: This forced tightening (QT) despite shock-led inflation, weakening QT’s intended disinflationary impact and leading to a miscalibration of policy magnitude.

Driver 2: Shadow Liquidity and Demand Elasticity

• Theory Gap Clarified: Inflation now emerges from the intersection of these supply shocks and the ability of Shadow Liquidity to sustain demand elasticity outside traditional metrics.
• Decoupling: Crypto flows supported payments and commerce in conflict regions (like Ukraine), expanding synthetic dollar liquidity and enabling consumption even as domestic banking channels and monetary policy were impaired.

The result is a Dual-Driver Inflation Map where wage-unemployment trade-offs explain less of headline inflation than supply shocks and shadow liquidity–induced demand elasticity.

The Path Forward: Parallel Diagnostics

To regain traction and credibility, central banks must adopt a Parallel Diagnostics Dashboard that tracks where liquidity is truly moving and multiplying:

• Liquidity Base: Monitor Stablecoin supply (total outstanding, net mint/burn) and Tokenized Cash (on-chain T-bill assets).
• Velocity and Settlement: Track On-chain turnover (transfer value divide by average balance) and merchant crypto settlement volumes.
• Credit and Leverage: Use DeFi Total Value Locked (TVL), average Loan-to-Value (LTV) ratios, funding rates, and liquidation heatmaps as real-time proxies for system-wide leverage.
• Fiat Divergence: Track the delta between the official M2 and the proposed Parallel M2, correlating this against real-economy indices like small business sales.
• Commodity Overlay: Track input costs (energy/food indices) and geopolitical event flags to distinguish between shock-led and demand-led inflation.

Conclusion

QE and QT still move numbers in official ledgers. But they no longer move the economy. The rise of Shadow Liquidity—combined with geopolitical shocks, currency substitution, and the collapse of traditional transmission channels—means the world is operating on two chains: one measured, one real.

Monetary policy collapses precisely where money is no longer counted.

Until central banks abandon the illusion that fiat aggregates capture total liquidity, QE and QT will remain optical levers—powerful only in theory, weak everywhere that matters.

Related analysis:

1. The Black Hole of Monetary Policy
2. Maple Finance Buyback Reveals Central Banks’ Blind Spot
3. How Crypto Breaks Monetary Policy