...Archive for November 2014

Some thoughts on QE

“Quantitative Easing” — economics jargon for central banks issuing a fixed quantity of base money to buy some stuff — has been much in the news this week. On Wednesday, US Federal Reserve completed a gradual “taper” of its program to exchange new base money for US government and agency debt. Two days later, the Bank of Japan unexpectedly expanded its QE program, to the dramatic approval of equity markets. I have long been of two minds regarding QE. On the one hand, I think most of the developed world has fallen into a “hard money” trap, in which we are prioritizing protection of existing nominal assets over measures that would boost real economic activity but would put the existing stock of assets at risk. My preferred policy instrument is “helicopter drops”, defined as cash transfers from the fisc or central bank to the general public, see e.g. David Beckworth, or me, or many many others. But, as a near-term political matter, helicopter drops have not been on the table. Support for easier money has meant support for QE, as that has been the only choice. So, with an uncomfortable shrug, I guess I’m supportive of QE. I don’t think the Fed ought to have quit now, when wage growth is anemic and inflation subdued and NGDP has not recovered the trend it was violently shaken from six years ago. But my support for QE is very much like the support I typically give US politicians. I pull the lever for the really-pretty-awful to stave off something-much-worse, and hate both myself and the political system for doing so.

Why is QE really pretty awful, by my lights, even as it is better than the available alternatives? First, there is a question of effectiveness. Ben Bernanke famously quipped, “The problem with QE is that it works in practice, but it doesn’t work in theory.” If it worked really well in practice, you might say “who cares?” But, unsurprisingly given its theoretical nonvigor, the uncertain channels it works by seem to be subtle and second order. Under current “liquidity trap” conditions, where the money and government debt swapped during QE offer similar term-adjusted returns, a very modest stimulus (in my view) has required the Q of E to be astonishingly large. The Fed’s balance sheet is now more than five times its size when the “Great Recession” began in late 2007, yet economic activity has remained subdued throughout. I suspect activity would have been even more subdued in the absence of QE, but the current experience is hardly a testament to the technique’s awesomeness.

I really dislike QE because I have theories about how it actually does work. I think the main channel through which QE has effects is via asset prices. To the degree that QE is taken as a signal of central banks “ease”, it communicates information about the course of future interest rates (especially when paired with “forward guidance”). Prolonging expectations of near-zero short rates reduces the discount rate and increases the value of longer duration assets. This “discount rate” effect is augmented by a portfolio balance effect, where private sector agents reluctant (perhaps by institutional mandate) to hold much cash bid up the prices of the assets they prefer to hold (often equities and riskier debt). Finally, there is a momentum effect. To the degree that QE succeeds at supporting and increasing asset prices, it creates a history that gets incorporated into future behavior. Hyperrationally, modern-portfolio-theory estimates of optimal asset-class weights come to reflect the good experience. Humanly, momentum assets quickly become conventional to hold, and managers who fail to bow to that lose prestige, clients, even careers. So QE is good for asset prices, particularly financial assets and houses, and rising asset prices can be stimulative of the economy via “wealth effects”. As assetholders get richer on paper, they spend more money, contributing to aggregate demand. As debtors become less underwater, they become less thrifty and prone to deleveraging. Financial asset prices are also the inverse of long-term interest rates, so high asset prices can contribute to demand by reducing “hurdle rates” for borrowing and investing. Lower long term interest rates also reduce interest costs to existing borrowers (who refinance) or people who would have borrowed anyway, enabling them spend on other things rather than make payments to people who mostly save their marginal dollar. Whether the channel is wealth effects, cheaper funds for new investment or consumption, or cost relief to existing debtors, QE only works if it makes asset prices rise, and it is only conducted while it makes those prices rise in real and not just nominal terms.

In the same way that you might put Andrew Jackson‘s face on a Federal Reserve Note, you might describe QE as the most “Kaleckian” form of monetary stimulus, after this passage:

Under a laissez-faire system the level of employment depends to a great extent on the so-called state of confidence. If this deteriorates, private investment declines, which results in a fall of output and employment (both directly and through the secondary effect of the fall in incomes upon consumption and investment). This gives the capitalists a powerful indirect control over government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis.

Replace “state of confidence” in the quote with its now ubiquitous proxy — asset prices — and you can see why a QE-only approach to demand stimulus embeds a troubling political economy. The only way to improve the circumstances of the un- or precariously employed is to first make the rich richer. The poor become human shields for the rich: if we let the price of stocks or houses drop, you are all out of a job. A high relative price of housing versus other goods, a high number of the S&P 500 stock index, carry no immutable connection to the welfare or employment of the poor. We have constructed that connection by constraining our choices. Deconstructing that connection would be profoundly threatening, to elites across political lines, quite possibly even to you dear reader.

A few weeks back there was a big kerfuffle over whether QE increases inequality. The right answers to that question are, it depends on your counterfactual, and it depends on your measure of inequality. Relative to a sensible policy of helicopter drops or even conventional (and conventionally corrupt) fiscal policy, QE has dramatically increased inequality for no benefit at all. Relative to a counterfactual of no QE and no alternative demand stimulus, QE probably decreased inequality towards the middle and bottom of the distribution but increased top inequality. But who cares, because in that counterfactual we’d all be in an acute depression and that’s not so nice either. QE survives in American politics the same way almost all other policies that help the weak survive. It mines a coincidence of interest between the poor (as refracted through their earnest but not remotely poor champions) and much wealthier and more powerful groups. Just like Walmart is willing to stump for food stamps, financial assetholders are prone to support QE.

There are alternatives to QE. On the fiscal-ish side, there are my preferred cash transfers, or a jobs guarantee, or old-fashioned government spending. (We really could use some better infrastructure, and more of the cool stuff WPA used to build.) On the monetary-ish side, we could choose to pursue a higher inflation target or an NGDP level path (either of which would, like QE, require supporting nominal asset prices but would also risk impairment of their purchasing power). That we don’t do any of these things is a conundrum, but it is not the sort of conundrum that staring at economic models will resolve.

I fear we may be caught in a kind of trap. QE may be addictive in a way that will be painful to shake but debilitating to keep. Much better potential economies may be characterized by higher interest rates and lower prices of housing and financial assets. But transitions from the current equilibrium to a better one would be politically difficult. Falling asset prices are not often welcomed by policymakers, and absent additional means of demand stimulus, would likely provoke a real-economy recession that would harm the poor and precariously employed. Austrian-ish claims that we must let a recession “run its course” will be countered, and should be countered, on grounds that a speculative theory of economic rebalancing cannot justify certain misery of indefinite duration for the most vulnerable among us. We will go right back to QE, secular stagnation, and all of that, to the relief of both homeowners, financial assetholders, and the most precariously employed, while the real economy continues to underperform. If you are Austrian-ish (as I sometimes have been, and would like to be again), if you think that central banks have ruined capital pricing with sugar, then, perhaps uncomfortably, you ought to advocate means of protecting the “least of these” that are not washed through capital asset prices or tangled with humiliating bureaucracy. Hayek’s advocacy of a

minimum income for everyone, or a sort of floor below which nobody need fall even when he is unable to provide for himself
may not have been just a squishy expression of human feeling or a philosophical claim about democratic legitimacy. It may have also have reflected a tactical intuition, that crony capitalism is a ransom won with a knife at the throat of vulnerable people. It is always for the delivery guy, and never for the banker, that the banks are bailed out. It is always for the working mother of three, and never for the equity-compensated CEO, that another round of QE is started.

FD: For the first time in years, I hold silver again. It hasn’t worked out for me so far, and was not based on any expectation of inflation, but since I write in favor of “easy money”, you should know and now you do.

Update History:

  • 2-Nov-2014, 6:55 p.m. PST: Added link to Ryan Cooper’s excellent Free Money For Everyone.
  • 2-Nov-2014, 8:50 p.m. PST: “The right answers to that question is are
  • “But who cares, because, in that counterfactual”.