In-depth analysis on Credit Writedowns Pro.

Economic Code Words

I was just having an argument/debate about quantitative easing. Marshall Auerback, Randy Wray and I all have posts here at Credit Writedowns which explain that quantitative easing does not create new net financial assets and is merely an asset swap which has no direct effect on the real economy.  Nevertheless, there is a vast difference in the terminology we use to describe these matters.

Why is that? Much of this has to do with Economic Code Words and the neo-liberal orthodoxy which has controlled the economics profession for the past generation. This orthodoxy is the one responsible for the increasing reliance of the US economy on the financial sector as anti-regulatory and pro-incumbent business policies gained sway ideologically. The result has been a leveraging up in the U.S. in a way that has benefitted the more well-to-do than average Americans and a financial system which is extremely prone to systemic crises.

I will get back to this shortly. First, let me say that from a technical perspective, quantitative easing involves the creation by the Federal Reserve of ‘electronic dollar credits’ to purchase Treasury securities in much the same way the Federal Reserve operates when defending the Fed Funds rate (see here for a discussion of the Fed Funds process).  This is an asset swap that does not create net financial assets because the bonds have now been replaced by the dollar credits. When interest rates are effectively zero percent, this is the asset swap equivalent of issuing treasury bills to replace whatever the Fed has just purchased (see On Liquidity Traps and Quantitative Easing  for a more in-depth discussion). Think of this as a barter between the Federal Reserve and some bank in which the Federal Reserve finds a willing seller of financial assets for the dollar credits it has just created. It then takes those assets out of circulation when it buys them. For the financial system as a whole, the monetary base has expanded (reserves are up) but net net, financial assets have not.

And remember, this is not credit easing. Bernanke said QE1 was an exercise in ‘qualitative easing’ whereby the Fed became the lender of last resort during a liquidity crisis in which no one would accept many financial assets at any price. That is its legitimate role as a central bank. My problem with the Fed’s balance sheet expansion is what you would hear from anyone who has a visceral negative reaction to central planning: the expansion is the product of centralized planning. I can understand temporarily lending during a liquidity crisis at a penalty rate. But the Fed never lent against good assets at a penalty rate during the crisis. It bought dodgy assets at inflated prices,  making it difficult to discern which firms were illiquid and which were insolvent. Clearly, this was its intention. This enabled insolvent companies to masquerade as solvent while the economy went through terrible unemployment and recession. The Fed, thus, transferred risk onto the taxpayer without any oversight because it refused all FOIA requests and now its balance sheet is four times the size it was just two years ago. Yet, they now want to do more.  It makes no sense to anyone except those who are already predisposed to activist government. This is  exactly why is everybody in an uproar about QE2.

But QE will not work because the demand for credit by creditworthy borrowers is not going to increase in a balance sheet recession where household income is stagnant and most are already stuffed to the gills with debt mortgaged against declining house prices. That is an environment in which the Fed will be pushing on a string and any liquidity will simply add to speculative excess both in the US and elsewhere. Many, including the Fed Chairman, will tell you that creating reserves actually gives banks loanable funds which can jumpstart the economy. This is clearly false as we already have $2 trillion in excess loanable funds on offer. QE is not about the real economy but animal spirits and leverage. It is a massive pump and dump. And savvy investors like Jeremy Grantham have already begun to sell.

But, here’s where the MMT’ers and I disagree.  This whole song and dance about QE not being inflationary misses the point. QE is about asset prices.  The true believers – retail customers and the inflationistas – may not be on to the pump and dump here – but guys like David Tepper know that this dash for trash has a sell by date and they will be out of risk assets in due course. Ordinary Americans will be left holding the bag when the economy relapses.  Moreover, as commodities have been financialized, you can already see the pass through of the (temporary) asset price inflation into commodity prices in the US and around the world.

The layman sees the Fed’s balance sheet expanding, banks making lots of money, but credit growth subdued, unemployment high, etc, etc and the only conclusion one can draw is that the Fed is printing a bunch of money and handing it out to their cronies on Wall Street. That’s what people in America are thinking. And, of course, there is some truth to this. So, at a minimum, politically, this is radioactive. And that’s why the Quantitative Easing Explained video has hit a nerve – despite some technical inaccuracies (the Fed cannot buy bonds directly from the Treasury in order to maintain the Fed’s independence, for example).

That leads me to the economic code words:

  • printing money
  • debasing the currency
  • banana republic
  • fiscal profligacy

These are all the things you would hear from those who have actually benefitted from the neoliberal orthodoxy which created America’s problems to begin with. But you will hear these same words from people who are uncomfortable with the easy money and debt accumulation like me too.  I prefer this terminology because that’s how I think of the matter – and that’s how most people do too. But these words have an ideological taint to them. And I got into some of this in my hyperinflation post (emphasis added).

What about the ideology?  Well, the MMT’ers say that the Austrian ideologues and the gold fetishists have a deflationary bias when inflation doesn’t change the real productive capacity of a nation. Clearly, the hyperinflation talk is a gimmick with which to discourage deficit spending. You should see this debate as about a specific policy prescription driven by ideology. The other side of this ideological divide was taken up by Dean Baker in the Guardian’s “Cliches won’t fix the financial crisis

Nevertheless, inflation does alter business decision-making via accounting’s tie to nominal numbers and the money illusion. Moreover, inflation reduces relative wealth by transferring income from those who receive the money first like banks versus those who receive their money later, your typical widow living on fixed income bonds and annuities. Finally, inflation encourages the accumulation of debt by benefitting borrowers over savers.  I see inflation as a problem to be avoided.

Ideologically then, I see inflation as the increase in the money supply.

Economics. an increase in the VOLUME of money, which eventually leads to a persistent, substantial rise in the general level of prices and results in the loss of value of currency.

-What is Inflation?, Credit Writedowns, June 2008

And where inflating the money supply does not eventually lead to consumer price increases, it does lead to asset price increases which foster a stronger boom-bust tendency.

So, people like me look at large government deficits in a fiat currency system as an invitation to print money and inflate the money supply. If you take this way of thinking to a logical extreme, you end up with what Marc Faber is talking about: hyper-inflation.

But, this is ideology – not economics.

I am not going to be cowed into using some PC way of talking about the Fed’s balance sheet expansion and its creation of electronic dollar credits. To me – and to any reasonable layperson – this is printing money, plain and simple. It’s a shambolic farce – even more so because it won’t do anything for the real economy except via animal spirits and leverage. Yes, it is the Bureau of Engraving  & Printing in the Treasury Department which actually prints dollars. But, clearly the Fed’s creating previously non-existent dollar credits is as close to the average person’s definition of plucking money from a money tree as you’re going to get.

And while the Fed is not going to be successful in debasing the currency because QE is just an asset swap, it is clearly trying to do so. At a minimum, it is creating currency revulsion and this will end the dollar standard rather sooner than later. The Fed has this wrong. They are ruining any shred of credibility they have on a monetary policy that does not work except via asset markets. Bernanke knows this too. It’s the ultimate financialization Ponzi response to a financialized debt-ridden American economy. It is an attempt to debase the currency and drive up asset price inflation. It is a tax on ordinary people who do not benefit from this asset price inflation in a world where real wages are stagnant or declining. It fosters a surreptitious transfer of wealth to the most wealthy. Other than that, it’s just fine.

The fact is America ran up too many private sector debts and ran aground as a result. President Obama attempted to fix the problem in part by focusing on fiscal stimulus – which in my view is clearly more effective than money printing. But his policy response has been ineffective for reasons I don’t have the space to get into here. Read "The Origins of the Next Crisis" for the in-depth view, if you’re interested.

Now, people are asking themselves: "what next?"  And so Bernanke starts up the QE – AGAIN. Are you surprised that people are outraged, with underemployment at 17% 3 years after a deep recession first began?

Update: I should add this commentary as well; it seems to me that ideological divides have increased rather than decreased of late – and QE2 has been front and centre in this. I have also seen it in the foreclosure crisis coverage. In my view the return to one’s ‘ideological home base’ is the outgrowth of the length of the economic crisis. It goes to basic human psychology and fear.  Fear is starting to grip people again after a brief period of technical recovery. Given the uncertainty that our inability to crack this crisis has engendered, fear is the emotion that now comes stirring up – and that leads to ideological rigidity.

If policy makers had been successful in fixing things, we would have had less polarization than we do now. When I read various blogs these days I see fewer nuances with a narrowing of views, a reduction in links to non-ideologically aligned blogs, and more one-sided rhetorical positioning. It’s as if bloggers are saying, "I am going to play to win" the ideological debates this crisis has spawned. I refuse to take that route. And I know some others I have talked to about this are also trying to guard against this as well. But these divides are increasing in the blogosphere, nonetheless, just as they are in the political world both in the US, in Europe and internationally.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

15 Comments

  1. Freddy12 says:

    This is double talk. So you don’t think QE does anything for the real economy, but you believe that it will cause asset prices to move higher? Should we assume that you are wildly bullish on equities and commodities currently? There is an obvious disconnect in your line of thought here.

  2. Freddy12 says:

    Dude, I am trying to have an actual debate with you. You say QE does nothing for real economy, but that it will cause asset price inflation. How can you have sustained asset price appreciation without fundamental improvement. There’s a flaw in your conclusions. Also, are you very bullish right now?

  3. jimh009 says:

    Edward,

    Another excellent post. I fully agree with what you say.

    However…one question if I may be so bold.

    > Marshall Auerback, Randy Wray and I all have posts here at Credit Writedowns which explain that quantitative easing does not create new net financial assets and is merely an asset swap

    OK. I’ve read those posts, and still am confused about why you (and apparently others) feel that QE is simply an asset swap. I simply do not understand how you arrive at that conclusion. Care to enlighten me – in simple words, if possible? :)

    When I see QE, I see the Fed printing money and buying T-Bills. From my admittedly limited understanding, that doesn’t seem as an asset swap – since when the Fed buys T-Bills it is essentially preventing private money from doing the same. Thus, that private money needs to go “somewhere,” such as commodities, China, emerging markets, etc…In short, the way I see it, when the Fed prints money and buys treasury debt, it’s forcing private money out of the bond market and into “something else.”

    When I think of asset swaps, I think of the Fed exchanging something for something else. Mortgage debt for T-Bills, for example. I guess I just don’t see the “swap” in QE2. So hopefully you can explain it to me in a simple and easy to understand way!

    > When I read various blogs these days I see fewer nuances with a narrowing of views, a reduction in links to non-ideologically aligned blogs, and more one-sided rhetorical positioning. It’s as if bloggers are saying, “I am going to play to win” the ideological debates this crisis has spawned. I refuse to take that route

    Thank you for that. It’s the primary reason I read your blog.

    • Thanks, Jim. The asset swap stuff is problematic because, as you attest and I said in the post, most people just see money printing. The key is that the bonds the Fed buys are no longer in the financial system. They have been bought and taken out of the system. The Fed now owns the bonds. So, these bonds – which are financial assets – have in effect been swapped with the dollar credits the Fed has used to buy them.

      Also note that this is exactly how the Fed Funds market and normal Open Market Operations are designed to work. If the Fed wants to ensure that its interest rate, the Fed Funds rate remains at the desired level it must stand ready to defend the rate with an unlimited supply of money which it uses in open market operations to buy Treasury bills and drive the rate down.

      See here:
      http://en.wikipedia.org/wiki/Open_market_operations

  4. Mytwocents says:

    QE 1 was asset swap. Actually making banks bad debts disappear. (if you wanna call those assets, LOL!) Fed purchased bad assets from banks supposedly to be sold of at a later date, to increase bank reserves and prevent even more banks from going belly up. Look up the list of banks already belly up at FDIC’s website. but since nobody audits the feds balance sheets, well debt is gone in to the fed abyss.

    QE 2 is the evil twin. China stopped buying long term treasuries a few years back, last year russia started selling treasuries I bet at the last treasury (so called) auction china didn’t buy any treasuries. If no treasuries get sold the government can’t finance it’s operations. Last year two japanese were caught trying to dump (sell) over 200 billion in treasuries. In the past all SS tax surpluses instantly got swapped for treasuries, but because of 20% + unemployment guess what… there’s actually more being paid out in SS benefits than it received. So even more treasuries have to be sold from the governments general fund and handed over to SS to pay out. If china isn’t buying treasuries, russia and japan are dumping, and SS needs to redeem treasuries held in trust fund then who buys it, you got it our boys at the FED. Not quite out of thing air, but some paper, cotton, ink etc!!!

    Or this could all be a bad dream, or a piece of fiction.

  5. fresnodan says:

    Do I agree with your analysis because it is so smart and wise, or do I think it is so smart and wise because I agree? Anyway, I really enjoy your insights.
    I would add one small point about QE – it is pretty much advertized as being “inflationary” so the sterile debate about “printing money” seems illogical to me. If it is not going to raise prices in general, it certainly is going to continue the mispricing of bad assets. It is amazing to me that the fans of QE have such a belief in the market that they think bad prices should not be allowed to come down (dare I say “deflate?”)

    • Thanks Dan. As you can see above my view on preventing these ‘bad prices’ from deflating is negative. It is really just a transfer of income from buyers to sellers of those assets. To the degree you are a renter, it’s a tax – and as such is actually very regressive to boot. The Fed should stop manipulating asset prices and allow these assets to settle down toward the mean level of price to income or price to rent.

  6. SouthWabashSoul says:

    Sorry Edward, I found this post confusing and kinda’ all over the place. MMT position on QE!! never really laid out clearly. And you used the words “Fed Independence” right before the “code words” as if that wasn’t one of them. Finally, in regards to your “money printing, plain and simple” comments at the end, I see this as Fed increasing M1 to catch up for years of credit M3 expansion. It was way past due and another trillion or two is likely justified. I’m sure there are some cool charts on graphs on the subject, I just can’t remember where I saw them. Thanks.