In economic circles, there has been a lot of buzz about Quantitative Easing of late. Basically, the U.S. Federal Reserve has lowered interest rates to near zero percent and the fear is that these cuts will not have enough effect on the willingness to lend in order to reflate the U.S. economy. Therefore, the Fed has decided to take more draconian measures, one of which is Quantitative Easing, flooding the economy with money.
This experiment is not without risks. There is the potential for very high inflation down the line if the Fed is successful. But, does the Fed have a choice? It seems that it is looking at deflation or depression on the one hand or stagflation on the other. Take your choice.
But before you take sides, first let me go back a few years in history to describe exactly just what quantitative easing, a policy first really practiced in earnest in Japan, really is. Wikipedia has an excellent definition.
Quantitative easing was a tool of monetary policy that the Bank of Japan used to fight deflation in the early 2000s.
The BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. More recently, the BOJ has also been flooding commercial banks with excess liquidity to promote private lending, leaving commercial banks with large stocks of excess reserves, and therefore little risk of a liquidity shortage.
The BOJ accomplished this by buying much more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities, equities and extended the terms of its commercial paper purchasing operation.
In essence, the Bank of Japan found that despite lowering short-term interest rates to zero it could not get its zombie banking sector to lend. Credit, the life blood of our fractional reserve banking system, was just not increasing. Therefore, the Bank of Japan began buying Japanese government bonds (JGBs) with money that it created out of thin air — that is they bought existing assets with money that did not previously exist. Central Banks can do this because they control the electronic printing presses. Now, the likes of Murray Rothbard, an Austrian School economist calls this counterfeiting. However, regardless of how you see this, this is how our monetary system works.
But this is also the definition of inflation. See my post, “What is inflation” for a primer on why inflation is not consumer price inflation, but rather an increase in the supply of money. And while the Japanese economy did not get higher consumer price inflation as a result of the massive quantitative easing, this money did create the carry trade as people borrowed in Yen and invested abroad. The Japanese central bank was then very much a factor in creating the global bubble we just experienced.
Printing money is effective because it has the effect of putting more high-powered money into circulation. The aim is to increase bank reserves enough so as to increase lending that results from those reserves.
And Fed Chairman Ben Bernanke knows this. He is a student of the Great Depression and deflation, a well-regarded economic historian. Bernanke earned the moniker “Helicopter Ben” a few years back as a result of some comments he made in 2002 at the National Economists Club regarding quantitative easing to avoid deflation before he became the Fed Chairman. Here is what he said as quoted on the Federal Reserve’s website:
As I have mentioned, some observers have concluded that when the central bank’s policy rate falls to zero–its practical minimum–monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8 Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
Translation: it is always preferable to a central bank to print money or create some reasonable facsimile of printing to prevent deflation before its onset than to try and deal with deflation once it has set in.
I strongly suggest you read Bernanke’s remarks in their entirety. The most important statement he made was about the electronic printing press and its effectiveness in combating deflation. If we are to take him at his word, Bernanke will print money — lots of it — to avoid deflation. The key, of course, is high-powered money. Rebecca Wilder said this quite well on a recent post of hers:
What is the difference between money and high powered money? Money is a function of two things
- The monetary base, which equals bank reserves plus currency in circulation
- The money multiplier, or how quickly the base switches hands in a fractional reserve banking system (for a discussion of money creation, see this wiki article).
The Fed is raising the monetary base through its QE policy and increasing its balance sheet (credit extended to the banking system) from $884 billion on August 28 to $2.1 trillion on November 28. The Fed simply creates new monetary base (reserves) out of thin air; hence, the printing money connotation.
This experiment is not working, though. Before the present day, conventional wisdom was that in Japan in the 1990s and in the U.S. in the 1930s, policymakers waited too long to begin any quantitative easing. Deflation had already set in and QE was pretty much a bust, as a result. However, we are beginning to see that it was not only the delay in policy, but the natural course of deleveraging which caused credit and the money multiplier to contract.
I mentioned this in April in my post “Finding a bottom,” which I quote her in its entirety because it is germane to why credit will contract:
As the writedowns at global financial institutions near $300 billion in capital lost as a result of the sub-prime crisis, the question as to when we reach a bottom is ever more urgent. Market history tells us that the severity of the bust after an economic upswing is usually related to the size of the original upswing. This mortgage and credit bubble being the mother of all bubbles requires a sustained and robust deleveraging to set things right. Therefore, the real economy in which we all live and breath should feel some very significant impacts for some time to come. My hope is this process will find a bottom late next year.
We are now in the midst of a financial crisis after a large speculative bubble. As such, the real economy effects will tend to be larger than during a garden-variety recession. The problem is the deleveraging feedback loop that needs to work its way through the system. The Federal Reserve, The Bank of England and the European Central Bank are doing everything they can to make sure this process occurs without a systemic failure in the global financial system like what was suffered during the Great Depression.
De-leveraging begins when the speculatively financed investments go bust and writedowns occur. Normally, banks can handle these writedowns without having to de-leverage because they are well-capitalized. However, when banks writeoff unexpectedly large amounts of capital, this reduces their capital base and makes the bank look more leveraged and risky as a financial institution. $300 billion is a large amount. When the financial sector writes off $300 billion in equity capital in the span of one year, some institutions start to look pretty risky. In a fractional reserve banking system (in which only part of deposits are held in reserves), banks risk ruin if depositors lose trust in their stability. Therefore, it is important for institutions to re-capitalize after large writedowns.
Re-capitalising can occur in one of three ways: the banks can increase their equity capital through paid-in capital, they can increase their equity base through profits or they can de-leverage. To date, banks have been forced to issue additional equity capital (often from sovereign wealth funds) in order to maintain strong balance sheets. However, the Federal Reserve has done all it can (and more — indeed, too much more) by lowering interest rates to banks in order to increase the spread between money lent and money borrowed, which will increase bank profits. This too will help banks — albeit slowly as the banks can only profit from these spreads over time.
Nevertheless, banks will not be able to strengthen their balance sheets quickly enough through those two methods without significant deleveraging. They will need to sell assets and reduce future credit availability in order to gain the rock solid balance sheets that customers, counter-parties, and consumers will require in a more cautious economic environment.
The Feedback Loop
How much deleveraging will need to occur? That brings us back to market history, which tells us that deleveraging will be extensive given the size of the speculative run-up earlier this decade. Moreover, the feedback loop with the real economy suggests that many more writedowns are to come. As investments have soured and credit availability becomes scarce, individuals and companies have started to feel the pinch in the real economy. Layoffs have begun in earnest. As a result, consumers have cut back. This will cause more financial distress in other lending sectors of the economy. Top on the list are Alt-A Mortgages, some Prime Mortgages (especially zero percent, zero down and adjustable rate varieties), Construction and Development loans, Corporate Real Estate loans, Credit Cards, Auto Loans and High Yield Corporates. From here, the feedback loop will begin again with losses, writeoffs, and credit tightening in the new distressed sectors as well as in the previously distressed sub-prime market. The feedback loop continues with more deleveraging, layoffs, consumers tightening their belt, and reduced corporate profitability.
At some point, this whole feedback loop will end a we will find a bottom. The hope is that we can do this with a minimum of damage to the real economy, a minimum of personal financial distress and as quickly as possible. When we reach the bottom is anybody’s guess, but expect this deleveraging process to play out at least for the entirety of 2008 and through well into 2009. Let’s hope that we find a bottom then.
When we do find a bottom we should know whether Bernanke has been successful. If he fails, prices fall, the real value of debt rises and depression ensues. If Bernanke succeeds, however, the outcome is less clear. Rebecca Wilder paints a good picture of what is at stake here.
Will the Fed’s QE strategy lead to inflation? In the short-term, no. The money multiplier is falling because the economy is in a nasty recession alongside a serious credit crisis. In this environment, the surge of high powered money will not cause prices to rise.Prices normally drop in a recession (deflation) because the demand for money (the ability to purchase goods and services) falls with rising unemployment and declining income (slackening demand for goods and services). But the 2008 recession is accompanied (or partially caused) by a credit crisis that induces banks to hoard the new base as excess reserves; this adds to the deflationary pressures. If deflation were to become embedded into consumer and firm expectations, then the macroeconomy could be facing a severe problem. So for now, and until the economy emerges from its recession, QE will not lead to inflation.
But what happens when the economy rebounds? Inflation becomes a serious risk if the Fed does not extract the high powered money. If the Fed gets it wrong, or its timing is off, then the money supply will rise quickly as banks start to lend more freely, and inflation results.
In the US’ case, I see the Fed getting it wrong as a serious risk to price stability (rising inflation). American consumers are not savers and love to spend; and although some suggest that the American saving behavior has changed, the evidence is far from concrete. Unless saving rises permanently – the economy transitions to a world where consumption is less than 70% of GDP – consumers will be more than happy to swoop up the new bank lending and spend that new easy money.
Quite frankly, I am not sure the Fed can get us out of this one. Money multipliers are plummeting and credit is just not increasing. Meanwhile, the real economy is falling off a cliff, meaning more loans will sour. How does the Fed believe it can increase lending in that environment? I’m sorry — deleveraging will continue apace.
But, what if I am wrong? What if the Fed can reflate the economy? Well, then we have to worry very seriously about the huge amounts of money sloshing around the system. If things get back in gear, inflation is going to be a very big problem. We can only hope this is a problem the Fed can handle. But, for most of us, this is the problem which we would rather have.
Quantitative easing – Wikipedia
All of the buzzwords in one post: quantitative easing, inflation and printing money – News N Economics
Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C.
November 21, 2002: Deflation: Making Sure “It” Doesn’t Happen Here – Federal Reserve Board