A reader asked me to comment on a video from the Big Picture conference of Jim Bianco commenting on the so-called wealth effect of quantitative easing. In the video, Jim takes the position that the Fed cannot create permanent wealth though QE. It can only create (temporary) “loss reduction”. Jim noted that we have had record stock mutual fund outflows in the United States, and that this had not changed even after the Fed began QE3. And he believes this is emblematic of the Fed’s inability to create permanent wealth through quantitative easing and that QE is going to produce the worst possible outcome for the Fed, producing – in the best of cases – a (temporary) wealth pickup for the wealthy and nothing for the rest. I agree wholeheartedly.
Let’s look at why QE won’t lead to permanent wealth creation.
Quantitative easing is merely large scale financial asset purchases (LSAP) by a central bank. These asset purchases may or may not expand the central bank’s balance sheet, depending on what the central bank intends to do. Conducting LSAP without expanding the balance sheet is called sterilised open market operations. If the central bank allows its balance sheet to expand, the LSAP is called unsterilised.
For example, last year the Federal Reserve initiated a quantitative easing program dubbed “Operation Twist” that was designed to reduce the amount of long-dated US Treasury paper available in the private sector and boost the amount of short-dated Treasury paper, without expanding the Fed’s balance sheet. The Fed was using sterilised open market operations to reduce the maturity of US government public debt in the hope that it would flatten the yield curve by bringing down interest rates for long-dated Treasuries because of a scarcity effect. These are the kinds of operations central banks are permitted to do.
Central banks are primarily focused on interest rates as a vehicle for economic influence, adjusting the overnight rate up or down in order to influence credit supply and demand. As far as actually buying assets, central banks are ‘asset swappers’, meaning that the central bank cannot add financial assets to the private sector by printing money. The central bank merely buys an asset with high-powered money and either sterilises this purchase with a sale of another asset in order to keep the size of its balance sheet unchanged or allows the transaction to proceed unsterilised. The example above shows the Fed making sterilised purchases of long paper via sales of short paper in order to bid up long-dated paper vis-a-vis short dated paper and flatten the yield curve.
Only fiscal agents ‘print money’ by adding net financial assets to the private sector through deficit spending i.e. creating a government liability not offset with a government asset in the form of a tax. So, what this essentially means is that the central bank cannot ‘create’ permanent wealth because it cannot add net financial assets to the private sector. It merely changes the composition of assets, making some assets worth relatively more and others worth relatively less. And to the degree its actions reduce interest rates, it has the effect of (temporarily) increasing the value of all financial assets through a (temporary) increase in the time value of today’s money.
One might conjecture based on Jim Bianco’s discourse that to the degree the Fed could get people to go out and start buying stuff based upon the wealth effect that low interest rates create, you might be able to get some sort of permanent wealth creation. But that read of the situation is false. If you think back to the last two decades and the wealth effect that came from the artificially elevated prices of stocks in the 1990s and housing in the 2000s, you can see that this artificial wealth effect was reversed when these bubbles burst. The wealth effect of rising stock prices based on central bank asset price manipulation is pure malinvestment, meaning it leads to lower long-term economic performance due to the misallocation of resources associated with the central bank’s manipulation.
Analogously one could say that a fiscal agent which adds artificial stimulus to the private sector by deficit spending in a way that produces no long-term societal wealth in the form of infrastructure or efficiencies that lead to productivity gains, is malinvesting. The goal of government is to create an economic structure, public infrastructure and rules and regulation that lead to longer-term productivity gains and increased socially desirable outcomes like higher life expectancy, lower infant death mortality, low crime rates, and increased educational attainment. A lot of this is ‘soft’ economics, meaning that it is not easily quantifiable. For example, researchers at Dartmouth College demonstrated that Europeans have consumed a much larger proportion of wealth garnered since the 1960s in the form of increased leisure and holiday time, while Americans have opted for greater material wealth. Ostensibly those differences reflect outcomes based on normative cultural priorities as opposed to benefits and deficiencies that can be objectively identified.
The debate at present is whether the US economy is suffering from an economic malaise that can be eliminated or diminished in some way by government without equally offsetting longer negative consequences like the ones we witnessed after the technology and housing bubbles. After all, many workers remain idle. And unless you think these workers are zero marginal product workers as some economists claim, there is every reason to find a way to get them productive again in order to increase output and wealth. Every day of lost potential output of idle workers is a deadweight loss, a day of irretrievably lost wealth creation – meaning the potential wealth can never be recouped. Clearly then, the benefits of stimulus are clear, the question is about the offsetting longer term consequences of said stimulus. And in today’s ideological context about the role of government, monetary policy is seen by many who support limited government as a better stimulative alternative than fiscal policy because it doesn’t lead to an increase in the size of government.
In sum, the private sector composed of individuals and businesses creates wealth. Government facilitates wealth creation by setting up an economic infrastructure that leads to improvements in the long-term social and economic outcomes that an individual economy most values. In this context, the Federal Reserve cannot create permanent wealth because it merely changes the time value of money by setting the overnight interest rate and transforms the composition of financial assets through open market operations. These are distributional tools that have limited real economy effect. The value and efficacy of the fiscal agent’s role is another completely separate issue outside of the scope of this post. On monetary policy, however, to the degree that the Fed errs on the side of easy money by holding interest rates too low for too long across the business cycle, as I believe it has these past two decades, the longer term effects on the real economy of these tools is negative because of the misallocation of resources.