More Debate on QE

The Jackson Hole conference starting today is expected to include a talk by Ben Bernanke on the benefits and costs of further monetary easing, which in ZIRP-land means quantitative easing. Gavyn Davies put up a good short list of arguments made against QE at the Financial Times, and most do not look terribly persuasive. One which I found interesting was:

“QE will weaken the Fed’s balance sheet, and undermine confidence in the institution.” This was a very powerful argument in Japan in the 1990s, which reduced the amount of quantitative easing which the BoJ was willing to undertake. If the Fed simply buys Treasuries, it is hard to see how this weakens the balance sheet, unless you believe that the US government could default on its debt. However, if the Fed were to buy private sector assets, like securitised debt and/or equities, then it could subsequently have to take mark-downs on these assets, and many people would see this as a problem. But the Fed probably should not be treated like a private bank, which would suffer a loss of solvency if it suffers a mark-down on its assets. The Fed does not have to mark-to-market like a private bank. And, anyway, does it ultimately matter if the Fed has a negative net worth? The answer would be yes if it undermines the public’s faith in the institution, causing people to reduce their holdings of dollars, in exchange for goods, or foreign currencies. But this is just another way of saying that there is an inflation constraint on the Fed’s ability to increase QE, which everyone would accept. So the balance sheet argument only holds as a special case of the inflation argument.

I think Davies is missing a part of the dynamic here. The intensity of the battle over Bernanke’s reappointment and the partial victory for the Audit the Fed movement are tangible signs that the Fed’s aggressive action during the crisis has led to a hard pushback from Congress. Part of it may be deserved loss of faith in an organization that utterly failed to see the crisis coming and refused to exercise any control over banks; another may be that Congress recognizes full well that the Fed was acting as an extralegal, off-balance-sheet funding vehicle for the Treasury, meaning a route for circumventing normal budgetary processes. So if the Fed were to balloon its balance sheet to, say, $5 trillion, my sense is that there would be enough concern about the scale of Fed operations, particularly if the problem is a lingering economic malaise rather than a crisis, to produce concern in some quarters and lead to Congressional prodding (recall, by contrast, that the 2009 QE was implemented when banks still were on the ropes). So the fear of political action may also be playing into how the Fed views this issue.

The problem (which many economists and analysts will readily acknowledge) is that QE is being used as a stand in for fiscal policy, and it is a not so hot second best in an economy where firepower was already deployed to spare banks pain and prop up asset values. And in the US, stimulus was not well targeted, in addition to being half-hearted.

George Magnus of UBS, in Thursday’s Financial Times, made a lesser of two evils argument in favor of QE:

Better, if necessary, to print money and be damned, rather than tighten policy and be damned. Under the former, there is always redemption by withdrawing the stimulus if circumstances warrant. Under the latter, there is only chaos.

While I am not unsympathetic toward the case for QE, I think Davis made the most potent argument at the top of his post:

“Quantitative easing was tried in 2008/09, and it did not work.” True, the Fed expanded the size of its balance sheet by about $1.5 trillion dollars in a matter of a few weeks in 2008, so QE was certainly tried. We do not know what would have happened if this had not been done, but there seems a strong chance that the banking collapse would have been worse, and the economic recession much deeper, without QE. In that sense, the policy ”worked”, but the cure does not seem to have been permanent. It is hard to isolate the real reason for this. It may be because QE is an ineffective policy tool, or it may be because not enough of it has yet been done. Take your pick.

This is narrowly true, but misses the point. When an economy is very slack, cheaper money is not going to induce much in the way of real economy activity.

Unless you are a financial firm, the level of interest rates is a secondary or tertiary consideration in your decision to borrow. You will be interested in borrowing only if you first, perceive a business need (usually an opportunity). The next question is whether it can be addressed profitably, and the cost of funds is almost always not a significant % of total project costs (although availability of funding can be a big constraint).

And even more important, to the extent money costs matter, the relationship between price and activity is asymetrical. Too costly funding can kill a project. But cheap money (except for scamsters) is not going to make a businessman wake up and say, “Gee, my borrowing rate has fallen 2% in the last six months. I really should go out an open an new store.” He’ll do that ONLY if money being 2% higher was a binding constraint. The prospects for his business are always a first order consideration, the cost of money second order.

So the state of demand in his market is a major consideration, and for most businesses, that’s a function of the health of the overall economy. Most businesses see lousy conditions and surveys of small businesses (which employ over half the people in the US) show them expecting their businesses to face even more difficult conditions in a year. Various bank surveys similarly show weak demand for business loans.

So cheaper money will operate primarily via their impact on asset values. That of course helps financial firms, and perhaps the Fed hopes the wealth effect will induce more spending. But that’s been the movie of the last 20+ years, and Japan pre its crisis, of having the officialdom rely on asset price inflation to induce more consumer spending, and we know how both ended.

Einstein defined insanity as doing the same thing over and over again and expecting different results. And to me, the most compelling reason to be against QE is that policymakers will nevertheless hope it might be effective if used again. They will therefore refrain from trying more politically difficult, but more promising course, namely, restructuring debts and using government spending to cushion the impact, with a keen focus on measures that will restore competitiveness and reduce our trade deficit.

Originally published at naked capitalism and reproduced here with the author’s permission.