Great Leap Forward


The Fed’s meeting again, and many expect another round of Quantitative Easing. People talk about a Big Bazooka, but the Fed keeps shooting blanks. No matter what it does, it won’t matter much.

There’s so much confusion about interest rate determination and effects of rates on the economy. Let me quickly discuss several seemingly unrelated topics that display the confusion.

By far the most important confusion we’ve had in recent years is over the relative importance of fiscal and monetary policy. I won’t go into that in detail here, but it is truly remarkable how policy makers deluded themselves into believing that central banks are all powerful. Indeed, it was believed that you really don’t even need fiscal policy as monetary policy alone can fine-tune the economy, maintaining growth, high employment and price stability. That was behind Ben Bernanke’s “Great Moderation” argument that should have been exploded by the Global Financial Crisis. Unfortunately, in the aftermath of the GFC the Fed’s supposed supremacy survived as we moved on to the belief that Uncle Ben could save us with Quantitative Easing: QE1, QE2, and soon, QE3.

After that there will be QE 4,5,6 and on and on until SOMEONE in Washington recognizes that QE is completely impotent. If we are ever to get out of this crisis, it will be fiscal policy that does it.

All that the Fed can do is to lower the overnight interest rate target—which it did—to zero (ZIRP). After that, QE simply keystrokes reserves to replace treasuries on bank balance sheets. Why-O-Why would anyone think that stimulates banks to do anything they wouldn’t otherwise do?

The one positive effect the ZIRP and QE had was to increase bank net earnings. Even though the Fed removed earning assets from their balance sheets, the net effect of apparently permanently low interest rate policy has been to lower rates paid on bank liabilities MORE than the rates have fallen on bank assets. That is to be expected—banking is a highly oligopolized business (a handful of banks control “market” rates, as discussed below) so they are able to prevent retail loan rates from falling as much as deposit rates fall. Further, banks are jacking up all kinds of deposit and checking fees—which works so long as they all do it lockstep (if a major bank or if a lot of small banks refused to do it, they wouldn’t be able to make the high fees stick).

The same thing happened back in the early 1990s as the Fed kept rates low to increase bank earnings so they could be recapitalized. It is implicitly a bank rescue policy. Nothing necessarily wrong with that.

But there’s a darker side. The low deposit rates and the high fees are wiping out savers. I’m not telling you anything you don’t know. You cannot even get half a percentage point on your savings at banks. Sure, your mortgage rate has also fallen, but the net effect has drained consumer’s income. Here’s a quote from a Credit Suisse report:

The side-effect of the Fed’s near-zero interest medicine – the collapse in personal interest income over the last few years. The decline in interest income actually dwarfs estimates of debt service savings. Exhibit 2 compares the evolution of household debt service costs and personal interest income. Both aggregates peaked around $1.4 trillion at roughly the same time – the middle of 2008. According to our analysis of Federal Reserve figures, total debt service – which includes mortgage and consumer servicing costs – is down $206bn from the peak. The contraction in interest income amounts to roughly $407bn from its peak, more than double the windfall from lower debt service.

Let’s put that in perspective. Remember the Obama fiscal stimulus? About $400 billion a year for two years—let’s say almost 3% of GDP. There’s been a big debate about whether it “worked”. Only the truly crazy believe it did not save us from an even worse recession than what we actually went through.

Well, QE is removing an amount of aggregate demand from the economy equal to half of the Obama stimulus. And that is not just for two years—it goes on and on and on, year after year after year, as long as the Fed pursues ZIRP.

So QE is supposed to stimulate the economy by taking 1.5% of GDP away every year?

Just as we learned in the case of Japan—which experimented with ZIRP over the past two decades—extremely low rates take more demand out of the economy than they put in. So the Fed has mistaken the brake for the gas pedal: QE slams on the brakes but the Fed thinks it is sending more gas to the economy. The only thing we can be thankful for is that the Fed is driving a rickshaw, not a Buick. The damage it can do is not lethal.

Don’t get me wrong, I’m not against ZIRP—I’d have ZIRP all the time—but we need to understand that it does not stimulate the economy.

So what all this really means is we CAN and indeed MUST ramp up fiscal policy. The demand gap is probably at least 6 or 7 percent of GDP—maybe more—without QE. QE adds another necessary fiscal stimulus of a point and a half. So, folks, with QE we get MORE tax cuts and MORE public infrastructure spending—the necessary size of the fiscal expansion is LARGER with QE! Probably 7.5 to 8.5% of GDP. We can completely eliminate the payroll tax, give income tax relief to all below $150,000 gross income, and ramp up spending on things that really matter like education, block grants to states and local governments, green energy, and public infrastructure. Thanks Uncle Ben!

Another thing that both the Fed and the Bank of Japan have proven beyond any reasonable doubt is that no matter how much the “bond vigilantes” desire higher rates, they cannot have them if the central bank wants zero! Forget about market determination of rates on treasuries. It’s not about supply and demand. The monopoly issuer of the currency determines the overnight rate. QE then drives the rate to the central bank’s “support rate” (rate it pays on reserves), and if the central bank’s commitment to low rates is credible, the term structure adjusts downward. It is hard to drive long rates below 2%, as Keynes argued, due to the risk of capital losses (wiping out the interest earned).

And if the markets don’t believe the central bank is committed to ZIRP it can take a while to bring down the long rates—however reality eventually dominates expectations so a determined central bank will bring down rates even on long term treasuries (as the Fed eventually did). Funny how expectations converge to reality rather than the other way around as Bernanke and other “New Monetary Consensus” economists believe.

The central bank can do it even more quickly if it stands ready to buy any maturity at a stated interest rate equivalent. But the point is that vigilantes can strike all they want but their alternative to the treasuries is the support rate on reserves.

Let’s move on to the LIBOR scandal. I won’t rehash the details—you’ve read about it. A handful of guys have been rigging LIBOR whilst pretending this is some kind of market-determined rate. Well, what do you expect oligopolists to do? They rig markets. All economists know this. Remember the story of the two gas stations on opposite corners? One cuts prices, the other must follow. Price falls to zero, then they hand out free loaves of bread to bring in customers for the free gas. If you are my age, you actually saw it happen. Oligopolists hate that. So they rig the market—agree to raise rates and share the spoils.

OK so the big London banks rigged the markets. It is absolutely normal behavior, even if illegal in the US. And $10 trillion of consumer and business loans were linked to the rigged numbers. OK, not a big deal–just yet another one of a long line of multi trillion dollar frauds created by our friendly big bankers to screw customers.

Nay, it’s a bit worse than that. They rigged the LIBOR rates because banks didn’t want to report the actual interest rates they had to pay to issue short term liabilities. That would have indicated what the market thought of their balance sheets—signaling they were deep in the pig excrement, so to speak.

So another part of the LIBOR scandal is that banks were trying to hide their financial situation.

But that’s still only half of the story. At some of the banks, the reported borrowing rates that went into the setting of LIBOR were manipulated by traders making bets on rates. You see, trading profits are much more certain if you rig the results. Load the dice and you’ll win more at craps. In some cases, the traders were making profits at the expense of their own bank—reducing LIBOR and therefore the bank’s income.

You’ve just got to love the morality of traders.

Oh, it gets worse. We now know that FRBNY president Timothy Geithner knew about all this rigging of LIBOR. And he snitched to the Brits. When they didn’t seem interested (there is some controversy over what he actually told them), he let it drop.

Well, that is not quite correct. As he and Chairman Bernanke worked out the $29 trillion bail-out of Wall Street, they decided to link some of the bail-out funding facilities to—you guessed it—LIBOR rates!  Yes, he linked bail-out funds to LIBOR—a rate rigged by the banks. For example, the Bear Stearns and AIG bailouts (Maiden Lanes I,II,III) were linked to LIBOR, as were the rates set for the Term Asset-Backed Securities Loan Facility (TALF) that issued nonrecourse loans. Nice job, Timmy. Use the rigged rates you supposedly were so concerned about that you briefly turned snitch.

One other example of rigged interest rates. We now also know that the biggest banks were colluding to screw all of our local governments in the muni bond market. The banksters took turns “winning” fake “competitive” bidding. All rigged to pay governments a lower interest rate on their parked funds.

Truth is, all the financial markets are rigged. For them, against us. It’s the way financial markets work. As I said, we’re screwed. There is no such thing as “market-determined” interest rates. What are euphemistically named “market” rates often result from backroom deals or less overt means of oligopolistic pricing (such as price leadership). The best more-or-less honest rate out there is the one set by the central bank—the discount rate and the Fed Funds rate in the US. That is what the Fed should have used in its bail-outs, and it is what should serve as the reference rate for loan rates set by regulated banks. The Fed Funds rate is the main policy rate in the US and it makes sense for other rates to be set relative to that rate—not relative to LIBOR.

Warren Mosler began warning about rigged LIBOR rates in the mid-to-late 1990s. When the Fed began considering dollar swap lines as a means of keeping a lid on dollar LIBOR in 2008, Warren argued it made no sense for the Fed to get involved with a rate that was manipulated by the banks. He proposed that no US financial institution should be allowed to use LIBOR in rate setting. Here’s Warren’s proposal: Or here’s a nice powerpoint:

Think about it. Why would the Fed use LIBOR, or allow regulated US banks to use it? As we know, the Fed sets the base interest rate in the US; this is its “handle” on US monetary policy. Why on earth would it let banks under its supervision use a rate set behind closed doors in London? Worse, why would it use that rate, itself, in its loans?

Probably this is due to some lingering belief in the supposed “economic efficiency” of market-setting of interest rates by the scissors of supply and demand. But we (now) understand that LIBOR was not a market rate—nor were the various other rates supposedly “market determined” by “supply and demand”.


CWHAugust 1st, 2012 at 4:56 pm

If I pour coffee in my cup, less than it will hold, none will overflow onto the table. I must tip the cup for that to happen.

TomAugust 1st, 2012 at 5:43 pm

"QE simply keystrokes reserves to replace treasuries on bank balance sheets."

That's only true if banks are the ultimate sellers of Treasurys, reducing their holdings by selling into the Fed's bid. If instead, as has been the case, banks and other primary brokers are merely traders, selling to the Fed Treasurys they buy ultimately from the Treasury, then QE creates both reserves and bank deposits (issued to the recipients of government spending). Since QE rarely exists without at least matching deficit spending, what it really does is change how that deficit spending works. Instead of the Treasury funding itself by issuing debt securities, it funds itself by issuing fully reserved bank deposits (while the Fed accumulates Treasurys on its balance sheet).

So QE's impact is not a question of what the banks will do with reserves in place of Treasurys. It's a more complex set of questions: what will the private sector do with more cash in the bank, what will banks do with more reserves, and how are those effects different from what banks and/or shadow banks would do with more Treasurys?

Of course if the Fed's buying agencies it's a different story.

I'm also skeptical of the power of QE especially when reserves are already so plentiful and see as many negatives as positives. But oversimplifying it as much as you have misses everything that's important about QE. The markets don't get excited about it for no reason.

You're also quite right about the lost income from savings hitting consumer demand, and the low rates being like a bank rescue policy. But I'm surprised you say there's "nothing necessarily wrong with" such a rescue policy. The lost income to consumers is what's wrong with it. That's how it's funded. There's no free lunch.

Your call for 8% of GDP more US deficit spending is of course a sure fire recipe for global meltdown. The dollar is the world's benchmark. If we start behaving worse than Argentina, there's nobody to take our pace.

Got ZIRP? « OVER LEVEREDAugust 1st, 2012 at 7:53 pm

[…] financial markets either positevely or negatively to varying degrees (see here). L. Randall Wray notes in a piece today for EconoMonitor about the darker side of ZIRP, which serves to wipe out savers […]

LRWrayAugust 1st, 2012 at 9:37 pm

Tom: you are at least confusing and maybe confused about QE. Makes no difference who sells treasuries to Fed–whether BofA or Susie Q–a bank's reserves get credited. And if Treas moves deposits to Fed, a bank deposit is debited as is the bank's reserves.

Argentina was on a dollar currency board. The US is on the dollar too but it is our own currency. Crucial difference. Just ask the PIIGS.

8% stimulus is a recipe for growth and low unemployment.

Rodney RondeauAugust 2nd, 2012 at 2:29 am

Tom: QE isn't funded by stealing from savers. When banks hold reserves it is like having a checking account with the fed and when they hold securites it is like a savings account. All those people holding Treasuries traded them in for reserves. It was a switch from one account to another one asset for another.and it all takes place on the feds computer. This has nothing to do with the real economy. If you went to your local bank and moved money from you savings account to your checking account what effect would that have on your local market?

Matt DubuqueAugust 2nd, 2012 at 2:57 am

I don't think anybody who actually STUDIES what the Fed says and actually READS the damn FOMC minutes thought that another round of QE was coming.

Read the Financial Times of London?

AndyAugust 2nd, 2012 at 7:36 am

When I hear respected economists here in the UK talk about 'fiscally neutral' stimulus, as if it's a given that this is the only option, I feel like I'm in a ceratin Munsch painting.

Neil WilsonAugust 2nd, 2012 at 8:42 am

"So what all this really means is we CAN and indeed MUST ramp up fiscal policy"

I'll ask the same question here.

Isn't 'overpaying' for bonds a form of fiscal stimulus?

ISTM that QE fanatics are backing off from the 'increases the amount of lending' line to the simple 'well we've given bond sellers more money than they would have got otherwise'.

And they want to do more. They want to seriously overpay for assets rather than merely marginally overpaying for them.

Strikes me they are completely ignoring the effect on savers with that idea.

ollyAugust 2nd, 2012 at 12:00 pm

"Makes no difference who sells treasuries to Fed"

That's not entirely true. When investors sell treasuries to the fed they get deposits in their bank accounts. QE drives up the price of treasuries (this is why the market gets excited about it), meaning that investors get larger deposits than they would otherwise when they sell them. However, QE also drives down interest rates, meaning that investors then earn little or no interest on those deposits. Being investors, they then look for alternative assets to buy. This portfolio rebalancing process drives up the price of other assets, such as corporate bonds and equities, which also has the added effect of making it cheaper for those businesses whose bonds and shares are being bought to borrow.

So QE boosts asset prices and makes borrowing cheaper.

ollyAugust 2nd, 2012 at 12:02 pm

Near zero rates also increase investor's appetite for risk, meaning that more money ends up flowing into more speculative markets, such as commodities, oil etc. This has the effect of pushing up prices in those markets, which then feeds back into higher CPI inflation.

If no substantial fiscal support is forthcoming, and the economy is in widescale deleveraging mode, then the inflationary effects of lower interest rates, higher asset prices, cheaper borrowing, and more speculation in commodity/oil markets, will be relatively muted. However, under non-deleveraging conditions, and with very large government spending and tax cuts, the effects of ZIRP and QE could be quite different. Asset prices, including house prices, and commodity and oil prices, could all go through the roof, feeding through ineveitably to high CPI inflation. In response to this the government would either have to raise taxes and cut spending sharply, and/or the fed would have to jack up interest rates.

ollyAugust 2nd, 2012 at 12:02 pm

None of this has happened in Japan because the government has never fully offset the private sector deleveraging and saving desires through fiscal policy, and the current account position hasn't changed enough to compensate for that either. As a result Japan has just continued to bounce along the bottom.

Joe FirestoneAugust 3rd, 2012 at 12:49 am

Agree with your very good reply, but Tom referred to "Your call for 8% of GDP more US deficit spending . . . " So, since US deficit spending this fiscal year is at $1.15 T and will likely end at about $1.2 T or 8% of GDP, I doubt that you'd advocate "8% more." It would be more like 2 – 3% more, or another $400 B, and a restructuring of the first $1.2 T right?

EEBAugust 8th, 2012 at 4:30 am

This is lke saying that if pigs had wings, they could fly. Maybe so, but it's irrelevant and immaterial. If the economy were, in fact, in a "non- deleveraging mode", then interest rates would not be zero and the banksters would not be able to speculate with free money from Uncle Ben. Of course, there may be wild speculation, anyway, and if there is, the end result will just be another Crash. ZIRP is not a figment of Bernanke's imagination; it is a response to an ongoing depression. Depressions don't magically end overnight, and the relevant system time constants are rather large. So, it is rest assured that ZIRP will end before this depression ends. Really, your only real hope for hyperinflation and interest rates to match would be if we suddenly did have a WWII- style fiscal expansion; perhaps a WPA on steroids.

ollyAugust 8th, 2012 at 7:35 pm

OK, but Randall Wray is advocating a permanent ZIRP:

"Don’t get me wrong, I’m not against ZIRP—I’d have ZIRP all the time"

(Quoted from the article above).