By Satyajit Das, author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming in Q3 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010). Joint posted with Roubini.com
In the film Ferris Bueller’s Day Off, an economics teacher, played by Ben Stein, launches into an improvised soliloquy: “… Anyone know what this is? Class? Anyone? Anyone? Anyone seen this before? The Laffer Curve. Anyone know what this says? It says that at this point on the revenue curve, you will get exactly the same amount of revenue as at this point. This is very controversial. Does anyone know what Vice President Bush called this in 1980? Anyone? Something-d-o-o economics. “Voodoo” economics.”
Voodoo Economics
In the late twentieth century, US President Ronald Reagan discovered voodoo economics. In framing policy responses to the global financial crisis, central bankers and governments have increasingly embraced more exotic forms of voodoo.
Since the early twentieth century, economics has been preoccupied with the business cycle. Economists, from John Maynard Keynes to Milton Friedman, have developed theories to explain boom-bust cycles. Most importantly, they sought to develop tools to manage these cycles, fostering progress and the creation of wealth whilst reducing the disruption and high cost of periodic crises.
Despite complex doctrinal differences, Keynes and Friedman’s followers believe that the correct policy measures allow a high degree of control over economies. During Le Belle Epoque from the late 1980s to around 2007, economists and policy makers luxuriated in the belief that most major problems of economics and management of economies were well understood, if not entirely predictable and controllable. The global financial crisis exposed significant problems in the state of human economic knowledge and also the ability to control events.
Economics Sine Qua Non
Policy makers have two major mechanisms through which they can influence the economy. Using fiscal policy, governments can adjust the level of spending relative to tax inflows. Using monetary policy, governments or, in modern times, “independent” central banks can adjust interest rates and the supply of money to manage the availability and cost of credit as well as inflation . Ultimately, both mechanisms are designed to influence the level of demand in the economy, creating the economic “nirvana” of the “right” level of growth, unemployment and inflation.
At the start of the global financial crisis, policy makers resorted to age-old remedies, increasing budget deficits and cutting interest rates. The only way out of the problem of excessive debt was strong growth and inflation.
Growth would increase the income and cash flows of indebted individuals, companies and countries enabling them to more easily pay back debt. Inflation would help debt repayments, reinforcing increases in incomes and cash flows, at least in nominal terms. Inflation would also reduce the real (inflation and purchasing power adjusted) level of borrowings, reducing the level of leverage within the financial system.
It was the least painful fix. Banks and investors, who had lent imprudently, would not be punished. Borrowers, who had taken on debt beyond their capacity to repay, would be rewarded. Prudent savers would lose, as the value of their savings fell in purchasing power. Despite recognition that consumption levels needed to be reduced to increase savings and lower reliance on borrowing, spending would be propped up to restore economic growth.
The morality and long term ethics of the actions and effects were not debated. Short term exigencies ruled as policy makers invoked familiar economic incantations: “there is no alternative” or “the alternatives are worse.”
Unfortunately, three years on, the heroic bet on growth and inflation does not appear to be working. Lethargic growth and low inflation rates, especially excluding food and energy prices, are prolonging the adjustment, delaying the anticipated return to pre-crisis prosperity.
Economic policy options are now limited. Fiscal policy entails taxing and spending and/ or borrowing and spending. As tax revenues fell as a result of slower economic activity, most governments resorted initially to borrowing to finance large budget deficits. The European debt crisis highlighted the limits of the ability of governments to borrow and spend. Near zero policy interest rates in the US, Euro Zone and Japan increasingly limits the ability to stimulate the economy through monetary policy.
Policy makers have resorted to unorthodox measures following the advice of English science fiction writer Arthur C Clarke: “The limits of the possible can only be defined by going beyond them into the impossible.” A key element of this strategy is “quantitative easing” (“QE”), another form of voodoo economics. However, QE may not be any more successful than previous strategies, posing other risks.
Quantitative Alchemy
QE is sometimes parsed as “printing money”. In reality, it is a little more complex.
Normally, central banks regulate the amount of money in an economy, by changing interest rates, the price of money. Changes in rates should change the demand for credit and the supply of money. Where interest rates are already at zero, other means are necessary to increase the supply of money in the economy.
If the economy were entirely cash based, this would just mean printing money. In Weimar Germany, the government took over newspaper presses to print money, such was the demand for bank notes.
In a modern credit-based economy, central banks buy government bonds, which are held on the central bank’s balance sheet. The cash paid for the bonds, usually reserves or low or zero interest rate bearing deposits with the central bank, can be exchanged by banks for higher return assets, such as loans to clients. The purchases also increase the price of governments bonds, reducing interest rates.
In theory, QE lowers borrowing costs and creates liquidity, increasing the supply of money and, hopefully, stimulating demand and inflation.
There are different flavours of QE. It can involve the central bank expanding its balance sheet by buying government bonds, changing its criteria to purchase less liquid and riskier securities or a combination. In all forms, the underlying concern is debt monetisation, that is, the central bank purchasing government bonds with artificially created money to finance tax cuts or government spending, causing hyper-inflation.
Desperate Times, Desperate Measures
In the late 1990s, Japan began using QE on a significant scale in an attempt to revive its stagnant economy. With interest rates at zero since 1999, the Bank of Japan used QE (known as ryoteki kinyu kanwa in Japan) to provide additional money to commercial banks for private lending. Since 2007, the United States, the United Kingdom and the Euro Zone have all resorted to similar strategies.
The Bank of England purchased £175 billion of assets by end of October 2010, primarily UK government securities and small amounts of high quality private sector debt. In November 2010, the UK Monetary Policy Committee (“MPC”) voted to increase total asset purchases to £200 billion. The European Central Bank (“ECB”) has used re-financing operations (a form of quantitative easing) to inject money into the Euro Zone economies. It has expanded the assets that banks can use as collateral for Euro denominated loans from the ECB.
The US Federal Reserve (“the Fed”) has been the most aggressive in using QE, launching several rounds of purchases. The scale of the Fed operation can be gauged from the increase in the size of portfolio. From $700–$800 billion of Treasury notes in 2007, the Fed increased the size of its security holdings to $2.1 trillion in June 2010 with current projections indicating that it will increase to nearly $2.5 trillion.
Initially, between November 2008 and March 2010, the Fed purchased around $1.25 trillion of bank debt, mortgage backed securities (“MBS”) and Treasury notes. After a short halt, the Fed resumed purchases in August 2010 when economic growth fell below expectations. Initially, the Fed committed to reinvesting repayments from its MBS portfolio in QE, around $30 billion a month. In November 2010, the Fed announced further quantitative easing measures, committing to buy $600 billion of Treasury securities by the end of the second quarter of 2011.
Chairman Ben Bernanke has repeatedly sought to distinguish the Fed’s actions from QE, preferring to call it – “credit easing”. Defending his policy, most notably in an opinion piece published in the Washington Post, he has repeatedly sought to reassure critics that QE is not unusual and well within the range of policy options available to central banks. In response, a number of well known economists published an open letter urging the Fed to reconsider and discontinue its large-scale asset purchase plans.
Does it do What it Says on the Can?
Advocates of QE believe that it will lower interest rates promoting expenditure, growth and reduce unemployment. QE, they argue, also enables banks to increase lending, lowers mortgage rates encouraging re-financing and boosts asset prices, further encouraging spending through the effect of increased “wealth”.
In reality, the identified benefits may prove elusive. Lower rates and increasing the supply of money, of themselves, may not boost economic activity.
In the US, many households are crippled by existing high levels of debt, low house prices, uncertain employment prospects and stagnant income. They are reducing, not increasing, borrowing. For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment.
Instead of being lent to customers, the reserves created by QE have persistently sat on bank balance sheets or been recycled into government securities. US commercial banks now have holdings of cash and government securities in excess of loans to customers. This echoes precisely what was observed in Japan when QE was implemented.
The sclerotic credit growth reflects the fact that banks are capital constrained to varying degrees, due to losses and also planned increases in regulatory capital reserve requirements. A fragile financial system and the risk of funding shocks means that banks are husbanding liquidity. The uncertain economic outlook has also made banks cautious in extending credit to entities, other than those that are “too big to fail”.
The general impact on real economic activity has been limited. The Fed’s QE programs to date have reduced long term interest rates, but bank credit has contracted, the housing market remains weak and economic recovery remains tentative. The experience is consistent with that of Japan where a prolonged period of QE did not result in economic recovery, growth, reduced unemployment or inflation.
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“The experience is consistent with that of Japan where a prolonged period of QE did not result in economic recovery, growth, reduced unemployment or inflation.”
Of course it doesn’t. You can only get “growth” again (if the US will at all, in the sense advertised) once all the debt is paid down or defaulted on. Until then, all earnings are extracted by the rentiers. Moreover, as in Japan, the problems in the US are being caused by loss of labor (and thus aggregate demand) to overseas areas (happily stimulated by the outsourcing tax credit law etc. of course), and were papered over by the credit boom.
Now, while I’m sure this is common knowledge, it always puzzles me why people like Das still treat QE as a viable option at all, because by giving it ‘equal time’ (that is, by focusing on the intentions of the legislators/administrators, rather than simply reframing the story in such a way that you can easily explain why QE cannot work, given the problems that exist) the best Das might achieve is that his readers feel confused why this (magical) ‘tool’ wouldn’t work.
Consider “In the US, many households are crippled by existing high levels of debt, low house prices, uncertain employment prospects and stagnant income. They are reducing, not increasing, borrowing. For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment.”
Why can’t he simply write “In the US, aggregate demand is low because of a high debt burden that still has to be paid off, while ‘consumers’ (read: people) are no longer willing to borrow to keep demand going. As a consequence, there is no reason for companies to invest”? The fact that “interest rates are low” is entirely irrelevant to this discussion. Das seems to be stuck in ‘supply-side’ thinking: why else would he follow up with “Instead of being lent to customers, the reserves created by QE have persistently sat on bank balance sheets or been recycled into government securities.”? Sure, SMEs have funding issues and are likely dying or being bought up by their bigger competitors (creating more oligarchical markets) far more than they would in a healthy market, but isn’t it more important to ask to what extent it is the case that companies are unwilling to borrow simply because they see no reason to do so? Yet this question — where demand comes from — is discussed nowhere in his entire article. Why not? Is this simply because he is sticking to the “party line” of acceptable discussion of QE, or is there a deeper problem? (I would argue that the problem is the latter)
There is no rule that says that individual companies should always try to grow; the only rule is that capitalist economies start to fail once this is no longer the case. But it can be a very rational decision not to go for further growth.
In response to ‘why authors like Das address the issue’ of QE:
The reason is that so much of what the Fed purports to do is based on ‘expectations’. If only the people who are benefiting from these tactics are discussing this, only those who expect to continue to be bailed out will be stating their opinions effectively.
I think it was a great article. And I was not puzzled by Das’ motivations at all.
Your comment was good and drew me in, but would have benefited fro more paragraph breaks to read all the way. Peace anyway.
I have three problems with this article:
1) “The morality and long term ethics of the actions and effects were not debated.” – in fact i remember clearly that “moral hazard” was debated a lot at the time of the bank bailout, mostly from a conservative point of view; it’s true that it was ignored by institutional actors at the time but became part of the popular framing of the debate and is apparently (to me) used today to sell austerity
2) “Banks and investors, who had lent imprudently, would not be punished. […] Prudent savers would lose” – it seems to me that “savers” are by definition a sort of investor, since they don’t save “in kind” but save some money that invest in financial assets or loan to banks, so this tistiction between savers and investors is quite dubious
3) I believe that original keynesian tought placed much more importance on the idea of rising wages, whereas neoceynesians usually think in terms of budget deficits/surpluses; as a consequence a tax break, for example, can be seen as “stimulus” from a neokeynesian point of view but is not stimulus from keynesian point of view (whereas government employing people would be). In this sense, keynesianism was really never tested in this crisis.
In regards your first point about about moral hazard being debated.
If you recall, the pudits would say ‘What about the moral hazzard aspect?” And the other would say “Yeah that’s a slippery slope. You don’t want to give benefits for acting criminally.” And then… moving on.
They never took it deep enough. They never got to the point that the whole thing was based on unassigned paper. They just scratched the surface for the appearance without ever having addressed the deeper moral hazards. What those hazards were, were never fully explored.
I like your points. I’ve felt very uncomfortable with the references to “tax breaks”, “tax reductions”, and especially “tax credits” as stimulus. I can see on an intellectual level how policy-makers can think of lower taxes as equaling more money in the pockets of consumers, but as a child of the Great Depression I agree that wages in pockets is far more important. Let’s face it, lower taxes go to the people who are paying taxes, which is not the people hardest hit by unemployment. If you want to increase consumer spending, you’ve got to get money into the hands of people who are not now able to spend, not the people who are already spending.
Nice analysis of why QE isn’t working. Basically it is at best a temporary measure hoping the economy will recover on its own. But the economy didn’t and this was likely because the money was spent in the wrong areas and didn’t encourage healthy and creative destruction which seems like the path we are being fairly forced to go down now…
http://www.springerlink.com/content/l6164wwru63810m2/
The lesson and warning of a crisis foretold: a political economy approach
Stefano Zamagni
That is why the current crisis will find no definitive solution until politics and civil society do not take back in hand the governance of financial activity, directing it to its natural goal which is that of being at the service of investments, production, exchanges. According to the famous saying of Baron Luis: “Give us good politics, and I will give you good finance”.
The limitless search of capital gains has meant that values such as loyalty, moral integrity, relationality, trust were gradually pushed aside to make room for principles of action aimed at the pursuit of short-term results. In this way, it was possible to spread the disastrous conviction on the basis of which liquidity of financial markets would be a perfect substitution for trust
The first sees the firm as community, in which various interested parties participate (workers; investors; clients; suppliers; territory), co-operating to attain a common objective, and which is organized to last some time.
Finally, from the 1960s in economics there began to take shape, until becoming dominant today, the idea of the firm as commodity, which, as such, can be bought and sold on the market like any other commodity.
The second aspect regards the ever more widespread dissatisfaction about the way of interpreting the principle of freedom. As is known, there are three constituent elements to freedom: autonomy, immunity, and capacity [to act]. Autonomy speaks of the freedom of choice: one is not free if one is not in a position to choose. Immunity, instead, speaks of the absence of coercion on the part of some external agent. In large measure it is negative liberty (or ‘freedom from’) which Isiah Berlin spoke about. Finally capacity (literally: the capacity to act), in the sense implied by Amartya Sen, speaks of the ability to choose, to attain objectives, at least in part or in some measure, which the subject sets himself. One is not free if one is never (or at least in part) able to realise one’s life plan. Well, while the liberal-laissez-faire approach is able to assure the first and second dimension of liberty to the detriment of the third, the statist approach, both in the version of the mixed economy and in that of market socialism, tends to privilege the second and the third dimensions to the detriment of the first. Laissez-faire is able to support change, but it is not as capable of managing the negative consequences of change, due to the serious temporal asymmetry between the distribution of the costs of change and those of the benefits. The former are immediate and tend to fall on the shoulders of the more ill-equipped sectors of the population; the latter accrue later and benefit people with greater talent. As J. Schumpeter was among the first to recognise, the heart of the capitalist system is the creative mechanism of destruction – which destroys “the old” in order to create “the new” and creates “the new” to destroy “the old” – but is also its Achilles heel, because unless adequate ‘safety nets’ are created it is obvious that those who see themselves damaged by the mechanism of creative destruction will organize themselves to boycott it, creating neo-corporatist lobbies to block the process of innovation from taking place. On the other hand, market socialism – in its various versions – if it proposes the State as the subject entrusted to face the asynchronisms that have been spoken about, does not damage entirely the logic of the capitalist market, but it restricts its area of operation and incidence. As one can understand, the challenge is therefore that of making all three dimensions of liberty hang together: this is the reason why the paradigm of the common good appears as at least an interesting perspective to explore.
In the light of what has been argued before, we can understand why the financial crisis cannot be said to be an unexpected or inexplicable event. That is why, without taking anything away from the indispensable interventions in the regulatory area and the new necessary forms of control, we will not succeed in stopping in the future analogous episodes if the evil is not attacked at its roots, that is to say intervening in the cultural matrix which up to now has supported the economic system.
Secondly, the time has come to replace the canons of scientific management, now obsolete because suitable for a model of industrial production which is no more acceptable, with those of humanistic management, whose central element is the human person and no longer the human resource. The post-modern society cannot tolerate that one continues to speak of “human resources”, by the same standard as one speaks of financial and natural resources.
The task of tying again the “ropes” between all those who work in the market and which this crisis has clumsily snapped falls to civil society. But where would one start in trying to carry on such a task? From the re-focusing of both of the economic discourse and of the new institutional setting on the category of the common good. Once a major part of cultural debate, this category has up to now been systematically confused – sadly even by experts – with that of total or collective good. Nothing could be more misleading and therefore noxious. That today the notion of the common good, on the wave of the events that one has tried to interpret here, may experience a re-awakening of renewed interest is something confirmed to us by a variety of signs and which leads us to hope. We should not be surprised by this: plunged into the looming crisis of our civilization, one is pushed to abandon dystopic attitudes, venturing along new paths of thinking and acting.
In fact, the total economy has been recovering. GDP has been rising steadily since early 2009. Restaurant usage, hotel usage, retail sales, imports, etc., are all slowly rising. Layoffs are dropping. The economic growth has certainly been weak, but there has been some growth. The question is, why? Why the slow steady growth, if consumers are supposedly pulling back to reduce debt? Why has the total economy been so stable?
Has it been the fiscal stimulus? It seems doubtful, since a significant fraction of the stimulus did not go to the people and companies with too much debt. Quantitative easing? Again, the money went into the banking system, but not to those who were burdened with debt. One partial explanation may be the temporary reduction in mortgage rates, which led to widespread refinancing which reduced the monthly payment burden of those with too much mortgage debt. Another possibility is that people with low saving and high debt are not yet facing up to their need to increase their savings.
Like Das, I am skeptical of the value of fiscal deficits and QE, because most of the money seems to go to the wrong locations in the economy. Yet, somehow, the economy has stabilized and is slowly growing.
Like the lyrics from a blues song (the one I remember is from The Doors on the LA Woman album), “I’ve been down so [expletive] long, it looks like up to me.” Yes, the economy is improving, especially in most YOY stats with the great exception being housing prices, but partially because we started from such a deep hole in March 2009.
Personal Income minus Govt Transfer Payments are still 3-4% below their previous peak (see Calculated Risk blog for some great graphs of this). Non-farm employment is still 5M-6M jobs below its Jan 2008 peak.
The economy is improving YOY, but the base of the economy is not solidifying much. We still have fairly unproductive sectors leading us, such as finance, health insurance, and retail without construction, manufacturing, or infrastructure.
The effects of The Great Recession will be felt for many more years.
Bring back some sanity to the accounting rules (i.e. mark-to-market) and watch just how stable the economy will be.
And here lies the fallacy of the FED’s QE …”encouraging spending through the effect of increased “wealth”.” Americans have been consuming their imagined wealth for years as they borrowed from their home ATM’s and credit cards. As a result the economy has lurched from on bubble to another.
The wealth effect is not a substitute for middle class paying jobs. It is nothing more than another inventive way for debt to replace income. Americans reached a debt saturation point in ’07-08, similar to ’28-’29. It is the credit bubbles and crushing debt that explodes economies.
Debt is not a substitute for income, nor a substitute for the productive economy. Until incomes rise and debt is discharged or paid down this economy will drag. Our policy makers consistently choose the phony wealth effect for real wealth. VooDoo economics produced with very slick smoke and mirrors. Nothing there.
It has been suggested (P. Krugman, for instance) that QE is diverting money to the stock exchange creating some health effect and also has devalued de dollar resulting in improvement of US c.a. balance.
This means that QE has somehow worked but also spur doubts about the sustainability of US recovery. Is there more room for QE to have a potitive effect??
All that’s missing from Satyajit Das’s fine essay is a concluding sentence:
CENTRAL PLANNING DOES NOT AND CANNOT WORK.
QED …
Of course, all the other things don’t “work” either, but I get your point.
deja voodoo
Deja voodoo – I tihink it’s through connection with the Hindu karmic cycle that we are seeing the voodoo stuff again and again.
Hopefully, a vampire squid reincarnates as a subprime borrower in his next life.
Adding more fuel to a broken system will not fix it.
Both the stimulus and austerity camps are reaching for inappropriate solutions in a kind of Pavlovian ideological reflex designed to avoid the real issues.
Until there is serious financial reform there will be no sustainable recovery. The sustainable recovery will be seen in a rising median wage.
Since the financial sector has co-opted a large segment of the governing elites, the reform will only be window dressing until the system of campaign funding is changed.
I disagree. The point of US QE has been to increase the velocity of money within our economy. As the rich elites have taken a larger share of the economic pie, that has left less money in the real economy so excess funds by individuals to spend are gone. So with QE, the idea is to inject more cash in the economy and get that excess cash spent. But our economic system is broken. Every time there is an economic transaction, some portion of that money is taken out of the economy and put in the savings account of some wealthy person. Remember that United health care CEO, that for every $700 spent on health care in the US, $1 went to him. And through taxation, those dollars are freed up to circulate in the economy again. But our system has chosen not to tax those persons and instead we just print money like QE to try to get that circulation going again.
Bernanke made a pact with the DEVIL—–by monetizing the debt with QE2—–buying a little more time for the greedy financial elites to steal everything possible. Monetizing the debt NEVER works; this is what tin-pot dictators do just before fleeing the country, for their lives. Bernanke’s QE2 is causing rampant food, clothing and energy inflation, peaking by the end of summer, putting the economy on the brink of yet another severe recession. Bill Gross predicts no QE3. When this becomes clear, markets will crash, canceling out the wealth effect. The DEVIL will collect, unfortunately, from the victims, not from the rapacious perpetrators! President Obama, “why does it seem the government preys on the American people, rather than promoting the general welfare.”
Oh, bummer!
“Monetizing the debt NEVER works…”
Really? I think Japan might disagree. But then so would huge swathes of history. Monetising debt isn’t an inherently bad idea – it all depends on circumstances.
E.g. If you’re the dictator of Poorasshitistan and your country doesn’t have a real economy, monetising the debt will produce rampant inflation (but then, keeping the debt might destroy the country anyway through massive double-digit unemployment).
However, if you’re an economic powerhouse like Japan, monetising debt might be an excellent idea. Your currency will remain strong and you’ll have a super time… I promise…
In other news, if you skip the maintenance on your car….IT RUNS JUST FINE AND YOU GET TO KEEP THE MONEY!
…and we’ll call it “advanced mechanics” and build up lots
of math to show why it’s true, then sit in the back and drink
beer until the jig is up.
Das misses the point. There was no “heroic bet”. The aim was never to fix anything. It was just to allow the thefts to go on as long as possible.
Das also doesn’t take into account the enormous wealth inequality in the country. As ep3 notes above, neither fiscal nor monetary policies work because so much of their effects are siphoned off to the unproductive rich. It’s like the old joke: “$10 for me, one dollar for you, $10 for me, one for you.” “Hey, I don’t like that. Do it the other way.” “OK, one dollar for you, ten for me.”
Sorry to say, but this whole piece is rather shabby. It reads a bit like the mainstream press but with a negative rather than a positive spin/prognosis.
‘Truisms’ such as this…
“The European debt crisis highlighted the limits of the ability of governments to borrow and spend.”
…should make any careful reader instantly suspicious. There’s so many differences between the Eurozone and most of the rest of the world. (Fixed-exchange rates, no currency sovereignty, the fact that some of the debts accrued by some of the countries, like Ireland, have nothing to do with governments borrowing and spending… the list goes on).
Pinch of salt? Nah… anyone got a bucket?
“voodoo economics” is a redundancy. :)