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)
Quantitative easing (“QE”), the currently fashionable form of voodoo economics favoured by policymakers in the US, is primarily directed at boosting asset values and creating inflation. By essentially creating money artificially, central bankers are seeking to return the world to stability, growth and prosperity.
The underlying driver is to generate growth and inflation to enable the problems of excessive debt in the economy to be dealt with painlessly. It is far from clear whether it will work
Monetary Phenomenology…
QE is designed to create inflation, at least just at the correct level. Given that one of the objectives of central banks is to keep inflation under control, it is ironic that they now want to create more inflation. Higher inflation would reduce the value of debt. Inflation may also induce more consumer spending, as people accelerate purchases, anticipating higher prices in the future.
The ability of QE to generate inflation relies on Milton Friedman’s observation that “inflation is always and everywhere a monetary phenomenon.” The quantity theory of money holds that the supply of money multiplied by velocity (the rate at which it circulates) equals nominal income, the product of real output and prices. Increasing money supply increases nominal income, boosting real output and/ or prices.
The role of money supply in inflation and economic activity is complex. Cause and effect is uncertain – does money supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply of money? Central banks control the monetary base, a narrow measure of the money supply made up of currency plus the reserves that commercial banks hold with the central bank. The relationship between the monetary base, credit creation, nominal income and economic activity is unstable.
A significant problem is that velocity of money or the rate of circulation has slowed. Banks are not using the reserves created and money provided to increase lending. The reduction in velocity has offset the effect of increased money flows.
The desire to increase inflation is also driven by fear of deflation. Economists measure the economy’s “output gap”, the difference between total demand and the economy’s potential to produce goods. When demand exceeds supply, inflation rises. When demand is less than supply, inflation falls (disinflation). In the extreme circumstances it becomes deflation, where prices start to fall.
Deflation makes it difficult to manage excessive debt. Cash flows and earnings fall making it harder to service existing borrowing. Debt must be paid back in money that is now more valuable as it gains in purchasing power. Nominal interest rates fall but after adjustment for inflation rates, real interest rates are high, discouraging borrowing. Falling prices discourage non-essential consumption, as the same item is likely to be cheaper in the future. For a central banker in an economy with high debt levels, inflation is the dream, deflation is a nightmare.
Milton Friedman famously argued that “helicopter drops” of money could be used to encourage spending and avoid deflation. A student of economic history and an acolyte of Friedman, Ben Bernanke restated the principle in 2002 arguing that “under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
The Fed justifies QE as insurance against the risk of deflation. But inflation levels remain modest, particularly if the effect of higher commodity prices is stripped out. In practice, creating inflation or even arresting deflationary tendencies is difficult. After many years and several rounds of QE, Japan still hovers on the cusp of deflation.
Ironically, if QE created the necessary inflation or inflationary expectations, then it would push up interest rates, potentially choking off economic recovery.
After the Fed launched QE2, long term US interest rates rose sharply, driven by fears of high inflation in the future. The hoped for fall in mortgage rates and generally lower interest rates did not occur to the extent anticipated. Since the announcement of QE2, 30 Year Treasury yields have increased by around 0.60%. The average 30-year mortgage rate has gone up from 4.25% in August 2010 to over 5% by January 2011.
Side Dishes…
Criticism of QE has focused on the risk of Weimar like hyperinflation. Debasement of a currency through debt monetisation can lead to very high levels of inflation.
In reality, the low velocity of money, the lack of demand and excess productive capacity in many industries means the inflation outlook in the near term remains subdued. Inflation will only result if bank lending accelerates and aggregate demand exceeds aggregate supply. America’s output gap is between 5% and 10% and considerably more monetisation would be necessary to create high levels of inflation.
QE’s real side effects are subtle. It discourages savings, drives a rush to re-risk, encourages volatile capital flows into emerging markets and forces up commodity prices.
Low interest rates perversely discourage saving, at a time when indebted countries, like America, need to increase saving to pay down high levels of debt. Low interest rates reduce the income of retirees or others living off savings, further reducing consumption.
Individuals saving for retirement received this piece of quixotic advice from Charles Bean, Deputy Governor of the Bank of England: “Savers shouldn’t necessarily expect to be able to live just off their income in times when interest rates are low. It may make sense for them to eat into their capital … Very often older households have actually benefited from the fact that they’ve seen capital gains on their houses.” In retirement, it seems everyone should sell their houses, take up residence on the streets or in a public park and live off the money released.
Low rates have driven a rush to increase risk, in search of higher returns. In January 2011, the difference between interest rates on speculative or non-investment grade corporate bonds and investment-grade debt fell to around 3.50%, the lowest level since November 2007. In 2010, companies sold a record $286.7 billion of junk bonds to investors driven by the need for higher rates. The search for yield extends to stocks and also structured products, where investors take on complex returns in return for additional returns.
The rush to re-risk has reduced general lending standards. Practices that contributed to the global financial crisis, such as “covenant lite” loans with low protection for lenders, have re-emerged. Under-pricing of risk is also evident, creating the foundations for future problems.
Financial Fetishes…
Voodoo was originally a religion that developed in America’s South, based on African beliefs syncretised with Christianity. Voodoo incorrectly became associated with exotic superstitions and occult practices. Unscrupulous practitioners made a fortune charging money for fake good luck charms or talismans kept to ward off evil – fetishes.
Voodoo economics, such as QE, resembles fetishes, objects believed to have supernatural powers. Despite evidence to the contrary, these financial fetishes are predicated on the belief that the theories and models are correct, policy makers know what they are doing and the actions will be effective.
In the voodoo belief system, a zombie is a fictional monster, usually a reanimated human corpse with normal appearance but no will of its own, controlled by a powerful sorcerer. Increasingly, the global economy risks entering a zombie phase. The economy appears to be functioning. In reality, it is moribund and stagnant, manipulated by central bankers and policy makers to give the appearance of normality.
In Ferris Bueller’s Day Off , Sloane ask Ferris: “What are we going to do?” Ferris replies memorably: “It’s not what we are going to do! It’s what aren’t we going to do!” As policies fail or prove ineffective, desperate policy makers merely apply them in larger doses or dream up new fetishes. QE2 is likely to be followed by further rounds of QE and other forms of voodoo economics.
If current policies fail to spur growth and inflation, then governments will borrow or print more money to increase spending, transferring funds to households or cutting taxes, building infrastructure or even writing off the face value of mortgages and other debt. If that fails then they can purchase other riskier assets. The Bank of Japan’s strategies now include buying stocks, lending to companies and providing even more money to banks to boost their capital and lending capacity.
In extremis, the central bank could charge people for holding money, forcing them to spend it by placing expiry dates on currency. Policy maker’s actions are shaped by Josh Billings’ observation: “The thinner the ice, the more anxious is everyone to see whether it will bear.”
The economic policy debate, at its core, is about the limits to human knowledge of the economy and the ability to control it. The global financial crisis and the policy response are increasingly exposing the limits to both. As author Richard Collier once remarked: “All motion is cyclic. It circulates to the limits of its possibilities and then returns to its starting point.”
Economists, central bankers and governments reject limits to their knowledge and powers. Their thinking mirrors the following exchange in The Dark Knight (the latest instalment in the Batman franchise):
Alfred: Know your limits, Master Wayne.
Bruce Wayne: Batman has no limits.
Alfred: Well, you do, sir.
Bruce Wayne: Well, can’t afford to know ’em.
Central bankers and policy makers would do well to heed Josh Billings’ advice: “I have lived in this world just long enough to look carefully the second time into things that I am most certain of the first time.”
24 comments
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Thanks for this insightful analysis. It’s definitely useful to get intelligent counterpoint to some of the Fed’s reasoning.
The only thing that I disagree with is that we will get more QE. I think that is being trumped by international geopolitical issues and domestic issues directly related to the resultant commodity price increases.
One thing that occurs to me, in my layman’s understanding* of the situation, is that monetary actions like QE “helicopter drops” can make sense as counter-cyclical responses, in (Keynesian) theory, but I’m not sure that the theory holds in our current situation. For starters, an effective counter-cyclical regime would require regulators to raise interest rates and tax revenues in the good times (“make hay while the sun shines”), but they didn’t, did they?
The other question I ask is whether the recession is part of a cyclical phenomenon, or not? I’m not so sure that it is. There are some seriously broken fundamentals out there, irreversible changes, such as the decline in demand for unskilled labour. Can we have a global economy to which a good proportion of people can make no effective, worthwhile contribution?
PS: IANAE*, but the recent crises have got me interested in economics and wondering whether I made the right career choice. 8)
I would say… It’s cyclical… but on a larger time-cycle than is commonly conceived. Investors have come to look on a very short-time frame. Therefore they have consistently missed a larger pattern. Plus so much is intentionally obscured.
It’s really time for a paradigm shift. This is a cycle, but so large that it is what they call a ‘singularity’ – so large people can’t imagine what’s on the other side… because they haven’t been given, or noticed, or wanted to know [ala batman] the signs.
Nothing grows forever.
We are at the limits of what the planet can deal with. Any economics insisting on perpetual growth, mathematically demanding perpetual growth, must break against reality eventually. Hence “voodoo.” Money is nothing anyway, and always was; all measurement mediums are. Paramount and inescapable is the health of the environment hosting the living systems we are part of. Until economics takes this fact on board it will be banging its head against the proverbial wall, chanting voodoo cants and waving magic numbers around to no avail. Actually, to less than no avail. We are doing ourselves and everything else harm by clinging to growth as our savior.
This message may be a bit too ‘tree-hugger,’ a bit too doom laden for most, but that doesn’t make it invalid, nor premature. Considering we’ve experienced a doubling of global poverty in the same period as a tripling to quadrupling of global GDP, and considering all living systems are in a state of decline, we surely have some rethinking to do. Numbers of dollars or yen or euro are irrelevant unless we address the planet’s ecosystems with the activities those monies might initiate, but currently don’t. While they’re used to prop up the vapor-wealth of stocks, commodity prices, and corporate power, we are wasting their true potential and ours.
Amen.
“Output gap” aha. Is that the millions of houses built on cheap money that nobody can afford to live in? I would rather call it a mismatsch between the actual demand and supply in the US economy. The only solution would be to force the people to demand what is being supplied or a massive reconstruction of the supply. Where can Americans find renewable energy, gas-saving automobiles and so forth? Oh, and by the way: Being forced to buy stuff and consume because otherwise the inflation eats up all your savings – is that the solution for a free society?
“Output gap” aha. Is that the millions of houses built on cheap money that nobody can afford to live in?
No, actually, that’s an inventory overhang. The “Output gap” is the difference between the GDP we could have, if everybody was working productively, and the GDP we do have, with 10%-15% actual unemployment.
The true wealth of nations, after all, is in the productive capacity of its citizenry.
Also, “demand” is a technical terms here. It’s not just what people want; it’s what they will pay for. There is no demand from those who can’t pay.
Spend on what you need. Take your savings out of paper and into real assets such as dividend stocks and precious metals.
Prior to the industrial revolution when the only currencies were precious metals, you still had inflationary cyles. They tended to track population growth. Food and property tended to increase more in price than manufactured goods.
Most of the people who write about these trends are historians, and sociologists. I have seen a paper written by an economist in response to their writing and it was almost infantile in its understanding of the issues. The desire to fit any tiny fragment of data to the “understood theory” was amazing.
@Russell,
Have you a reference to the economist you are referring to? Thanks.
The Fed is caught in a terrible feedback loop in hopes the “helicopter drops” will eventually cause an increase in velocity. The adjusted monetary base has tripled in just a few short years. But IMHO, the potential damage caused by the sheer amount of new money created far exceeds any benefit from a miniscule increase in velocity.
The Feds monetary policies are immoral at best. Punish the savers and force people to spend in fear that the present value of our money will rapidly deteriorate. Reinforce the same behaviors that caused the crisis in the first place. Wall Street needs to readopt the potentials of risk and failure. Until this happens, the TBTFs will continue to hold the entire world hostage.
The metaphor “helicopter drop” implies scattering money on the ground – ie giving it to many people, including poorer people, who presumably would spend that money into circulation and stimulate the economy.
Instead, the Fed’s “discount window” gives money only to the super-rich – for example, to the TALF wives in Matt Taibbi’s latest Rolling Stone expose’ – or to big banks which sit on the cash rather than lending it into circulation.
The reality of “discount window” may end up making the “helicopter drop” prove to be just as much of a fantasy as “trickle-down” economics was.
The Helicopter only flies to Wall Street. Duh – winning.
“In the voodoo belief system, a zombie is a fictional monster, usually a reanimated human corpse with normal appearance but no will of its own, controlled by a powerful sorcerer. Increasingly, the global economy risks entering a zombie phase. The economy appears to be functioning. In reality, it is moribund and stagnant, manipulated by central bankers and policy makers to give the appearance of normality.”
The problem with this analogy is that it suggests Bernanke et al are powerful wizards capable of controlling the zombie. But I think that is not correct: they are themselves zombies, and no one is in control.
Another possible cause for inflation is the devaluation of your currency in the world markets. With your money worth less, imported goods cost more … and the u.s. imports a hell of a lot. With the u.s. abusing the privilege of having the king fiat currency for a long time now, being rightly blamed for the majority of the global economic crash of a few years ago, and owing so much money to other countries, it seems to me that it is a very real danger that countries opt for another international king currency at some point and no longer give the irresponsible criminal financial element in this country … and that is inclusive of the federal reserve and our all-wonderful fucking government … any more latitude to treat the global financial system like their play thing by allowing them to print up leverage to boss the world’s markets around with.
Z
Another possible cause for inflation is the devaluation of your currency in the world markets. With your money worth less, imported goods cost more … and the u.s. imports a hell of a lot. With the u.s. abusing the privilege of having the king fiat currency for a long time now, being rightly blamed for the majority of the global economic crash of a few years ago, and owing so much money to other countries, it seems to me that it is a very real danger that countries opt for another international king currency at some point and no longer give the irresponsible criminal financial element in this country … and that is inclusive of the federal reserve and our all-wonderful government … any more latitude to treat the global financial system like their play thing by allowing them to print up leverage to boss the world’s markets around with.
Z
A weaker currency doesn’t cause inflation per se; it only makes imported goods more expensive. This would be good for us — it would increase the incentive to produce goods in America, which would encourage employment of American workers (at the expense of the Chinese).
We don’t benefit that much from having a reserve currency — that just means that other countries hold our government’s loans as a store of value. That’s enabled our government to maintain the fiction that it borrows to finance its debts, but it has little real effect on our finance.
Similarly, the notion that US inflation drives worldwide commodity inflation is silly. If food is traded in dollars, who cares? Other countries have other currencies, and if the dollar depreciates, their currencies become more valuable. Inflation in one currency can’t cause sustained price rises in commodities in terms of all foreign currencies simultaneously — that requires actual demand in excess of actual supply.
The real reason American QE is causing commodity increases is because it frees up money for speculators in commodity markets, particularly in conjunction with Exchange-Traded Funds that operate basically as shares of stock in, say, Copper. It’s precisely because QE *hasn’t* caused uncontrolled dollar-inflation that it can cause commodity-price inflation; if the dollar were hyperinflating, then we wouldn’t be able to credibly buy stocks of commodities in a way that drove up the price.
Tiercelet,
Thanks for the intelligent reply. I agree with you that the extra money flowing into the banks/wall street from qe has played a role in the increase in commodity prices … giving wall street the leverage to push around the markets and increase the values of their commodity holdings. I also agree that u.s. inflation doesn’t drive worldwide commodity inflation.
I don’t agree with you in regards to your thoughts … as I understand them … on dollar devaluation in relation to inflation, though I may not have done a very good job at stating … or clarifying … my case. If the dollar loses it reserve status as the king fiat currency, I would think that’s going to free up a lot more dollars … decrease the demand for them … that were used in international transactions, which could lead to a run from the dollar and decreased purchasing power for the dollar, which again would lead to inflation in a country that we import so much.
I’ve heard the argument that cheap imported goods keeps inflation down, which makes sense to me. Why would more expensive imported goods not increase inflation?
I also agree that a devalued currency would increase the incentive to produce goods in America, which would encourage employment of American workers, however there’s going to be a lag before we can industrialize-up and bring certain types of manufacturing on line that has been sent overseas.
Anyway, if you think that I have any blind spots on this, I’d appreciate you informing me about them. I know considerably more than your average person about these matters, but I know that I certainly don’t know everything about it.
Z
Again the subtext here is that policymakers are making good faith but wrong policy choices. But this isn’t the case. Policymakers aren’t intellectually limited. There is no mistaken belief in voodoo economics, that they keep trying it over and over expecting a different result. They are crooks. They preside over a system of looting. How else to explain that they know the real economy has been hollowed out and their response is not to fix anything but gloss over the disaster so that they can extract rents from it for as long as possible?
Unless kleptocracy, wealth inequality, and class warfare are woven into the explanation, there really is no explanation. Kleptocracy, on the other hand, explains why there have been no prosecutions of the banksters, why Bernanke, Geithner, and Obama persist in policies that have been shown repeatedly to have failed, why they eschew policies and reform that are known to work, and why there has been no real effort to fix anything or help the bottom 90%. Similarly, wealth inequality, as ScottA notes above, tells us why helicopter drops won’t work. They go overwhelmingly to the rich who use them to pump up the paper economy as opposed to the real one where must of us live. As a result, the effect on velocity is negligible. Finally, it is part of class warfare to keep us talking this way, to distract us, keep us acting like what is criminal is really a sound system that has just run into a rough patch, and above all to keep us from pointing fingers at the crooks (on Wall Street and in Washington) and doing something about them.
“Given that one of the objectives of central banks is to keep inflation under control, it is ironic that they now want to create more inflation.”
Given that the other objective of central banks–certainly of the Federal Reserve–is to maintain full employment, and given that first-year economics classes teach that these conflicting goals must be traded off against each other, I’m having trouble applying the word “ironic” here. Maybe it’s like that Alanis Morissette song: the irony is found in the unreliability of the narrator.
Indeed. Not to mention that inflation that’s too low is also out of control.
The Fed’s supposed to hit an inflation target, not just make it lower. Deflation is Bad.
tiercelet: Well said. This goes all the way back to Aristotle. Virtue consists in achieving an appropriate balance between two extremes. The soldier who breaks ranks to charge the enemy alone is not brave–he is foolhardy. The central bank that fears inflation with unemployment above eight percent and ten-year bonds below four is, similarly, not wise. They are foolish. They are fighting, as generals are always said to do, the previous war.
Re: “Deflation is Bad.”
In a sense yes. But the measure of deflation is in no small part dependent on an asset class that was over-valued and in need of price correction – housing.
Borrowing what you cannot pay is bad. [Lending what you know cannot be repaid is also bad.] Houses returning to affordable levels is good. Unfortunately, too many people did the former, so the latter feels like pain.
“Deflation is Bad.”
or
False value seeking trend is unfriendly in a rigged system to the extractors of everyones toil…ROFLMAO[!]
But, how much was wrought upon it, how much cannot be undone, not what_but_whom is thrown a life preserver in the neoliberal freemarket seas. Hasty travel upon treacherous waters thingy with fur coats and fat wallets disembarking to thee heroic melody’s…used to drown out the screams of lessors trapped, nay locked below.
Do you see how they massaged history, real events, too burnish their already blinding glow….cough…Molly Brown!…sigh.
At the end of the day though…its all about jobs…giggle.
Skippy…Semantics…indeed!