QE: The Slogan Masquerading as Serious Policy
The U.S. Federal Reserve signaled the end of its controversial $600 billion bond-buying program as planned. And not a moment too soon. This was probably the most over-hyped event since the launching of the Titanic. Frankly, I’m not surprised by the lack of impact of QE2. I’ve always regarded it as a slogan, rather than a policy, and contended that its effects were oversold and predicated on a fundamental misunderstanding of basic monetary operations. The Fed introduced a program whose central thesis was that the unprecedented central bank intervention would reboot bank lending. Yet three years later, total bank loans are lower than they were before the Fed undertook quantitative easing.
The inability of monetary policy initiatives to do anything more than stabilize a very shaky financial system was always clear from the outset, if only policy makers truly understood what the problem was. There wasn’t a shortage of credit nor were interest rates punitive with respect to intended borrowing. People just didn’t want to borrow because the economy was collapsing and they were carrying too much debt.
As Stephen Randy Waldman has noted, the mainstream belief that quantitative easing would stimulate the economy sufficiently to put a brake on the downward spiral of lost production and increasing unemployment was nonsensical and based on a completely wrongheaded understanding of basic monetary/banking operations. He quotes from Winterspeak:
People believe that fractional reserve banking, in some weird way, has banks taking deposits, multiplying it (through what seems like a strange and fraudulent process), and then making a larger quantity of loans. In fact, banks make whatever loans they think make sense from a credit perspective, and then borrow the money they need from the interbank market to meet their reserve requirements. If the banking sector as a whole is net short of deposits, it can borrow the extra money it needs from the Fed. If you think this is a weird and pointless regulation you are correct. Canada, for example, has no reserve requirements and yet seems to have a banking sector. The quantity banks can loan out is constrained by capital requirements and credit assessments.
Reserves, then, are like a bank’s checking account at the Fed. A bank can lend those reserves only to another institution that is allowed to hold reserves at the Fed. Banks do lend reserves to one another in the fed funds market, but since banks already have more than a trillion dollars in excess reserves, there is no need to give them more in order to encourage them to lend to one another.
Those who point to the success of QE2 make the following observations: In the US, growth accelerated after the implementation of QE2 from a 1.7% annualized pace in the second quarter to 2.6% in the third quarter and 3.1% in the fourth quarter. Inflation expectations ceased falling and began rising back to normal levels. Confidence rose. And the pace of hiring improved meaningfully. In both February and March, private firms added over 200,000 jobs. Since the Fed’s policy began, the unemployment rate has fallen a full percentage point.
But just because a rooster crows first thing in the morning doesn’t prove that this is what causes the sun to rise. These are two separate occurrences with no underlying causation. The very deficits now decried so loudly by the deficit hawks and ratings agencies are likely what engendered recovery, not QE2.
So what has QE2 actually achieved? Little in the way of positive impact, but much in terms of its deleterious impact by fomenting additional speculative activity, notably in the commodities complex — gas and food prices. Obviously, with other determinants of aggregate demand in question, commodity prices and the gasoline price in particular now matter. The price of gasoline is almost as high as it was at its brief peak in May-July 2008. In the past, increases in expenditures on gasoline could be managed by consumers because they had access to credit. That is certainly less true today. Rising fuel prices could tip the economy towards greater weakness. As it now stands, the U.S. economy has been growing around trend (2.7%) and the first quarter was probably below that. Tipping the economy towards weakness would bring growth way below the current optimistic above trend consensus.
Though it cannot be proved, in the minds of many the current wave of speculative and investment demands is tied to the Fed’s emergency measures of ZIRP and QE. Within the Fed itself, a number of inflation hawks have reflected this belief, notably Dallas Fed President Richard Fisher and former Kansas President Tom Hoenig. If so, this inadvertent adverse consequence of QE means that the Fed might be hoisted on its own petard.
In sum, whether one wants to focus on the bank reserves or the deposits created by QE2, it does not increase the “ability” of banks to create loans or the private sector to spend that did not exist before. In both cases, the effect of QE2 is to replace a longer-dated treasury with shorter-term investments within private portfolios, which on balance reduces income received by the private sector. Whether or not that increases spending would depend on whether the private sector wishes to borrow more or to reduce saving out of current income (things they can do anyway with or without QE2). Again, it makes little sense to encourage households and firms to increase debt or to reduce saving within the current context of record private sector debt. But the current prevailing deficit hysteria is, perversely, encouraging precisely that state of affairs.
Ultimately, QE2 screwed savers by robbing them of income through the Fed’s treasury purchases, undermined banks’ earnings by in effect swapping a higher yielding treasury with bank reserves that today yield a mere .25%, and eviscerated the living standards of the middle class by helping to spike the speculative punch bowl in the commodities space. Not a bad trifecta for a Fed Chairman who claims to be doing everything in his power to prevent us from becoming the next Japan but who in fact is hastening our arrival at that very destination.
This post first appeared at New Deal 2.0 where Marshall also blogs.