The Ultimate QE is the Fed’s Coming Purchase of Real Assets

I was having an exchange with a bunch of market watchers about Stephen Roach’s comments to Tom Keene on QE. I agree with Roach that as QE represents ‘what got us into the mess’ it is unlikely to be the magic elixir to get us out. Printing money is not the road to prosperity; it can only ever be a temporary liquidity provision until either more income and cash flow are found or until debt is written down to sustainable levels.

Here are some thoughts on what may eventually be the ultimate QE i.e. when the Fed starts buying non-Treasury/MBS financial assets and actual real assets. I will underline the most important points.

Zero is toxic

First of all, low rates subsidize debt accumulation which creates systemic risk and leads to financial crises. This is how all financial crises happen and the key elixir making it happen are unusually low nominal rates of interest and the allure of easy capital gains both by borrower and lender.

if the assets supporting debt do not have the anticipated cash flow required to support the debt, it is irrelevant whether the assets exist as security. The cash flow they throw off will be insufficient and writedowns and default are inevitable.

But let’s take a step back for a second. We are looking at debt/income, debt/cash flow and debt/GDP ratios and making determinations of individual and aggregate creditworthiness. Sometimes these determinations are wrong. In a Ponzi phase of the secular credit cycle, they are wrong on a systemic level that causes a financial crisis and depression. The question is how to get out of the crisis.

Getting out of the hole

I see four ways to get out of crisis that either increase the denominator (income, cash flow, GDP) or decrease the denominator:

1. by paying down debts via accumulated savings.
2. by inflating away the value of money
3. by reneging in part or full on the promise to repay by defaulting
4. by reneging in part on the promise to repay through debt forgiveness

What we want to see is the first way to debt reduction. But the debt overhang after a Ponzi phase is too large for that to be effected in a quick and politically sustainable way. The other three ways will have to come into play to varying degrees. In this crisis, we have a ways to go.

Bottom line: excess credit growth creates what Minsky calls Ponzi finance and that leads to crisis. You have to get the debt down to a sustainable level that is dictated by the cash flow of the assets to which that debt is secured and the income of the borrower or the crisis will never end.

Fiscal or monetary?

Here’s the question: is this a fiscal or monetary problem? Clearly we are talking about excess credit creation so at heart we have a monetary problem but I do think Ponzi finance is brought on due to a skew in which some borrowers accumulate debt because they are income-deficient. So there is strong evidence that part of the policy response must be fiscal in nature.

A friend of an Austrian-Monetarist persuasion wrote me the following in favour of a monetary solution:

ZIRP and bond purchases (loans) by the Fed are not the answer. Asset purchases are. The stock of unreserved bank credit dwarfs the stock of secular base money. Create the base money needed to deleverage the banking system and then put a cap on base money going forward. Let the banks then re-leverage in system with symmetric risk/reward like the rest must do should we choose to roll the dice. Bank credit then would rationally trade at a discount to par (rather than being artificially supported by government constructs like the FDIC) should the banks get cute.

Banking will thus become yet again a boring, but essential, endeavor to intermediate credit in a knowledgeable fashion. Our best and brightest would then be incentivized to enter the productive economy at the margin. Imagine that?

The MMT approach as enumerated by Warren Mosler is to solve this via fiscal policy:

1. A full FICA suspension
2. $150 billion one time distribution by the federal government to the states on a per capita basis to get them over the hump.
3. An $8/hr federally funded transition job for anyone willing and able to work to assist in the transition from unemployment to private sector employment.
4. An energy policy to help keep energy consumption down as we expand GDP, particularly with regard to crude oil products.

So that’s the debate right now.

My conclusion

I agree that base money will have to continue to expand toward the unreserved bank credit – or we get another panic deleveraging and systemic collapse. Of course, we know the monetarist solution is never going to happen and that the Fed will continue QE and rate easing until they are forced to change tack.

I would bet on near-systemic collapse before the Fed starts either asset purchases or Congress resorts to fiscal activism. The austerity juxtaposed to nearly 23% unemployment in Spain tells you that countries today are willing to go a long way using more conventional policy responses before they are willing to recognise that the debts simply cannot be repaid. But eventually, the Fed is going to purchase more than just treasuries. They will purchase a lot of financial assets and probably some real assets as well. This is a ways off but it’s coming.