The global economy has been slowing for nearly a year now, both in developed economies and in emerging markets. Things were already weak before this global growth slowdown began. It almost seems like we have been in a permanent state of crisis since 2007 now. So clearly, there is reason for central banks to take action.
My view late last year as the slowdown was beginning was that limited policy space would lead to inaction, deterioration and then strong reaction just to maintain a muddle through. And this has largely been the case. In Europe, after doing nothing while yields have spiked, Mario Draghi has begun the OMT program, which is the most controversial ECB action ever. In the US, Ben Bernanke has begun QE3, the fourth round of Fed easing since the crisis, using both the communications and the asset purchase channels.
But have the central banks just turned to the printing press to ease the pain of crisis then? The FT’s Izabella Kaminska and I have been trying to set the record straight on this – to no avail. Izzy tried a second go. So I will have at it here too. And while I believe my answer will stick to the facts and accurately describe what’s happening, I will say here at the outset that the explanation won’t satisfy everyone because this is an emotional topic that distorts people’s ability to take in the facts objectively. People believe what they believe. But, hopefully, you who are reading this will take what I write at face value.
On Fiscal Policy Space
First, let’s take a step back and look at why central banks are becoming aggressive. After a huge financial crisis, unemployment has skyrocketed and economies remain weak globally – this, a full five years after the crisis began with BNP Paribas halting withdrawals from three of its funds savaged by the American subprime meltdown. Bailouts ensued and government debts ballooned. Still today, governments in Europe, the US, Japan and elsewhere are all in extreme deficit spending mode, with U.S. deficits topping $1 trillion for the fourth year on the trot. This is unprecedented.
The conventional wisdom is that deficit spending is bad, a sign of reckless or crisis spending that is unsustainable. And so predictably, governments in Europe and North America have been called to task for their large deficit spending. In Europe, to make matters more complicated, euro zone governments are not monetarily sovereign. So the view that euro zone government deficit spending is unsustainable has turned into a belief that some euro zone governments will default and/or leave the euro zone and depreciate their currency. Meanwhile, in the US and Britain, despite large deficits, government bond yields are at record lows.
I say this is predictable because I called it four years ago. In November 2008 I wrote that “[r]ecently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.
“While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted.
[…]
“Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt? This doesn’t make sense to me. Read my post “Charts of the day: U.S. macro disequilibria” to see greater detail on some of the headwinds we face.
“I would normally consider myself a deficit hawk as well. However, this is not the early 1990s. The recession will be much deeper, the possibility of systemic risk much greater. And the imbalances are much larger. I think it sensible to use this period of economic weakness to get the country on the right foot. And, quite frankly, this is not a 2-years-and-you’re-done kind of process. This is going to be a decade-long struggle to restore balance and reduce debt. I am talking about 2018 and not 2012 here.”
Now, you can agree with me or disagree with me about whether government can prevent a debt deflation through deficits. Some like Hugh Hendry do. I have voiced my concerns on this front as well. Nevertheless, clearly the prediction here about the severity of the crisis was correct. So the question is what to do about it.
What I am saying here is that fiscal policy space is limited. First, an increase in private savings and a reduction in private sector demand translates into larger deficits by pure accounting identity unless you can depreciate the currency. Then you have the extra burden caused by bank bailouts. And that is something that has been going on for five years. Frankly, I’m amazed that the US has been able to deficit spend on this scale for this long without deficit hawks forcing it to cut. Everywhere else you look, whether its the euro zone where the spectre of national insolvency looms or to Britain where deficits are just as high as in the US or Spain, the move to cut those deficits has already begun. I’m not going to argue the merits of deficit reduction here. But I do want to flag this as the major reason that central banks have turned activist.
Printing Money
Without the fiscal agents helping – in fact, with fiscal agents sucking money out of the economy, central banks have turned to QE, OMT, LSAP, LTRO and the other gobbedlygook monikers they use to defang the psychological impact of their aggressive policy changes. But the fact is the increase in central bank balance sheets is unprecedented. If you had asked any mainstream economic commentator or economist on August 9, 2007 when the credit crisis began how large the Fed’s balance sheet would be five years later, I guarantee you not one of them would have said $2,806,187,000,000 in total assets. And the ECB, Bank of Japan and other major central banks have been equally aggressive in expanding their balance sheets too. This is the source of unease.
The question then is: how are the central banks doing this quantitative easing? Is it ‘money printing’?
Well, first of all, you’ve got Ben Bernanke calling quantitative easing money printing both in 2002 and again in 2009. The evidence is clear. Moreover, Bernanke suggested in his famous 2002 ‘helicopter’ speech that this ‘money printing’ could be inflationary and debase the currency.
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).
So, if the Federal Reserve Chairman is using that terminology – ‘printing money’ – to describe what he’s now doing, you can understand why others would as well. Personally, I often use that phrase – ‘printing money’ – to describe quantitative easing too, especially when I am talking to non-finance people because quantitative easing is a made-up and meaningless term – as it was intended to be. So, the real question is not the semantic debate of whether the Fed is printing money, the real question goes to what impact this has on the economy.
Asset Swap
I explained quantitative easing in detail about a year and a half ago. See my post on how quantitative easing really works for the full explanation. I think the important point here is to describe the direct transaction. On Monday, Ben Bernanke described two unconventional monetary tools the Fed is using including QE. He described QE this way:
The first of these less-traditional tools involves the Fed purchasing longer-term securities on the open market–principally Treasury securities and mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The Fed’s purchases reduce the amount of longer-term securities held by investors and put downward pressure on the interest rates on those securities. That downward pressure transmits to a wide range of interest rates that individuals and businesses pay. For example, when the Fed first announced purchases of mortgage-backed securities in late 2008, 30-year mortgage interest rates averaged a little above 6percent; today they average about 3-1/2 percent. Lower mortgage rates are one reason for the improvement we have been seeing in the housing market, which in turn is benefiting the economy more broadly. Other important interest rates, such as corporate bond rates and rates on auto loans, have also come down. Lower interest rates also put upward pressure on the prices of assets, such as stocks and homes, providing further impetus to household and business spending.
So what happens is the Fed decides it wants to buy a bond. Using the Federal Reserve Bank of New York’s trading desk, the Fed makes a trade. It receives bonds that its bank counterparty owns and gives its bank counterparty money credit of equivalent value. The key here is that the money used to purchase these bonds was created as an electronic ledger entry solely for the purpose of acquiring the bonds. The Fed ‘printed money’ and conducted a swap of that money for existing financial assets. That’s what quantitative easing is.
From the Fed’s point of view, its balance sheet has increased. It now has an asset that it previously didn’t own, the bond it bought. And this asset is matched by a liability it previously did not have, the electronic money credit it created. And the Fed can do this ad infinitum. Or as Ben Bernanke quipped in 2002, the Fed can “produce as many U.S. dollars as it wishes at essentially no cost.” So that’s QE from the Fed’s perspective.
From the bank’s point of view, there is no change in the size of its balance sheet, just a change in the composition of its assets. It has sold one asset, a bond, and received in exchange another asset of equivalent value, an electronic money credit at the Federal Reserve. On net, no financial assets are added to the private sector through quantitative easing. The Fed is strictly forbidden from adding net financial assets to the private sector. Its role with regard to the private sector is limited to conducting asset swaps of exactly this nature, buying and selling financial assets and paying for them with electronic credits on its balance sheet ledger.
So when you see pictures like this one that were making the rounds as a Bernanke childhood photo, you know it’s just hyperbole. I think it’s funny because I know it’s hyperbole. Some people actually think that’s what’s happening. It’s like the Washington-beholden-to-its-Chinese-banker stuff. It does make for good laughs on Saturday Night Live. But, it is bogus economics.
It’s the same thing again with the helicopter picture in the post I wrote quoting Ben Bernanke’s 2002 speech saying “The government has a printing press to produce U.S. dollars at essentially no cost“. It’s not literally true that the Fed is actually just throwing money from a helicopter. That’s what the fiscal agent does. Whenever the US government spends, it adds net financial assets to the private sector without a corresponding debit. When the US government taxes, it takes out net financial assets from the private sector without a corresponding addition. It is the fiscal agent that prints money and it is the fiscal agent that would create helicopter money if it ever came to that. I guarantee you, real helicopter money getting into the hands of people who would spend it on goods and services or to reduce debt would have a MUCH bigger impact than QE dollar for dollar. Real helicopter money is not coming. More likely is a giant Hoover to suck up private sector money rather than drop it out of helicopters.
The economic effects
This difference in who can actually add net financial assets to the private sector is not just “semantics”. It’s a big deal because it tells you what the economic effects of policy are.
Central banks traditionally act through interest rate policy. Ben Bernanke told us so on Monday:
Following this standard approach, the Fed cut short-term interest rates rapidly during the financial crisis, reducing them to nearly zero by the end of 2008–a time when the economy was contracting sharply. At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy tool for dealing with economic weakness was no longer available. Yet, with unemployment soaring, the economy and job market clearly needed more support. Central banks around the world found themselves in a similar predicament. We asked ourselves, “What do we do now?”
What he’s saying is that he would lower rates if he could. But he can’t because rates are effectively zero. I have said this time and again myself. So it’s good see Bernanke so directly confirm for us that QE is not a first-choice monetary policy.
But, on the whole, Bernanke is saying that:
Unable to reduce short-term interest rates further, we looked instead for ways to influence longer-term interest rates, which remained well above zero. We reasoned that, as with traditional monetary policy, bringing down longer-term rates should support economic growth and employment by lowering the cost of borrowing to buy homes and cars or to finance capital investments.
That’s it. That’s QE right there. Now, no one knows whether QE actually brings down longer-term rates in a way that supports economic growth. The only case we have in experience of trying this kind of thing is Japan and it’s not like economic growth is gangbusters there, now is it? So, I think it is apt that Bernanke looks to Japan in deciding what to do when the policy rate is zero percent and then does what the Japanese did, but more aggressively. Last Thursday I was on an investing panel for Euromoney on investing in inflation and one of my fellow panel members told us that the difference between Japan and the US is that Japan didn’t act quickly enough and that the US has done. I believe this is what Ben Bernanke believes as well. To wit, I would agree that Paul Krugman was right when he said in 2010 that we need $8-10 trillion worth of quantitative easing to get the kind of economic impact the Federal Reserve wants. And given what we know about the reaction to QE in the past, $8-10 trillion of QE is a complete non-starter.
My view is similar to Stephen Roach’s view, namely that QE represents the kind of policy and thinking that got us into this mess. It is unproven and to date, it has not been particularly effective. Quantitative easing doesn’t add net financial assets to the private sector. Nor can QE target specific sectors of the economy outside of housing or short-term municipal funding. I don’t think QE will work. But I believe the Fed and other central banks believe they need to be aggressive because they want to be able to say they did everything they could unlike their counterparts during the Great Depression. As to the debate over whether QE is printing money, it’s irrelevant. The question is whether QE is effective all on its own. And so far, the answer has to be no. After all, even after years of deficit spending and quantitative easing, we are still in an economic crisis five years after it began. That doesn’t sound effective to me.