Thursday, December 13, 2012

Quantitative Easing: Third Time Is Not the Charm

The Fed is at it again. Yesterday, the Federal Reserve announced a fourth round of quantitative easing, which entails buying $45B worth of long-term Treasury securities per mensem. Apparently, the third time, which was only within the last few months, wasn't the charm. Although it's called quantitative easing, why don't I feel at ease? What is it about quantitative easing that the IMF deems it "unconventional policy?"

Under less dire circumstances, the Fed's normal recourse is to buy short-term government bonds to lower the interest rate. The idea of a lower interest rate is to encourage spending because once again, the assumption is that the issue with the economy is due to aggregate demand. The issue right now is that the interest rates are essentially zero. The interest rates have been this low for quite some time, which means that the Fed cannot lower the short-term interest rates any further. In attempts to stimulate the economy, the following takes place under quantitative easing: the Fed purchases assets (e.g., securities, bonds) from banks and other financial institutions (mostly or solely private firms) with recently issued money. Banks would then lend this new money to consumers and businesses, which would ideally motivate consumers and businesses to spend more money.

The reason why I call this "unconventional policy" is because it's a very new concept. The academics are still trying to fight this one out. It might work. It might not work. It might have a negligible effect. Either way, I'm skeptical about the Fed's success. As Alan Greenspan points out in his autobiography (p. 478), the Fed's pre-1979 track record for avoiding inflationary episodes is "not a distinguishable one." Let's also remember that the Fed was unable to foresee the Internet bubble or the housing bubble. Why extend the powers of an entity that historically has been problematic at controlling inflation?

But I also have to look at results of the previous three rounds of quantitative easing. When is the quantitative easing supposed to end? The Fed doesn't know. If the markets keep doing poorly, those in markets will have to keep guessing what the Fed will do next before each FOMC meeting, which breeds more uncertainty while creating additional distortions of market signals (e.g., price-gouging laws) [in the credit market], and yes, disincentivizing saving, as well as punishing those who save. If job growth improves, the Fed has not provided any reliable indication of when it will stop with quantitative easing.

And then there's the matter of economic indicators themselves. I know that job growth isn't linear, but if we continue at this average rate of employment growth, we won't close the pre-recession jobs gap for another 11 years, and this is without taking U-6 unemployment into account. GDP growth is not all that inspiring. Consumer confidence is still low. Assuming this is a recovery, it's a pretty stagnant one.  If we take this scenario to mean that it's not working, then all we have done is have more dollar bills than we would have otherwise, which would devalue the dollar. Devaluation doesn't only affect other countries that use the dollar as currency (e.g., Ecuador) or countries that have their currency pegged to the dollar (e.g., Saudi Arabia). It has a ripple effect in the global markets, as well.

Let's assume that quantitative easing does end up working by expanding the monetary base (note that this doesn't expand M2, which is a necessity for GDP growth) and translates into the growth of the money supply and consumer spending. And let's assume that it's doing its job by keeping interest rates low while decreasing unemployment. The perceived success of the stimulative effect (read: looser monetary policy) will cause expected inflation to rise. The Fed would then feel the need to keep at that pace, and before you know it, the inflation rate spirals upwards, at which point we would have a repeat of the 1970s and the high inflation that occurred. If that happens, then the Fed's balance sheet only increases in size, especially if there is a default on the mortgage-backed securities. Even worse, an asset bubble could pop, and given how the housing bubble burst, I don't think we want that. It would be all the more difficult to undo all the injections of those reserves if this scenario took place. This can be avoided by making sure inflation expectations don't get out of hand, but once again, skepticism ensues.

And who can forget about how the Fed ultimately decides to unload all these acquired bonds? If the Fed cannot do so adequately, the economy will have substandard economic growth for years.

Ultimately, my issue lies with the fact that the Fed has been doing everything in its power to keep [long-term] interest rates artificially low, which from a Keynesian's point of view, is supposed to be this great stimulus. This effect hasn't taken place, but even if it works, it misdiagnoses the problem. The problem is not with short-term disincentives to spend. The problems are long-term and structural. If we want to talk about handling unemployment and inflation issues at the root of their cause, we need to address such things as cutting government spending (most notably entitlement spending), deregulation, tax reform, education reform, and immigration reform, just to name a few. Whichever methods the government decides to take, one thing is for sure: cheap money is not a quick fix.

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