The greatest monetary experiment, ever

Summary: We live in an age of wonders. We have technology that previous generations would consider science fiction or fantasy. Social changes beyond precedent, such as gender equality. Not least, we’re conducting monetary experiments on a scale never before attempted. Success by the Bank of Japan and Fed will create a new world, one with little or no fear of printing money. One the other hand, their programs create known risks — and seldom mentioned unknown risks. Today we have two articles that describe this monetary experiment, and aspects of it seldom mentioned.

See our Monetary Wizard
See our Monetary Wizard

(1)  The Great Experiment

The Ultra-Easy Money Experiment
By William White, 12 June 2013

Former deputy governor of the Bank of Canada, former head of the Economic Department of the Bank for International Settlements. Excerpt:

The world’s central banks are engaged in one of the great policy experiments in modern history: ultra-easy money. And, as the experiment has continued, the risk of failure – and thus of the wrenching corrections and deep economic dislocations that would follow – has grown.

In the wake of the crisis that began in 2007, policy rates were reduced to unprecedented levels, where they remain today, and measures were taken to slash longer-term rates as well. Nothing like it has ever been seen before at the global level, not even in the depths of the Great Depression. Moreover, many central banks’ balance sheets have expanded to record levels, although in different ways and for different rationales – further underscoring the experimental character of the monetary easing now underway.

The risks implied by such policies require careful examination, particularly because the current experiment appears to be one more step down a well-trodden path – a path that led to the crisis in the first place.

World Glow

… It can be argued that each cycle of monetary easing culminated in a credit-driven “boom and bust” that then had to be met by another cycle of easing. With leverage and speculation increasing on a cumulative basis, this whole process was bound to end with monetary policy losing its effectiveness, and the economy suffering under the weight of imbalances (or “headwinds”) built up over the course of many years.

The Swedish economist Knut Wicksell raised concerns about such problems long ago. He suggested that a money rate of interest (set in the banking system) that was less than the natural rate of interest (set in the real economy) would result in inflation. Later, economists in the Austrian tradition noted that imbalances affecting the real side of the economy (“malinvestments”) were of equal concern.

For a more detailed analysis see “Overt Monetary Financing and Crisis Management.

(2)  There are risks because it’s an experiment

“QE’s ‘inconvenient truth’”, Richard Koo, Nomura, 18 June 2013 — Excerpt:

QE debate has focused exclusively on benefits while ignoring potential costs

In spite of the ramifications of this issue for the central banks of Japan, the US, and the UK, there has been surprisingly little discussion or theoretical research regarding the question of how to approach and address it.

There have been many academic papers discussing the merits of QE ever since the BOJ first faced zero interest rates more than a decade ago. However, there have been almost no papers discussing the costs or risks involved in winding down QE.

This is an extremely irresponsible approach and is similar to arguing that fiscal stimulus will boost the economy while completely ignoring all the problems associated with fiscal deficits.

Most papers on QE ignore causes of zero interest rates

Moreover, the majority of academic papers on QE seek to investigate the additional policy options available to central banks facing zero interest rates. Very few have asked why economies have not recovered after interest rates were brought down to zero.

This is a blind spot shared by a large number of orthodox economists. Their analysis starts from the existence of an external shock and does not try to examine the properties of that shock. A good example here is Princeton professor Paul Krugman, who when prescribing an inflation target and QE for Japan’s deflationary woes declared that the cause of deflation was irrelevant.

But if balance sheet adjustments in the private sector are the reason why the economy did not recover even after the central bank took interest rates down to zero, the implication is that no matter how much QE is undertaken, the money multiplier will remain negative at the margin and the money supply will not increase as long as businesses and households are not borrowing. Without growth in the money supply, there is no reason why monetary policies should have any impact on the economy.

No analysis of what will happen to broader economy when QE is ended

In addition, the costs of QE cited in the IMF report noted above are limited to microeconomic effects, such as a delay in necessary structural reforms at banks and in the broader economy, an increase in future bad loans due to a dulling of banks’ ability to manage risk, a dysfunctional interbank market, and impairment of the central bank’s balance sheet. There is almost no detailed analysis of what will happen to the broader economy when QE is discontinued.

A look at papers published by the IMF and other organizations shows that while the authors do mention risk management at private-sector banks, they tend to discuss the broader economic costs of discontinuing QE in rather vague terms, perhaps because they themselves have been instrumental in promoting its adoption.

As one example, the report noted above mentions in just a few lines that, given the possibility of a sharp rise in interest rates, central banks need to maintain a close dialogue with the market and focus on the policy duration effect when bringing QE to an end. This is clearly not enough considering the extent of the potential problems when a central bank that has bought up 30% of longer-term government debt issuance decides to sell that debt. …

QE offers few benefits but has major side effects

Moreover, it would be one thing if we could say with confidence that QE leads to a quicker economic recovery. But money supply growth in Japan, the US, and the UK has been extremely low in spite of aggressive QE. In the UK, where the monetary base increased more than anywhere else on a percentage basis, private credit has contracted steadily ever since the Lehman failure, and the central bank was unable to prevent a double-dip recession.

The data show that—as balance sheet recession theory predicts — QE can do very little to stimulate an economy during a balance sheet recession. But when the economy finally emerges from recession, the central bank will be forced to mop up liquidity injected under QE, and that process can impede the recovery via an abrupt rise in long-term interest rates.

Better days are coming, for some of us.

(3) Other posts in this series

  1. The April jobs report shows continued slow growth, bought at great cost, 3 May 2013
  2. The greatest monetary experiment, ever, 20 June 2013
  3. Status report on the US economy. Recession? Collapse?, 25 June 2013
  4. Look at the US economy: see the trends!, 1 July 2013
  5. Good news about the US economy!, 2 July 2013

(4)  For More Information

Posts about Monetary Policy:

  1. Important things to know about QE2 (forewarned is forearmed), 21 October 2010
  2. Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
  3. Explaining the gold standard, the Euro, Default, Deflation, and Hyperinflation, 17 December 2011
  4. What every American needs to know about the Federal Reserve System, 31 March 2012
  5. What are the limitations of the Fed’s power? It’s neither impotent nor omnipotent!, 17 February 2012
  6. The lost history of money, an antidote to the myths, 1 December 2012
  7. Monetary Magic applied to cure America’s economic ills, 20 February 2013
  8. The World of Wonders: Everybody Goes Nuts Together, 21 February 2013

14 thoughts on “The greatest monetary experiment, ever”

  1. Biggest problem is ‘consumer debt” is still high. QE fed the banksters and left the “little people” high and dry.. The only failure caused by the “misallocation” of resources for political and moral reasons.. not financial..As the old saying goes “It is not how much you spend but what you spend it on”… buying toxic paper by the Fed yet “little people” still losing homes, wages stagnate, and unemployment remains high is THE problem.. The better question to ask is “could we have spent the money more wisely”..not should we have spent the money at all.. Problem w/ many economists is they forget there are people at the bottom..

    One of the only reasons this and TARP ere enacted was it was “politically expedient” and agreeable to the Oligarchs…

    1. Economists say US households have substantially deleveraged in terms of debt ratios: debt/assets, debt/income, etc.

      But these aggregates are misleading in nations with highly unequal distributions of wealth and income. Like USA. The people who owe the numerator are not the same as those owning the denominator.
      Income and assets have risen for the top 10% (& 20%), which doesn’t help the bottom 90% who are overleveraged.

      Total household debt is down, and continuing to fall, as the most economically stressed default, and the fearful boomers attempt to paydown debt before retirement.

      The big growth story in household debt is education loans, the new subprime. A horror story for another day.

  2. I suspect that easing money supply further to generate inflation risks producing perverse effects if neither consumers, nor corporations are the _direct_ receivers of the increased monetary mass. Currently, salaries are largely stagnating or even decreasing, the share of wages in the economy has been going down for decades, labor has lost negotiating power (disappearing unions, high level of unemployment, offshoring).

    Wage earning people risk being crushed between (1) rising inflation (2) stagnating salaries with no possibility to negotiate raises (3) debt (mortgages, student, etc) that remains as difficult to write off as before. As for corporations, the big, rich ones are not investing their huge profits because of a general lack of demand, whereas small and medium-sized ones cannot because banks refuse to lend them the QE money…

    1. One widespread fear about the recovery circa 2009 was that we might get stagnant wages with mild inflation. In fact we did get a mild case of that, with real wage growth near zero for most workers (earned income growth has been mostly at the top).

      As for inflation — as a previous post showed, it is falling. Broken through the Fed’s floor of 2%, into the buffer zone in which the Fed can act before it goes into deflation. It disturbs some of us that this is happening despite massive Fed easing. Like a car being pulled backwards while your foot is hard on the gas.

      But the Fed says it is not worried, that this 18-month trend is “transitory”, and the focus must remain on the coming “tapering” of easing.

      As I have written for many years, I wonder if the 1914-2000 era of inflation (a structural bias to inflation) has ended, and another deflationary era begun (bias to deflation).

    2. Permanent deflation is impossible due to banking accounting rules which can be changed permanently. These accounting rules are changed with Mark to imagination and QE which are only reason banks still exists. Unvinding QE would cause banks to be shut down, so there will be no tapering off of QE no matter what they are promising now.
      QE allows for failed investments to be realized, those investments into fradulent paper which came to a halt. Imagining easing out of QE would mean recognizing that banks are insolvent which will not happen. That is what ballance sheet recession means.

      Permanent deflation means permanent and instituionalized QE and Mark to imagionation rule which would, in tandem with increasing automatization, enable 0.1% to achieve the world beautifully presented in In Time and Hunger Games movies.

      1. “Permanent deflation is impossible”

        What a fascinating statement.

        On a literal basis it is true but of little value. Nothing is permanent. Inflation, deflation, price stability, the political and economic regime itself. The only constant is change. Birth and death. All that lives, dies.

        On a shorter perspective it is false. We have had a century with deflationary tendencies and a century with inflationary tendencies. Who can say what the future holds?

        But the big lesson from such statements is the folly of making them. The world changes rapidly, each cycle different than the last due to the combination of social, economic, and technological change. Nobody knows what the 21st century holds for has.

  3. QE is not inflationary, it is deflationary in long term.
    QE only allows for realization of allready made investments, which would collapse without QE, does not create more investments which would be inflationary.

    QE is a swap of investment paper for cash by Central bank. Since those failed investments, saved only by QE, are not productive investments (money on money investments) they can not cause inflation in the real economy.
    Financialization means that 0.1% ers are separated economy, they invest into themselves and for increase of their static wealth that has no implications on the real economy. When that collapsed in 2008 because of the banking accounting rules of Mark to Market of investment papers, oligarchs changed the accounting rules into Mark to imagination and started QE. Banks can keep failed investments unrecognized by Mark to Imagination untill FED takes it over just before maturity when it would have to be recognized. FED swaps failed paper for money and lets it expire in their books (money printing in order to save banks and oligarchs’ investments).

    QE has nothing to do with real economy so it can not produce inflation.
    It is only a swap of one kind of debt (investment papers) for another kind of debt (money) that would never be called in.
    Debt that would never be called in has no real implication on debt burden, only accounting matter, it can take any ammount of more debt that a computer can fit onto screens. There is no limit on debt that will never be called in. That is what QE does. It allows for investments to never be called in by swaping it for cash before maturity.

    There would be no easing out of QE since that would mean a stop for paper investments and collapse of financial markets with it. Collapse of finacial markets would mean a drop in GDP numbers which can not be allowed for reasons of national pride not because it would have real economic effects, since it doesn’t,

    Banking became a separate economy of shuffling papers around for purpose of cash fllow presentation, without having any effects of matching investments with production. Banking is a separate world of oligarchs investing into themseelves and for themselves allowing them to escape reality and create worlds of Hunger Games and In Time.

  4. Central banks cannot create monetary velocity any more than a General can fight a war without troops.

    1. RRoss raises an important point. The Fed has inject vast quantities of money into America’s economic veins. Our slow growth of aprox 2%/year since 2009 owes something to that, plus the massive fiscal stimulus (ie, big deficits). But it has produced an artificial flush of health, not an organic (aka sustainable) recovery.

      As RRoss suggests, look at monetary velocity (the ratio of quarterly nominal GDP to the quarterly average of M2 money stock). It’s not a pretty picture.

    2. Very interesting chart, great that you posted it.

      Velocity increased suddenly in the early 1990s, reached a high-level plateau, collapsed approximately at the time the .com bubble burst, regained slightly during the real-estate boom, and then crashed again. It looks as if we are in a long period of unwinding all the accumulated bubbles (.com, real-estate, student debt still to come, what afterwards?)

      1. That is possible.

        It is also possible that the debt supercycle burst because we transmitted into a new economic regime, one with deflationary tendencies — and hence hostile to debt, the opposite of the post-ww2 era.

        These are complex matters, on the edge of the known. We can guess, but not yet know.

        For more info see:

    3. Well in a sense they can..first think about a comparison between different stimulus.
      current ones cleans up the bad paper left in the banks and increases said banks bottom line w/ no effort. Banks don’t want nor need to “risk” anything..
      Secondly take the “stimulus money”.. BUY the bad mortgages, pay them off THROUGH the owner creating a debt free (at least re: house) and possibly very solvent owner. Now the “little people” have cash and or equity..
      Velocity of money (heading to Lowes ect.) is QUITE different in this case. “WE” would be in a boom cycle right now..
      Of course you have the “moral hazard” of giving “little people” something for nothing..

      OR take the billions from QE and give it a direct payout to people/states.. “Velocity” can be controlled by the Fed, if one “spends wisely”..

  5. Richard Koo’s essay correlates the key symptoms with their ultimate causes. Bravo for pointing out how the Fed has become an engine of deflation no matter how much it claims to inflate by “printing” money, or to have an “inflation target”.

    If you want a scientific description of this causation, from first principles, I heartily recommend the
    Menger-Austrian economist Antal Fekete. One essay on this subject is
    Other coursework at his site completes the picture and describes the solution that will eventually emerge, once the failure of the present monetary order is widely enough recognized.

    1. The paper has glaring errors… Nobody (well let us assume the “central bank is gov.. See HR2990) can “create” new money.. Using a poor analogy let us assume the 1% “collects all it’s money and puts it under a mattress thus drying up almost ALL available currency. What would happen?? Say the Fed then injects “new money” into the economy.. what would happen??
      Short answer is the “mattressing” would cause inflation due to too few “dollars” chasing too many goods and/or a new system of barter or exchange arises destabilizing the civil order.. AFTER the Fed “injection” inflation would decrease and stability begin..
      And, again, the MAIN reason for deflation now is the total lack of the moral courage to put the money in the hands of the “most efficient” spenders.. i.e the general public and in the hands of the most efficient “collectors”…. I assume (going out on a limb a bit here ) MMT or most likely “real Keynsians” understand what the current error is but it is better than nothing…
      “It is not how much you spend it on but on what you spend it” will determine the inflationary/deflationary aspect of it……………

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