Summary: It is all about models. That’s true about all sciences, from physics to climate to economics. If you don’t believe in models, you don’t know what model you use. Today we will discuss two models that describe quantitative easing. The correct model describes the likely outcome from ending QE3, and whether it will be easy or painful.
“Risk is life, life is risk. Only death corresponds to sustainable equilibrium. Any interesting out-of-equilbrium system (biological, ecological, societal, economic and so on) is prone to downside as well as upside risks, the non-certain outcomes that give rises to disruptions as well as opportunities.”
— Didier Sornette, Professor at the Swiss Federal Institute of Technology, March 2012
Contents
- Two models of the economy
- One step further … into addiction
- The source of our confidence
- For More Information
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(1) Two models of the economy
“Danger breeds best on too much confidence.”
— “Le Cid” by Pierre Corneille (1636)
There appears to be a consensus among economists (with a dissenting minority) that …
- QE3 no longer helps the US economy (see this report),
- If continued, QE3 eventually will have baleful effects on the economy,
- QE3 should therefore be ended (with tapering in December the first step),
- The US economy is close to resuming normal growth.
- Conclusion: reversing it slowly will have few effects.
The obvious rebuttal is that #1 and #5 are false. The first is false, as a quibble: QE3 is still boosting asset prices (although the mechanism is unclear), which was one of the intended results. Second, merely announcing tapering in June sparked a fast, large spike in interest rates. The ten year Treasury yield went from 1.6% to almost 3.0%. This suggests that ending QE3 might have large and unexpected effects. These are details, however, compared to the deeper issues.
Mainstream economics assumes a mechanical model of the economy. Turn the monetary crank clockwise and the red rod rises; turn it counter-clockwise and the red rod lowers. While analytically simple, it is quite daft to imagine the American economy works like that.
Large complex systems work differently. They adapt to inputs in subtle ways. Withdrawal of the input does not restore the original status quo, it produces unpredictable new effects. Consider Prozac. Withdrawal from Prozac brings on strange new problems, not just the original depression.
And so might ending QE3 have ill effects. Although difficult to predict, there are obvious candidates. Such as another spike in interest rates, which might depress the economy (e.g., it home construction and auto sales). And force a substantial drop in asset prices. The latter probably has few direct effects on the economy, but might have large psychological impacts. Asset prices — stocks, farmland, home values — have become indicators of America’s health. A drop in their values might trash confidence. The combination might push the economy into recession, since it’s running at stall speed (GDP <2%).
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(2) One step further … into addiction
“the correct analogue {to QE} remains that of a heroin addict. The tapering concerns are the equivalend of withdrawal symptoms. Obviously, it is possible to exit an addiction if the addict is willing to go through “cold turkey”. But {my} base case is that the current Fed leadership has no stomach for “cold turkey”.
— Christoper Wood (strategist, CLSA) in the 15 November 2013 issue of “Greed & Fear”
There is another complex dynamic that monetary policy might resemble: addiction to heroin (see the posts in the For More Info section). If so, then the ill effects from starting the taper (note the addiction terminology) might be large and painful.
Here is another difference between the consensus model and this alternative, seeing the economy as like a biological organism. Mainstream economists see tapering as necessary, and the resulting pain as easily overcome by exhortation — “Courage, comrades! Onward to normalized interest rates!” Also, the consequences of delay are minor.
The addiction model implies that the coming pain will be intense. Delay in tapering will result in still greater withdrawal pains. Exhortations to courage will accomplish nothing. Addicts need understanding and support, not advice.
(3) The source of our confidence
The more responsibilities central banks have acquired, the greater the expectations for what they can achieve, especially with regard to the much-sought-after trifecta of greater financial stability, faster economic growth, and more buoyant job creation. And governments that once resented central banks’ power are now happy to have them compensate for their own economic-governance shortfalls …
— “The Uncertain Future of Central Bank Supremacy“, Mohamed A. El-Erian (CEO & co-Chief Investment Officer of PIMCO), Project Syndicate, 11 November 2013
The greatest effect of tapering might be on a pillar of the post-crash recovery: confidence in the Federal Reserve. The Fed’s exercise of unconventional monetary policy — it’s now manufacturing a trillion dollars per year — gives them a reputation of the sort usually associated only with gods. A beneficent god, using its power to give gifts to America.
But now comes the other side of the cycle, when the Fed must inflict pain rather than provide joy. Except for a minority, we are psychologically unprepared for this shift — confident in the Fed’s ability to normalize interest rates without a shock, believing the odds of recession (probably horrific in our weak condition) to be near-zero. We see the distribution of outcomes as having only one tail. Awareness of risk has disappeared from our horizon.
But risk grows strong on disbelief, and grows even stronger on euphoria.
“Reality is that which, when you stop believing in it, doesn’t go away.”
— Philip K Dick’s speech “How To Build A Universe That Doesn’t Fall Apart Two Days Later” (1978)
(4) For More Information
(a) Other articles about this subject:
- “The Uncertain Future of Central Bank Supremacy“, Mohamed A. El-Erian (CEO & co-Chief Investment Officer of PIMCO), Project Syndicate, 11 November 2013
- Bridgewater Daily Observations, recent — Comments about monetary policy by one of the world’s greatest hedge funds
- “Confessions of a Quantitative Easer“, Andrew Huszar, op-ed in the Wall Street Journal, 11 November 2013 — “We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street.” Huszar is now a senior fellow at Rutgers Business School. He was a Morgan Stanley managing director, and in 2009-10 ran the Fed’s $1.25 trillion agency mortgage-backed security purchase program
- If the Fed grows unhappy with us, we might find ourselves Sinners in the Hands of an Angry God
(b) Monetary policy as addiction:
- Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine., 19 September 2013
- The great monetary experiment enters a new phase, with America as the stakes, 27 October 2013
(c) About the greatest monetary experiment, ever:
- Important things to know about QE2 (forewarned is forearmed), 21 October 2010
- Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
- The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013
- The World of Wonders: Everybody Goes Nuts Together, 21 February 2013
- The greatest monetary experiment, ever, 20 June 2013
- Different answers to your questions about the momentous Fed decision to delay tapering, 20 Sept 2013
- Do you look at our economy and see a world of wonders? If not, look here for a clearer picture…, 21 September 2013
- Two warnings about quantitative easing, the taper, and what comes next, 27 September 2013
- Dr Hunt explains the great monetary experiment. It will be historic, no matter what the result., 20 October 2013
(d) Other posts about monetary policy:
- The Fed is not wildly printing money, as yet no hyperinflation, we’re not becoming Zimbabwe, 2 March 2010
- Why the U.S. cannot inflate its way out of debt, 16 March 2010
- What are the limitations of the Fed’s power? It’s neither impotent nor omnipotent!, 17 September 2012
- Lessons from the failed forecasts of inflation since the crash, 5 October 2013
- Let’s learn about hyperinflation. Who knows what the future holds for us?, 21 October 2013 — esp section 3, about the sudden onset of inflation
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“The two models agree that QE3 must end soon.”
Why? The “mechanical model” you characterize would imply this if “the red rod” were rising too high. Would that be inflation? Employment? Ratio of actual to potential GDP? What shows any sign of rising too high any time soon?
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The addiction model could imply this if:
1. The condition being treated has abated.
2. The treatment isn’t working.
3. The treatment is causing ill effects that outweigh the (estimated) beneficial effects.
4. The patient is not yet as addicted as he or she will become with continued treatment¹, and the treatment is not working well enough to justify the increased difficulty of withdrawal.
In any case, the object, when the medicine is no longer helpful, is to withdraw it so as to cause the least collateral damage and/or suffering. The appropriate protocol depends highly on the specifics of the drug in question—e.g., withdrawal from opiates can be miserable, but it is not dangerous; while withdrawal from barbiturates can be life-threatening if not managed properly.²
What is not a reason for withdrawing a medication that is on the balance helpful is the mere fact that an addiction (which was expected and considered when deciding that the treatment was indicated) is continuing past some arbitrary length of time.
What indicates that our current situation is analogous to one in which it is time to end treatment?
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Is there not another model which says that while “liquidity trap” conditions persist, quantitative easing cannot do significant harm (though it isn’t likely to help much, either), but withdrawing it could do real damage? I gather the implication is that this situation changes whenever, and for whatever reason, the liquidity trap ends; at that point, the theory is that the easing must end, but that there will be little ill effect from reversing it quickly.
I don’t claim to follow why those things should be, just that I’ve understood that as the bottom line of what economists like Paul Krugman are saying.
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¹ Continuing the same dose of an addictive drug past a certain length of time does not further increase the degree to which a patient is addicted. Beginning shortly after tolerance to a given dose has stabilized (the effects of the medication are no longer decreasing), the difficulty of eventual withdrawal will be approximately the same no matter how long the regimen continues.
² The protocol used in “rehab”/12-step settings is a whole other thing—of dubious medical validity—inapplicable to addiction that is a consequence of appropriate medical treatment. The object there is not to minimize the ill effects of withdrawal, but to establish a psychological framework for resisting relapse.
Having sent this, now I can’t find anywhere in Fabius’ post where the text I quoted appears. I know I copied it from somewhere… it’s in my clipboard history…
My apologies for implicitly attributing something to the post which it does not say.
Coises,
It’s not the models that say that QE3 must end soon, but the consensus of economists. That opinion rests on some fairly strong research.
(1) It’s not doing much good, perhaps having no beneficial effects now.
(2) It’s already having significant and growing ill effects. The asset price bubble is large and growing. Distorted price signals create bad economic decision-making (e.g., investment flows), but the rising leverage leads to economic damage when it collapses. Since the top few 1% own almost everything, the wealth created is highly unequal and increases social tension.
(3) While inflation is too low, the massive increase in bank reserves (up ~60% YTD) creates the danger of rapid inflation when the economy reaches full potential. This can happen quickly, as monetary velocity accelerates. The longer QE3 runs, the more difficult the task of normalization.
(4) Starting the taper does not mean ending the effective aspects of monetary policy: ZIRP (zero interest rate policy) and forward guidance about rates.
For more information see: “How Stimulatory Are Large-Scale Asset Purchases?“, Vasco Cúrdia and Andrea Ferrero, San Francisco Fed, 12 August 2013
Coses,
I don’t want to carry the “addiction model” too far, as it is an analogy — the starting ponit for constructing an economic model. However, a few points.
(1) What drug?
Thanks for catching that; different drugs have different effects. The drug analogy usually used as a comparison to QE is heroin, as in my posts about this. I have added that to the post.
(2) “Continuing the same dose of an addictive drug past a certain length of time does not further increase the degree to which a patient is addicted.”
I know zip about this. But as research I skimmed several articles, all of which said that addiction is a function of “dosage and duration of usage”, and that the different facets of addiction tended to grow worse with usage.
(3) Treatment
I do not believe the drug analogy can be extended into the details of treatment and recovery. But I believe most treatment for heroin recovery has some form of tapering the dosage as an early step.
“But now comes the other side of the cycle, when the Fed must inflict pain rather than provide joy..”
God must do this also.
Joao,
So our Fed god mirrors the greater God. Perhaps the Fed gov’s are taking lessons.
For politicians the ‘Dow rising’ is a sign of success. QE is a way to just make that happen so there’s going to be tremendous pressure to not stop it from the political side. There’s always some kind of ‘critical, important, blah blah’ election right around the corner, and the end of this party is going to make anyone in power massively unpopular.
I think I see how QE gooses the market. At least one part. If a stock pays, 3% dividend, and bonds pay 3% interest, that can make the stock attractive. If you’re looking for 3% income then why not buy the stock? If interest rates go up, and bonds are paying 6% then, in order to get that same yield from dividends the stock price has to go down by half. There’s vast amounts of money all sloshing around the markets looking for a little more yield, and it goes where it has to go. QE by keeping interest low makes dividend stocks attractive relative to bonds.
Cathryn,
QE3 has not depressed interest rates.
On 12 December 2012 the Fed announced the full QE3, increasing monthly buys from $40 billion to $85B (the additional purchases being Treasury securities). The ten year treasury was aprox 1.6% then. That was the low since then.
The announcement in May of tapering coming this year sent the Ten year Treasury rate up to almost 3%. Announcement that the tapering would be delayed notched them down slightly, now ~2 3/4%.
If the Fed wasn’t buying all those bonds (QE), if the USA needed to fund all of its debt from the bond market, rates would go up. This is basic supply and demand. I mean, I wonder if this is even possible? Is there $40B/month of money out there ready to leap into Treasuries? The Chinese have been complaining about QE, they don’t seem so eager. The USA has to make these bonds attractive enough for investors to cash out other assets and turn them into treasuries — there aren’t a lot of ways to do this other than paying more interest.
Cathryn,
Analysis of complex systems precludes such simplistic analysis, especially when based on contrafactuals (I.e., what if X did not happen?).
What we know is that rates did not fall in a clear fashion (i.e., accounting for noise of short-term fluctuations) from start of QE3 in September 2012 through the May 2013 announcement of plans to taper.
That is all we know.
For more detailed analysis I recommend reading the articles in the For More Info section. By major experts.
Most economists believe the linkages from QE to the economy are very weak. Therefore, ending QE should have very little effect on the economy. (The basic problem is bad bank assets, which the Fed is shoveling under its carpet, but FAS 157 has already taken care of the problem–they don’t have to recognize them!) The pain inflicted will probably come in the form of market manipulation, to set up the shorts, and prepare for the next leveraged market rally.
The structural problem is excessive income and wealth concentration, and until something is done about that, circular flow of income and product in the economy will remain constipated.
Benign,
“Therefore, ending QE should have very little effect on the economy.”
You have repeated the content of section one, and totally ignored the rebuttal that I (and many others) have given to it.
Your comment looks like you read the title and summary, not the post.
I like to assume that the FED and US government are are perfectly capable of understanding what’s going on.
Despite the deficiencies of economic theories, the FED can observe the present and past. The FED can observe the lack of action on the part of the government and industry when it comes to regulation for the sake of system stability.
The FED is willing to learn from their own mistakes and compensate for the lack of action by other regulatory parts of the system (i.e., Congress / executive branch parts that regulate finance).
I’m further assuming these goals on the part of the FED:
(1) maintain a 3-way compromise between (a) moderate unemployment, (b) minimal consumer-price inflation/deflation, and (c) prevent collapses in stock/real-estate prices
(2) don’t screw up the US’s international trade position as a great power
(3) don’t rock the boat (except, just maybe, as necessary for goal #2)!
Granted that is a lot of assumptions, curious to hear if I’m off on these.
Anyhow, I think weaning the US off of QE is a “nice-to-have”. Something to be “explored”. As long as QE holds up the other goals, I’m having trouble seeing how concerns about debt levels, addiction to financial stimulus, and malinvestment, would ever win.
oh and I forgot: (1)(d) lower interest rates
asdff,
The Fed’s goals are a matter of statute.
#1 is correct.
The others are wrong.
The international trade position of the US is a matter for the Treasury (i.e., value of the dollar) and Dept of Commerce.
Lower interest rates is not a goal. Interest rates are a function of the economy and Fed policy. Lower is not always better, any more than it is for your body temperature.
The Fed exists to “rock the boat” in the sense of bank regulation and “taking the punch bowl away” when the party gets too hot.
asdff,
I don’t see the basis for any of your assumptions in history. Central banks try, but assuming they are able to do those things is a matter of faith, not evidence.
“Anyhow, I think weaning the US off of QE is a “nice-to-have”.”
You make no mention of a time horizon. Ending QE is a when, not an if, to (so far as I know) almost everybody with any competence in this field. Assuming you refer to the time period under discussion now — the next two quarters — the exact time tapering starts might make little difference. The rate of tapering is more significant.
If you are speaking more broadly, about the period during which the taper is ended, only a minority of economists agree with you, and an even smaller set of financial experts. Certainly history provides almost nothing but contrary evidence to your faith.
This has been extensively discussed in the posts about current monetary policy — listed in the For More Information section — citing a large body of history and expert analysis. I’m not going to rehash all this yet again here, especially since it will just repeat.
“There appears to be a consensus among economists that QE3 no longer helps the US economy.”
Perhaps, but the IGM Forum of 50 economists from November 6 shows 56% of them agreeing with the statement that “The Fed should not reduce its purchases of mortgage-backed securities and treasurys until there is clearer evidence of strong and sustained employment growth.
http://www.igmchicago.org/igm-economic-experts-panel
DM,
Thanks for posting this result from the IGM Forum! That is quite interesting.
Perhaps this vote results from the population: these are “senior faculty at the most elite research universities.”
The economists I read on these matters are at Wall Street firms, private forecasting firms, government, ngo’s and international agencies.
Perhaps these economists are engaged in a different way then “senior faculty at elite universities”.
Fab –
Sorry, my sense of humor eludes people sometimes.
Yes, there will be a collapse of confidence (happens to be my research area), and it will hurt. It will happen when the unemployment rate crosses above its adaptation level. See “Animal spirits in America, April 2009” in ArXiv.
But my structural analysis remains mainly valid, I’m believe.
B9
Benign,
(1) “Sorry, my sense of humor eludes people sometimes.”
Your sense of humor has got to be better than mine.
(2) Confidence
That’s a controversial subject! Managing confidence has become a major economic variable, as seen in the attention paid to the confidence surveys. The effect on confidence was a major factor in the design of QE3.
IMO this is problematic thinking. I have a half-done article about this.
As for a collapse, it depends on the path of the economy. If the consensus is correct about the coming acceleration, then all will be well.
(3) “But my structural analysis …”
Not sure what you mean, but about QE3 your view agrees with the vast majority of economists.
Wall Street likes to think that it can influence the Fed with whisper campaigns about what they think the Fed will do. Or, perhaps more likely, Wall Street gets really nervous and starts making noise in the hope that the Fed will listen to them.
Lately I’ve been hearing rumours from the Street that the Fed is going to expand QE rather than taper it. The most aggressive prediction is that the Fed will push the bond buying programs to $140 billion per month. I very much doubt that the authors of these rumours have any special knowledge but this information gives you an understanding of where the Street stands on tapering.
Pluto,
“Lately I’ve been hearing rumours from the Street that the Fed is going to expand QE rather than taper it.”
Just gossip.
As for the Fed, IMO it’s de facto subsidiary of the major banks. That was the story of the First and Second National Banks, and is equally so of the Fed.
Pluto,
Here is, I believe, the first mention of the possibility of the Fed expanding QE3. Just idle speculation, like the subsequent mentions that I have seen.
From the of Jim Reid (Fixed Income Strategist), Deutsche Bank, 8 November 2013 — He refers to a report by John-Paul Smith, with DB:
Pluto,
“Wall Street likes to think that it can influence the Fed with whisper campaigns about what they think the Fed will do. ”
That’s because the history of the Fed shows it responds to its masters. For one of countless examples see “Confessions of a Quantitative Easer“, Andrew Huszar, op-ed in the Wall Street Journal, 11 November 2013 — “We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street.” Huszar is a senior fellow at Rutgers Business School, was a Morgan Stanley managing director. In 2009-10, he managed the Federal Reserve’s $1.25 trillion agency mortgage-backed security purchase program.
Some, a minority I’ll admonomies not as basically stable systems subject to exogenous shocks, but as dynamic systems potentially capable of intrinsic instability when some system parameter reaches a critical value. Minsky proposed a mechanism by which total private sector debt could grow until a type of debt saturation leads to an instability like we may be seeing now. Waiting to return to business as usual once the nasty shocks of technology innovation and foolish lending after 911 subside is wrong headed if this is correct. The simile is the economy is like a boat drifting toward the top of Niagra Falls. Our Fed motor is roaring at full throttle keeping us in place. If they cut back, even a little, over we go.
“Finding Out Where Janet Yellen Stands“, Kevin Warsh, op-ed in the Wall Street Journal, 12 October 2013
Warsh is a former Federal Reserve governor, a lecturer at Stanford’s Graduate School of Business and a distinguished visiting fellow at the Hoover Institution.
Excerpt:
Almost every Fed chairman in the past 60 years has manipulated interest rates to brighten the economic outlook for incumbent presidents or newly elected presidents who won by large margins.
The purchasing power of the U.S. dollar has fallen 94 percent in the past 100 years. The only way you can create inflation is by creating more money that is backed by the same reserve assets; the Fed is the only entity that can create more money.
Ben Bernanke’s quantitative easing (QE) programs have pumped billions of unfunded dollars into the economy, thereby setting us up for massive inflation in the very near future. If this isn’t a form of financial terrorism, it is incompetence of the highest order
Zaid,
“Almost every Fed chairman in the past 60 years has manipulated interest rates to brighten the economic outlook for incumbent presidents or newly elected presidents who won by large margins.”
Can you cite a study showing a correlation between Fed policy actions and size of the President’s victory margin. That sounds quite unlikely.
“The purchasing power of the U.S. dollar has fallen 94% in the past 100 years.”
During those hundred years we have been one of the most successful nations on the planet. Low steady inflation has no ill effects. The Fed’s 2% target allows them time to react to deflationary forces. Deflation is highly destructive to a high-debt economy like ours.
“The only way you can create inflation is by creating more money that is backed by the same reserve assets”
That is not remotely correct. Milton Friedman showed that inflation results from the money supply growing faster than required by the economy.
Too fast and too slow are both bad. During the late 1800s the gold standard prevented necessary monetary growth, like forcing a growing child to stick with the same shoes. Repeated depressions were the result.
“Ben Bernanke’s quantitative easing (QE) programs have pumped billions of unfunded dollars into the economy, thereby setting us up for massive inflation in the very near future.”
You folks have been saying that with delusional confidence since early 2010. In fact inflation is below the Fed’s 2% alarm line, and falling. As I said, Americans suffer from a failure to learn.
“If this isn’t a form of financial terrorism, it is incompetence of the highest order”
Failure to learn is incompetence. Failure to acknowledge failed predictions is incompetence. Those making failed forecasts — often with precise dates — of inflation “in the very near future” are incompetent.
Note that during this period I have consistently said there would be no acceleration of inflation, and deflation was the more serious threat.
http://fabiusmaximus.com/2013/11/15/monetary-policy-tapering-58477/#comments
It is a fact that almost every Fed chairman in the past 60 years has manipulated interest rates to brighten the economic outlook for incumbent presidents or newly elected presidents who won by large margins. The purchasing power of the U.S. dollar has fallen 94 percent in the past 100 years. The only way you can create inflation is by creating more money that is backed by the same reserve assets; the Fed is the only entity that can create more money. Ben Bernanke’s quantitative easing (QE) programs have pumped billions of unfunded dollars into the economy, thereby setting us up for massive inflation in the very near future. If this isn’t a form of financial terrorism, it is incompetence of the highest order.
Ziad,
Can you cite any reliable sources to support your statements? Most of this look wrong.
(1). “It is a fact that almost every Fed chairman in the past 60 years has manipulated interest rates to brighten the economic outlook for incumbent presidents or newly elected presidents who won by large margins.”
I am not even sure what that means, but looks quite false. It does not even make sense. Presidents want good economic news in the last two years of their term, to boost odds of electoral success for them or their successor. Which is why they push for harsh measures in the first two years (e.g., tax increases, anti-inflationary measures).
(2). “The purchasing power of the U.S. dollar has fallen 94 percent in the past 100 years.”
And your point? During those 100 years the US experienced fantastic growth, replacing Britain and the world’s superpower. Clear evidence that theory is correct, that slow inflation has no ill effects.
(3). “The only way you can create inflation is by creating more money that is backed by the same reserve assets”
History and theory show that is false. Inflation is the relationship between the money supply and the supply of goods and services.
(4). “Ben Bernanke’s quantitative easing (QE) programs have pumped billions of unfunded dollars into the economy, thereby setting us up for massive inflation in the very near future.”
People like you have been saying that for 5 years. Inflation has fallen thru the Fed’s 2% floor! and might be heading towards deflation — a very bad thing. Repeated falsification of claims like yours has had no effect, which tells us something about your intellectual processes.
(5). “If this isn’t a form of financial terrorism, it is incompetence of the highest order.”
Look at the plank in your own eye before denouncing the mote in Ben’s.