The key to understanding the future of QE3, and the future of our economy

Larry Kummer, Editor

13 years ago

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%).

(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: