Wagering America on an untested monetary theory

Summary: After years of quantitative easing, with the Fed starting to slow the third great wave, officials are breaking their facade of confidence to admit what many of us have long said. They do not know how QE works, or the effects of ending it. QE is an experiment, one of the greatest economic experiments of the modern era. That is the most important thing to know about QE, and the fact most carefully hidden (until now). We might find the next few years quite exciting. Here are two articles to help you understand, and so prepare.

Money world


“We don’t understand fully how large-scale asset purchase programs work to ease financial market conditions. Is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”

— William Dudley (President, Federal Reserve Bank of New York), speech at the American Economic Association Annual Meeting, 4 January 2014

“The problem with QE is that it works in practice but it doesn’t work in theory.”
— Ben Bernanke, speech at Brookings Institute, 16 January 2014

“When you believe in things that you don’t understand, then you suffer. Superstition ain’t the way.”
– Stevie Wonder, “Superstition” (1972)

(1)  Weekly comment by John Hussman (former Prof Economics at U MI, portfolio manager of the Hussman Funds), 20 January 2014 — Excerpt (red emphasis added):

What FOMC officials are really saying is that aside from a very predictable effect on short-maturity interest rates, there is no mechanistic link between the monetary base and any other variables – financial or economic – that they are trying to control. There is a sense that creating more monetary base helps stocks advance, and that this contributes to economic confidence. What’s missing is a transmission mechanism that operates through identifiable banking and economic channels – other than promoting a speculative reach-for-yield and the psychological exuberance that accompanies a bull market.

The fact is that Treasury bond yields are above where they were when QE2 was initiated in 2010, and year-over-year growth in non-farm payrolls, civilian employment, real GDP and real final sales have at best done little but hover at the thresholds that have historically bordered expansion and recession. Good economic policy acts to ease constraints that are binding, and monetary policy can clearly be useful in that regard – particularly during liquidity crises when depositors are rushing for cash. At present, however, quantitative easing acts by massively loosening a constraint that is not binding at all, drowning the economy with idle bank reserves that aren’t even desired. That’s going to have negative consequences.

… Regardless of my objections to the course of monetary policy, I think the Fed’s intentions are good, and I share Janet Yellen’s concern for the unemployed. I just believe that there is no demonstrable mechanism that reliably links the actions of the Fed to the outcomes it seeks, and that the unintended effects are greatly underestimated.


Happy and sad

If there is any lesson to be learned from the past 15 years, it is that the U.S. economy is desperate for scarce savings to be allocated toward productive investment and job creation, and that the economy is enduringly harmed by policies that divert investment activity toward speculative revelry. The impulse to address the collapse of one cyclical distortion through the creation of yet another has the consequence of structurally undermining the economy for a far longer period.

Hussman touches on an unmentionable: that the technology boom centered on Silicon Valley is in fact driven by stock market investors pouring money into mostly unprofitable companies in search of speculative gains — and the complex financial machinery of Silicon Valley manufactures such companies. Into this pit pours much of America’s seed capital.

Investment booms are an inherent part of free market systems (predating fiat currency and modern banking systems). They leave losers, and the infrastructure they built (e.g., canals, railroads, the Internet). What will be left when the current boom passes?

(2)  Tom Keene interviews William White (Chairman of the economic development review committee at the OECD; bio here), Bloomberg Briefs, 21 January 2014 — Excerpt (red emphasis added):

Q:  The key question for many people is not just the Fed’s ability to taper, but its $4 trillion balance sheet. How concerned are you about that?

A:  The honest truth is nobody knows. We’re in a situation that is completely unprecedented. Nothing like this has ever been done before. And I think you can make plausible arguments on both sides.

And as it stands at the moment, there are significant risks that will be associated with moving from what is a highly experimental and highly unbalanced state of affairs back to what we would hope to be a more balanced and more normal state of affairs. I’m worried.

Q:  What is the biggest danger? Is it a communication thing? Or is it an actual danger of massive hyperinflation?

A:  No, I don’t think hyperinflation is the big worry at the moment. High inflation is always possible after a period of massive monetary stimulus. It’s possible.

But I think this is less likely than the problems of continuing disinflationary and indeed even deflationary pressures in the U.S. and perhaps even the global economy. And the reason why I say that I think is that my concern would be that there has been an awful lot of artificial stimulus to asset prices of all sorts, an over extension of leverage in many instances. We’re back, in many respects, to a situation that is similar to what we had in 2007 and 2008.

The point is that the whole thing collapses in the context of a taper or monetary tightening, or a shock of some other sort. Then we’ve got a problem.

Q:  Are we worried that there is a sluggishness which leads to deflation?

A:  Absolutely. … If we do have another significant downturn, I think it would be highly likely that there would be a significant amount of deflation that went along with that. And that is a very dangerous state of affairs….

Q:  Is that beginning to fade? The Fed would argue it is. As the economy picks up in the U.S., should we see that go away?

A:  …If indeed the economies – not just the U.S., but the global economy – continue to recover after this long period of essentially recession, at least relative to potential growth, then I think the worry would be that we have to take all of those extra reserves out of the system. We have to find some way of raising interest rates back up to more normal levels. In that kind of environment, the worry probably would be more of inflation getting out of control if indeed the recovery continues.

The downside, and I don’t think anybody has any capacity really to forecast this, is that if the weight of debt globally leads to the nation’s recovery aborting so that we have another downturn and get into a kind of Irving Fisher world of debt deflation where the burden of the debt becomes ever greater because the prices and the profits of the corporations are getting smaller, then we’re in a very different world.

If you think about the world as not a machine but a complex adaptive system, one thing we know about those systems is that forecasting it is almost impossible.

For More Information

(a)  Posts about monetary stimulus:

  1. The lost history of money, an antidote to the myths, 1 December 2012
  2. A solution to our financial crisis, 25 September 2008 — Among other things, large monetary action
  3. The lost history of money, an antidote to the myths, 1 December 2012
  4. Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine., 19 September 2013

(b)  Posts about our great monetary experiment:

  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. The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013
  4. The World of Wonders: Everybody Goes Nuts Together, 21 February 2013
  5. The greatest monetary experiment, ever, 20 June 2013
  6. Different answers to your questions about the momentous Fed decision to delay tapering, 20 September 2013
  7. Do you look at our economy and see a world of wonders? If not, look here for a clearer picture…, 21 September 2013
  8. Two warnings about quantitative easing, the taper, and what comes next, 27 September 2013
  9. A Fed Governor speaks honestly to us about the costs and risks of our monetary policy, 18 January 2014



10 thoughts on “Wagering America on an untested monetary theory”

  1. Instead of being lender of last resort I view QE as the Fed being collateral buyer of last resort. QE is
    thus a form of price support program operated through the Fed. Lehman failed because
    their collateral was deemed no good for incremental lending. TARP was the Fed response to this, another
    form of collateral price support.

    As with any price support program, the result is that government ends up
    owning ridiculous amounts of the supported goods. Right now the Fed holds 40% of all treasuries

    Less obvious, buyers of those same goods must pay too much which distorts decision making and allocation
    of capital decisions. In this case savers pay too much for financial products like stocks which are in market
    equilibrium with bonds. When price supports are removed and markets return to equilibrium there is predictably
    a glut as government disgorges its inventory. Heh, maybe they’ll give away treasuries and MBS to poor
    children along with our school lunch programs.

    1. Peter,

      I understand your viewpoint, but it’s not exactly correct.

      (1) Fed buyer of last resort

      The Fed is an agency of the Federal government. When the Fed buys debt the Treasury issues, it is canceling the debt — much the same as when you pay your taxes (you are returning a Federal Reserve note to the issuer).

      For a very good technical (i.e., accounting) reason this shows as debt on the Fed’s balance sheet rather than just decreasing the US public debt: the Fed balance sheet is largely a trading account. It went from $800 billion before the crash to $4 trillion today. But at some point much of that will be shed (at least, that’s the plan).

      So the dynamics of QE differ radically from the Fed buying real stuff.

      (2) Does QE push up the prices of financial and/or real assets? Are they lowering the income of savers?

      As said by the folks quoted in this (and previous posts), there is no obvious transmission process by which QE does so. In fact, QE2 and esp QE3 have not even lowered Treasury interest rates — which is a common transmission mechanism affecting asset prices.

    2. I offer this as a transmission mechanism for how QE encourages credit expansion. Right or wrong a lot of lenders think like me. What if my loan goes sour because the posted collateral deteriorates? His posted bonds lose value as interest rates rise or the market decides MBS are crap? Better if I don’t lend.
      Then out comes the Fed with an announcement it will buy this collateral at full retail into the foreseeable future. Well, if the Fed intends to eat its own cooking forever who am I to argue. Loans away!
      Psychology in the form of Keynes animal spirits largely boil down to this psychology of lending and its effect on credi expansion. Like most psychological boosts the efficacy wears off with time.

      1. Peter,

        “Then out comes the Fed with an announcement it will buy this collateral at full retail into the foreseeable future.”

        That does not seem correct, for two reasons.

        (1). There has been no acceleration of lending vs treasury or government-guaranteed mortgage-backed securities — the things the Fed is buying — during QE3. In fact, outstanding loans are down! From $1,808B in Dec 2012 to $1,812B on Jan 8.


        (2). These are government-guaranteed securities. Why does the fact that the a Fed is buying them make them more desirable as collateral? Rates are up during QE3′ so their prices are down.

    3. I think the Fed buying MBS is allowing some kind of work around for the tightening of rehypothecation limits that occurred after the GFC. Here is an out take from the wikipedia entry for hypothecation:
      “In 2007, rehypothecation accounted for half the activity in the shadow banking system. Because the collateral is not cash it does not show up on conventional balance sheet accounting. Before the Lehman collapse, the International Monetary Fund (IMF) calculated that US banks were receiving over $4 trillion worth of funding by rehypothecation, much of it sourced from the UK where there are no statutory limits governing the reuse of a client’s collateral. It is estimated that only $1 trillion of original collateral was being used, meaning that collateral was being rehypothecated several times over, with an estimated churn factor of 4.[4]

      Following the Lehman collapse, large hedge funds in particular became more wary of allowing their collateral to be rehypothecated, and even in the UK they would insist on contracts that limit the amount of their assets that can be reposted, or even prohibit rehypothecation completely. In 2009 the IMF estimated that the funds available to US banks due to rehypothecation had declined by more than half to $2.1 trillion – due to both less original collateral being available for rehypothecation in the first place and a lower churn factor.[4][5]

      The possible role of rehypothecation in the financial crisis of 2007–2010 and in the shadow banking system was largely overlooked by the mainstream financial press, until Dr. Gillian Tett of the Financial Times drew attention in August 2010 [5] to a paper from Manmohan Singh and James Aitken of the International Monetary Fund which examined the issue.[4]”
      The holding of non cash assets for purposes of increasing this kind of invisible leverage have largely ended. It’s time for banks to find another way to keep the game going and so they tell their Fed to convert these assets to cash reserves. I’m not smart enough to figure out how these reserves are allowing banks to lever up again but they are very creative guys.

  2. The effect of QE is on financial asset prices. Currently this stock is at $41T . If the Fed had not been buying ~4T worth of bonds over the last 4 years, there would have been $4T in fewer sales of these assets – a substantial ‘price support’ for stocks and bonds. We now support capital not only through tax and structural means, but directly like we supported agribusiness in the 1960’s and 1970’s through asset purchase.

    1. joh,

      Can you cite any evidence for your theory, which contradicts the experts cited here (and in the many other posts, listed in the For More Information section).

      Almost every dime the Fed printed in QE3 is on deposit by banks at the Fed, reserves earning 1/4%. Adjusted reserves are up arpox $1 trillion since the end of 2012, now $2.5 T.

  3. Hussman displays a baffling ignorance of the reality of the American economy over the past 20 years — a level of cluelessness inexplicable in an economist who purports to be knowledgable about the current state of America’s economy.

    If there is any lesson to be learned from the past 15 years, it is that the U.S. economy is desperate for scarce savings to be allocated toward productive investment and job creation…

    Amazingly, Hussman conflates “productive investment” with “job creation.” The big story of the American economy since the year 2000 has been that productivity gains have accelerated, yet job creation has collapsed, and wages have remained flat.

    FM doesn’t seem aware of this basic fact of modern America either. FM states (accurately) that

    …the technology boom centered on Silicon Valley is in fact driven by stock market investors pouring money into mostly unprofitable companies in search of speculative gains — and the complex financial machinery of Silicon Valley manufactures such companies. Into this pit pours much of America’s seed capital.

    But FM neglects to mention, or perhaps to recognize, that pouring America’s money into tech booms is precisely the problem with the U.S. economy. Each new Silicon Valley makes its money by destroying American jobs while creating very few new ones. In fact, the process seems exponential, with increasingly more jobs getting eliminated while increasing fewer new jobs get created.

    Consider the progression: Intel and Microsoft in the 1970s created hundreds of thousands of new jobs. In the 1990s, google created 20,000 new jobs. By the 2000s, Facebook created 3,500 new jobs. This progression proves typical of Silicon Valley businesses. As time goes on, the tech firms find more ways to do more with fewer workers — that’s the source of their profitability. But this means that the more investment gets poured into Silicon Valley tech firms, the more jobs will be lost and the fewer jobs will be created.

    No economist appears to be concerned with the logical end result of this socioeconomic progression, well described in the article “The rich and their robots are about to make half the world’s jobs disappear.”

    If the American economy cannot find another way of generating wealth than by exponentially destroying the jobs that support our middle class, the only alternatives involve police state represssion of a vast mass of impoverished proles that will make the novel 1984 looks like a fun kiddies’ book, or another French revolution.

    The entire focus of this article seems strange, since FM titles it “Wagering America on an untested monetary theory.” I’m sure that the fed governors understand quite well that QE is unlikely to do much to revive the U.S. economy, but since the Tea Party sociopaths dominating congress have deliberately chosen to do absolutely nothing to pass infrastructure or stimulus spending bills that would pump up aggregate demand, the fed governors likely realize that trying a hail-mary pass like QE is better than doing nothing.

    The real story here is the total dereliction of duty by our current congress. Any reasonable person can think of half a dozen major infrastructure projects too big for private investors to finance, which America badly needs, and which would also tremendously stimulate aggregate demand:

    1) Knock down and rebuild America’s major cities to make them bicycle- and pedestrian-centric rather than auto-centric and introduce nuclear-plant-powered electric light rail to enormously reduce our dependency on foreign oil;

    2) Create another Manhattan project, this time focused on renewable energy using known proven technologies, like nuclear power and solar-electric power;

    3) Build a vast high-speed bullet rail system throughout America. The U.S. already has the best freight train system in the world — why can’t we complement it with a passenger rail system of equal excellence and extent?

    4) Build something like Elon Musk’s “hyperloop,” a set of partially evacuated high-speed tube trains with the individual trains travelling at 800 mph. This was suggested by the RAND corporation in 1972, and can be done with existing technology.

    5) Strip out al the private greedy slow for-profit internet providers and replace ’em with a vast nationwide low-cost gigabit internet network, so that America no longer falls behind Bulgaria on the list of world internet speeds.

    Yet congress funds none of these projects, not a single one. Trillions for tax breaks for billionaires and endless unwinnable foreign wars, but not one dime to improve American infrastructure. It’s absurd, insane, demented, self-destructive, and just plain nuts.

    1. Thomas,

      I find your comment quite difficult to understand.

      (1). “Amazingly, Hussman conflates “productive investment” with “job creation.” ”

      Reading FAIL. No, he does not. The “and” in the sentence shows that he understands these are two distinct things: ” be allocated toward productive investment AND job creation”.

      (2). “FM neglects to mention, or perhaps to recognize, that pouring America’s money into tech booms is precisely the problem with the U.S. economy. Each new Silicon Valley makes its money by destroying American jobs while creating very few new ones.”

      Saying that this is a problem is IMO not accurate. This is inevitable progress. We must adapt to it; fighting it is the road to ruin.

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