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.
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“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.
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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:
- The lost history of money, an antidote to the myths, 1 December 2012
- A solution to our financial crisis, 25 September 2008 — Among other things, large monetary action
- The lost history of money, an antidote to the myths, 1 December 2012
- 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:
- 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 September 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
- A Fed Governor speaks honestly to us about the costs and risks of our monetary policy, 18 January 2014
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