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Economic Schools of Thought and Market Performance – Part Deux

In a previous post I put together a hypothetical benchmark global portfolio so we could take different economic schools and analyze how they might have helped us navigate the current bull market.  I want to continue the series today.  As a reminder, here’s the benchmark allocation and performance:

US Stocks: 20%

Foreign Stocks: 20%

REITs: 5%

Corporate Bonds: 19%

US Govt Bonds: 29%

High Yield bonds: 2%

Global Bonds: 3%

TIPS: 2%

CAGR: 9.7%

Standard Deviation: 3

Sharpe Ratio: 3.13

So, next up – the Behavioral Economists.  This was more difficult to allocate because they don’t make a huge number of market prognostications, but I think this is a good approximation:

US VALUE Stocks: 20% – Behavioralists like Robert Shiller have favored equities for much of the ride higher with a tilt towards value arguing that many segments of the market are overvalued.

Foreign Stocks: 20%

REITs: 0% – Behavioralists like Shiller have generally been bearish on housing since the recovery.

Corporate Bonds: 19% –  Shiller has stated on several occasions that the bond market is not in a bubble and is instead rallying because of the Fed’s forced flight to income earning instruments.

US Govt Bonds: 29% –  See above.

High Yield bonds: 2% – See above.

Global Bonds: 3% – See above.

TIPS: 7% – Shiller has stated his bullishness of TIPS in recent years.

CAGR: 8.7%

Standard Deviation: 1.5

Sharpe Ratio: 5.5

Shiller and the behavioralists kill it.  Although they reduce the return of the benchmark by 1% per year they substantially increase the risk adjusted returns.  Using vague macro commentaries from Shiller appears to have led to a decent asset allocation over the last 5 years.  Behavioral finance helps.

Next up, Market Monetarists.  The Market Monetarists have had a pretty good track record over the last 5 years.  They’ve repeatedly stated that inflation would remain low and their “Chief Economist” Scott Sumner has repeatedly discussed his general belief in owning a diversified stock portfolio.  Of course, that works great in a bull market and we’re not analyzing the bear market here so there’s that.  Anyhow, here’s the rough approximation:

US Stocks: 40% – Scott Sumner wasn’t just bullish about US stocks.  He begged and pleaded for the Fed to create a stock market bubble in 2009.

Foreign Stocks: 0% – QE was super bullish for US stocks so why go into foreign markets?

REITs: 0%

Corporate Bonds: 24% – Sumner has explicitly recommended that the US government buy AAA rated bonds.  Plus, MMers have said inflation and rates are likely to remain low over the last 5 years.

US Govt Bonds: 0% – Fiscal policy is a “bad idea” according to Sumner and can have unintended consequences.  Skepticism over government spending would lead them to be bearish.

High Yield bonds: 31% – Just guessing here, but the portfolio reallocation effect of QE would have led MMers to be bullish on high yield bonds.

Global Bonds: 3%

TIPS: 2%

CAGR: 12.6%

Standard Deviation: 5.3

Sharpe Ratio: 2.3

Sumner and the MM guys put up some good numbers here.  Their bullishness on stocks sets them apart in the nominal return category, but their risk adjusted returns suffer a little bit from being overly allocated in assets that are all highly correlated.  As a result their risk adjusted returns aren’t as good as the behavioral economists, but their CAGR outpaces them by a pretty wide margin.

Tomorrow we’ll touch on the New Keynesians and the Post-Keynesians, but that’s all the time I have for today.


The Death of Outside Money

One thing the financial crisis exposed was just how deeply backwards a lot of economic theory was in terms of understanding money.  Most economic schools build their model of the world around outside money or money created by the government and the central bank.  This includes bank reserves, cash and coins.  And they tell us that credit and inside money (bank deposits primarily) are secondary because these are just “multiplied” or “leveraged” versions of outside money that are convertible into outside money.

Of course, I’ve argued that this is wrong and that we have a truly endogenous system in which we can all create money and banks hold a special importance because of their centrality to the payment system we all use.  The “moneyness” of the item they create is unique in ways that outside money is not in regard to playing a crucial role in everyday economic activity.  In other words, when understanding the monetary system it is best to start from the inside out, not from the outside in.  In addition, we’ve discovered that the money multiplier is a myth, that banks don’t lend reserves, QE doesn’t create high inflation and the impact of increasing quantities of outside money is pretty muted.

I’ve previously touched on the declining usage of cash in our society, but I was further reminded of this fact while reading this Business Insider report on the future of payments.  They note the slow death of cash in processing payments:


As technology advances the banks are actually taking an even stronger hold over the system.  They are making outside money increasingly less important.  And they are exposing the reality that our monetary system is not constructed around outside money, but indeed revolves around the stability and strength of our banking system.  Some might find that alarming, but that’s how the system has always been designed.  The corporations rule the day and the government bends over backwards to service their needs.  The construction of our payment system is no different really.

Economic Schools of Thought and Market Performance

David Beckworth asks a really interesting hypothetical on Twitter – which economic schools would have fared well since 2009?   That is, if you’d used the general understandings of specific economic schools then which ones would have helped you navigate the markets and which ones would have hurt?

To think of this, imagine if we took the various schools of economics and their chief figurehead and then placed that person in the role of Chief Economist, Chief Market Strategic and Head of Portfolio Management over the last 5 years?  We can’t be certain how the various schools would have performed, but we can get a pretty good idea using a very general framework.

To analyze this we can take some basic assumptions about portfolio construction by building a global benchmark using the Global Multi Asset Portfolio and then constructing a general portfolio backtest knowing whether a certain school would have been bullish or bearish on certain components.

So, for instance, the benchmark portfolio would be roughly:

US Stocks: 20%

Foreign Stocks: 20%

REITs: 5%

Corporate Bonds: 19%

US Govt Bonds: 29%

High Yield bonds: 2%

Global Bonds: 3%

TIPS: 2%

CAGR: 9.7%

Standard Deviation: 3

Sharpe Ratio: 3.13

First up, the Austrians.  Here’s my best reconstruction of their portfolio where components I was unsure about I just left unchanged.  Keep in mind this is a very general hypothetical so let’s not get too emotional or anything about how I went about doing this:

US Stocks: 0% because the USD is ending due to QE and the coming hyperinflation.

Foreign Stocks: 40% to get non-dollar exposure.

REITs: 5%

Corporate Bonds: 0% to avoid USD exposure.

US Govt Bonds: 0% to avoid exposure to rising interest rates.

High Yield bonds: 0% to avoid exposure to rising interest rates.

Global Bonds: 10% to get non-dollar denominated asset exposure.

TIPS: 0% to avoid USD exposure.

Gold:  30% for inflation protection.

Precious metals: 15% for inflation protection.

CAGR:  9.5%

Standard Deviation: 18.6

Sharpe Ratio: 0.57

Not as bad as you might have expected considering how awful the rising interest rate and hyperinflation prediction has been.  But also note that the portfolio was whipped around like a rollercoaster.   The risk adjusted returns are sort of atrocious compared to the benchmark.  The precious metals and gold positions would obviously dominate the portfolio and have been extremely volatile positions for the last few years.  In fact, all of the returns in this portfolio would have come in the first 2 years of its lifetime when many people were buying metals because they actually thought that it would protect them from the coming hyperinflation…..

This is just a fun little hypothetical using a bull market portion of the cycle, but I think it gives some general idea about how useful some of the ideas of certain economic schools are when applied to a real life portfolio.  Anyhow, I have to run, but I’ll post a few of the other schools in the coming days….


Lavoie on Endogenous Money and Effective Demand

Marc Lavoie has a nice paper in the Review of Keynesian Economics discussing Steve Keen’s views on endogenous money.  Marc is typically balanced and fair in his views.  And he highlights some important points:

  • Endogenous money matters and should be included in any macro model of the economy.
  • Many neoclassical economists overlook this fact completely and have been exposed in recent years as having flawed models.
  • Despite the importance of understanding endogenous money most of this stuff is not new at all and so those using the understanding of endogenous money should be careful not to overstep here.

Here’s the full Lavoie conclusion, but you can read the entire paper here:

“We are grateful to Steve Keen for having induced Krugman to engage in a public discussion over the role of bank credit and money creation. We are also grateful to Keen for designing a program that helps us to understand the dynamics of an integrated real and financial system. However, reading Keen’s paper, one gets the impression that he has discovered something fundamental about bank credit, something that previous and current post-Keynesian economists were not really aware of. I would argue instead that contemporary post-Keynesian authors, along with monetary circuit authors, have long been cognizant of the importance of bank credit and its impact, notably through their discussions about the relevance of Keynes’s finance motive, from the mid 1960s until now, as well as their insistence that saving does not finance production while credit does. I don’t think that the way forward is to go back and get trapped in the Swedish or Robertsonian time-lag analysis.

All post-Keynesians certainly concur with the idea that banks have the capacity to alter the level of aggregate demand, and hence that it would be desirable for banks, debt, and money to be included in models of macroeconomics. Indeed, one could argue that it was this realization that led Eichner (1987) to write down the equivalent of equation (1a) or (1b). There are several examples of post-Keynesian macroeconomic models that incorporate banks, debt, and money – for instance, Godley and Cripps (1983) and Godley and Lavoie (2007), just to mention those that I am most familiar with. For practical and pedagogical reasons, not all post-Keynesian models respond to such strictures: several models do not attempt to integrate the real and the financial sides of the economy, or they leave aside the role of non-bank financial intermediaries. But this does not imply, as Keen claims, that we need a redefinition of aggregate demand such that the starting point of macroeconomics is that ‘effective demand is equal to income plus the turnover of new debt’ (Keen 2014a, p. 286). Nor does it mean that aggregate supply needs to be redefined ‘to incorporate the financial markets’ (ibid., p. 290). 8 To provide new definitions of existing terms will only lead to a maze of confusions.”

Keen makes the grandiose claim that his approach leads to a ‘new, monetary macroeconomics’ (Keen 2014a, p. 286). While statements of this kind may appeal to an internet audience, I doubt they will convince readers of this journal.

Q&A -The Answers, Part 1

Lots of questions.  Thanks.  I’ll break this up in two parts since there were so many.

How do you feel about P2P/marketplace lending (e.g. Lending Club, Prosper) as an asset class?

CR:  I have never used one of these services, but they’re basically unsecured personal loans.  The technology makes this useful and simple, but it’s still an unsecured personal loan at the end of the day.  Not exactly the least risky way to make a loan, but since it opens the credit network up to a wide scope of borrowers then it’s a nice service.  I don’t know what the figures are here, but my guess would be that P2P borrowers tend to be of lower credit quality which makes the whole structure of the business somewhat unstable.

Effem says:

I will assume you are a fan of “free markets” as a general statement. Why then are you in favor of the Fed (essentially a political body) setting the price of short-term money? Wouldn’t be be better off letting the market set the price, as it does most other prices?

CR:  I’m not really “for or “against” the Fed.  I describe the Fed for what it is – a great big clearinghouse that helps to smooth the interbank settlement process.  In general, this is a good and necessary thing and I don’t think the government could do it better (as in a nationalized banking system) or that the private sector could do it better (by having the clearinghouse be managed privately).

The key point in regards to interest rates is that we have a reserve system and because of this the banks will try to reduce their holdings of reserves in the interbank market unless they are incentivized not to.  This means that interest rates would decline to 0% without the Fed manipulating the rate higher at all times.  But this is only the overnight rate and while this is an important rate it is not all rates.  The “market” sets most other interest rates to a large degree (your credit card rate, mortgages, etc).

Curious says:

Do you think you could outrun an ostrich?

CR:  No.  An ostrich can sustain 35 mph according to the internets.  A Cullen Roche can sustain about 5-10 mph according to my extensive experience running with him.

Brian says:

Do you believe the suspension of mark to market accounting had everything to do with the market bottom or purely coincidental?

Also, just got your book. Looking forward to it.

CR:  There’s no doubt that the relaxation in accounting standards helped improve the overall situation.  I don’t think it’s unreasonable to say that this was an important turning point.  After all, it was essentially the point where the government stepped in and declared an all out war on the crisis.  Even to the point where they admitted they were willing to change the rules of the game in order to save the banks and the system.

Will the contrast in their Governors economics between Kansas and Cal. or Minnesota vs. Wisconsin get to affect policy?

CR:  I don’t know the specifics behind the different governors, but since governors determine policy to a significant degree I would assume that different political ideologies will lead to different outcomes.  But I can’t really answer the question without an extensive knowledge of the specific governors.

You mention that reserves don’t leave the banking system.

What about when reserves are collateralized as repurchase agreements which are then used as leverage to bid up stock, bond, and commodity markets?

Are those “reserves” still in the “banking system?”

CR:  A bank can always be thought of as leveraging its capital position to do various things.  But even if a bank were to collateralize reserves those reserves would still not “leave” the banking system in any practical sense.  It’s sort of like making a loan to someone with your Apple stock as collateral.  Your Apple stock doesn’t leave the secondary market where it trades.  Just like reserves don’t leave the interbank market.

Dan says:

OK. Really basic question compared to all we read on your blog. But my question comes from reading your book. From the chapter on investment vs savings:

1. Can a company have a policy of never paying dividends? If so, why would anyone ever buy such a stock either as an investment or as a way to allocate saving?

2. After the IPO, why does the company care about the value of the stock? Unless the company employees happen to own some of the stock, why would they care if the price goes up or down? I mean they already raised the money at the IPO and they don’t have to give the money back if the price goes to zero right? And if the stock values go way up a 100 times the price of their original purchase this doesn’t mean the company get more money right? It just means that “savers” are competing to own the stock and bidding up its value.

I am just curious about this after reading your book–which I’m enjoying.

CR:  Berkshire Hathaway has never paid a dividend.  When you buy a stock you are purchasing a claim on the company’s future cash flows.  That doesn’t mean that you must necessarily obtain part of the cash flows though.  You can literally trade that claim to someone else in the future because they believe that the future cash flows will be more valuable than they presently are.  Buying a stock that doesn’t pay a dividend is a little bit like buying gold.  You’re buying an asset that doesn’t pay you an income stream and you’re hoping that someone will believe that asset is more valuable in the future.  The difference, of course, is that a stock has a source of underlying output whereas a rock is, well, just a rock.

After an IPO the company is owned by its shareholders so management must answer to the shareholders.  If they don’t manage the company in a way that benefits the shareholders then management will be replaced.  The savers who own the stock demand that the company continue to grow in a way that helps protect them from purchasing power loss.  If the firm can’t achieve this then it has no value to its shareholders.  So the shareholders hold the firm accountable for increasing profits.

Andrew says:

What do you think of Josh Brown’s relentless bid theory?

CR:  There’s a lot of truth to it.  But I also think the stock market is simpler to understand than we often make it out to be.  The stock market is basically the summation of a whole bunch of poorly informed and irrational participants guessing about the future prices of stocks.  They move in herds, they act on emotion and they are programmed to think that they should be overweight stocks relative to everything else.  And so long as there’s no good reason to sell then the path of least resistance tends to be up.  And I think that’s been the story of the last few years driving this “relentless bid”.  It’s not that everything is so great or that asset managers are now buyers (they’re always net buyers), but that there doesn’t seem to be anything that is so worrisome at present that stocks sustain a downturn.  In other words, there hasn’t been a powerful trigger to send these irrational participants setting their bids lower and lower on a monthly basis….

dctodd27 says:

Would you ever utilize leverage in a client portfolio?

CR:  Depends on what you mean by leverage.  Would I implement a risk parity styled approach, buy options or utilize other strategies that implicitly utilize leverage?  Yes.  Would I leverage a portfolio, as in, buying 100% equities and then leveraging the account on margin by 20% through outright equity leveraging?  No.  Would I use these silly double or triple leverage ETFs?  Absolutely not.  I don’t think leverage is a necessary part of a portfolio and I think it adds the potential for uncontrollable tail risk type events.  Tail risk events are the biggest risk to the average investor’s portfolio so anything that substantially increases the odds of them occurring is generally a bad thing.

TheRealKess says:

Who would you rather get drunk with? Mark Cuban or Kim Jong Un.

CR:  Kim Jong Un.  Without a doubt.  Dennis Rodman described his parties as “7 star parties”.  DENNIS RODMAN SAID THAT.

3 reasons Yellen’s FOMC remains dovish

By Sober Look

What makes Janet Yellen and a number of other FOMC members so dovish with respect to monetary policy and in particular the trajectory of rate normalization? A Credit Suisse report sites 3 key factors, which Yellen calls  “unusual  headwinds”:

1. Tighter fiscal policy.

The combination of lower government spending and tax increases has created a drag on economic growth (see chart). This drag is now diminishing, but given the tepid recovery Yellen still views it as a headwind.

US gov spending

2. Relatively tight credit in the mortgage market.

Janet Yellen: – ” … it is difficult for any homeowner who doesn’t have pristine credit these days to get a mortgage. I think that is one of the factors that is causing the housing recovery to be slow. It’s not the only one, but I would agree with that assessment.”

A recent study by Goldman compared current lending conditions in the mortgage market with the 2000 – 2002 period (supposedly “pre-bubble” period). The results indeed seem to point to tighter lending standards at this time (see chart).

3. Low household wage growth expectations.

While US wages have been growing at around 2% per year, expectations for growth remain depressed.

Yellen (see House testimony video below): – ” … households have unusually depressed expectations about their own future income gains. And I think weighs on their feelings about their own household finances and is holding back consumer spending.”

Wage increase expectations

Unlearning From Peter Bernstein

By Ben Carlson, A Wealth of Common Sense

“I don’t think that many investors have learned that the more you press, the more problems you get into.” – Peter Bernstein

By far the best thing I read this week was an article by Jason Zweig. It had nothing to do with current events or risks in the markets. In fact, it was published almost a decade ago for a story in Money Magazine.

It was an interview with the late Peter Bernstein, the legendary investor, author and philosopher on the investing process.

This was my favorite Q&A from the article:

Q. Over the course of your career, what are the most important things you’d say you had to unlearn?

A. That I knew what the future held, I guess. That you can figure this thing out. I mean, I’ve become increasingly humble about it over time and comfortable with that. You have to understand that being wrong is part of the process. And I try to shut up at cocktail parties. You have to keep learning that you don’t know, because you find models that work, ways to make money, and then they blow sky-high. There’s always somebody around who looks smart. I’ve learned that the ones who are the most smart aren’t going to make it. I don’t know anybody who left investing to become an engineer, but I know a lot of engineers who left engineering to become investors. It’s just so infinitely challenging.

Unlearning is an important concept for a sound, unbiased process. Many investors spend their time in constant search of new and exciting securities, asset classes, hedges or ETFs to add to their portfolio.

Not nearly enough work is done on simplifying or uncluttering portfolios or investment ideas. Instead of adding complexity to an investment process it makes sense to get rid of bad habits or define certain fund structures or assets to keep out of your portfolio.

Bernstein shares a common trait found among the great investing minds – the ability to admit what you don’t know, namely what’s going to happen in the future. This self-awareness seems to be the first step towards developing the correct mindset when investing in the financial markets. Another quote from the story along this same line of thinking:

After 50 years I still haven’t got it all clear. Any that’s okay, because I understandthat I haven’t got it all figured out. In a hundred years, I won’t have it all figured out.

A good rule of thumb for those that constantly make prognostications about the future of the markets is that the more precise their forecasts are the less likely it is that those predictions will come true.

Admitting you don’t have it all figured out (and never will) can be an enlightening event for an investor because it frees you up to focus only on what is within your control and ignore those areas which are out of your control.

It’s amazing how truly sound investment advice can withstand the test of time. Bernstein didn’t provide a specific set of portfolio construction guidelines or the perfect investment strategy that everyone should follow in this interview. But he did provide some big picture principles and a sensible perspective, which are much more important in the long run.

Do yourself a favor and read the entire Zweig interview with Peter Bernstein called Peter’s Uncertainty Principle: Part I & Part II

Also, see Zweig’s tribute to Bernstein from this week where I found the original interview:In Honor of Peter Bernstein (WSJ)

Q&A – Ask me Anything

Sorry for the slow posting this week.  Life and work got in the way.  Let’s do another Q&A to make up for it.  Go ahead ask me anything.

“Conventional and Unconventional Monetary Policy with Endogenous Collateral Constraints” (gulp)

That’s the title of a new paper by Michael Woodford of Columbia.  Woodford has been one of the more important economic voices regarding the use of QE during the crisis.

The always smart David Andolfatto has a nice interview with Woodford discussing the paper and his thoughts.  Here’s a basic summary:

  • It’s not a paper that claims to have given anything like a complete analysis of the situation that we’re currently in. It’s more an exploration of some important considerations and how they’re connected to each other.
  • Even when asset purchases might have useful effects, one should ask how far it is useful to go with them, because even in the cases where there are beneficial effects of shifting some risk of a certain side on the central bank’s balance sheet, it definitely doesn’t mean that then shifting more and more of it can only be better.
  • I think there are real questions about how far you would want to go down that path.

Here’s what I found really interesting:

  • Woodford appears extremely skeptical about the efficacy of QE after all this time.   It’s amazing that, after 5 years of this, the smartest people still don’t seem to have a full grasp on QE’s wide ranging and questionable effects.
  • Woodford stresses the point that more and more QE might not be the ideal approach in an environment where the private sector holders of these assets don’t necessarily want to see their options relegated to those that the Central Bank determines.
  • Woodford emphasizes the importance of fiscal policy and the idea that more and more QE gives the appearance that the Central Bank has everything under control which actually reduces the need for fiscal policy.

Go check it out.  It’s a little wonky, but interesting.

The Problem Is Not Debt?

I’m continually baffled by the inability of economists to connect the dots on the causes of the financial crisis.  This piece by Dean Baker essentially rejects the role of debt in the downturn, but Dean is clearly failing to connect the cause and effect and how debt rippled through the economy.

Of course, there were many contributing causes to the financial crisis, but housing played a particularly important role.  And it was the extension of credit that helped enable what turned into a record boom in housing.

The story is not terribly complex:

  • 1995-2005: Very loose lending standards and record high demand for mortgage debt led to an explosion in household debt.


  • 2003-2007: The housing boom expands, residential investment booms, employment picks up and economic growth improves in large part based on the growing bubble in real estate prices.
  • 2003-2007: Wall Street securitizes these loans and sells them thereby creating a multiplier effect based on the assumption that real estate prices won’t decline.
  • 2006-2009: Real estate activity slows, price acceleration turns into deterioration, economic growth begins to slow before the contagion starts to spread through the financial system as deteriorating housing prices and economic activity begin to impact the financial system.
  • 2008-2009:  The financial system seizes up under the pressure of defaults and de-leveraging and Congress and the Fed enact their extraordinary measures to stop the bleeding.
  • 2009-Present: The financial system slowly crawls out of a de-leveraging phase where a boom in household debt and financial system leverage preempted the collapse in real estate and the economy.

In his analysis, Dean Baker cites a chart showing personal consumption expenditures as a % of GDP and declares that PCE never really weakened.  But this is an empty argument.  It could just mean that PCE fell in relative terms to the fall in GDP and therefore has the appearance of not declining.  Either way, this is the wrong way to measure the strength of PCE.  A better perspective is this one which shows that something devastating happened to PCE in 2008:


Or, if you don’t like that view you can take PCE as a percentage of potential GDP to see just how much PCE actually did decline:


Anyhow, I am not sure why so many economists reject this story.  It doesn’t seem terribly complex to me and anyone who talked to Wall Street bankers before or during the crisis will tell you that this was what was really going on at ground zero of the financial crisis.  Then again, most economists don’t even consider debt and inside money to be particularly relevant to the economy because they don’t seem to embrace endogenous money for some reason.  So maybe that explains it, but probably not.


Asset Price Gains and Economic Fragility

One of the most important concepts I harp on in my book is the concept of savings versus investment.  When you develop a sound understanding of the monetary system and the capital structure it becomes clear that the way we use these terms on a daily basis is not totally accurate.  In fact, what we think of as our “investments” is really part of our “savings”.

I bring this up because Ben Carlson has a smart post on his site about the relationship between asset prices and savings.  And what’s interesting is that as asset prices increase we also tend to see a decline in the personal savings rate.  I’ve reconstructed this view in the chart below showing household net worth relative to the personal savings rate:



What’s most interesting about this is the perverse sort of nature driving this trend.  In essence, asset prices should improve as the economy improves and so we bid up prices because we think they’re worth more.  But this “wealth” is largely paper wealth.  It’s unrealized even though it’s right there in our accounting statements.  So we feel wealthier.  Indeed, we feel like we have more savings.  But it’s largely just paper gains and not realized.  So you get this inherent fragility built into a financial system where people could actually begin to spend well beyond their means just because they think they’re wealthier than they might really be.

This phenomenon explains why the housing bust was so important to understanding the great financial crisis and also explains why the Fed is so hypersensitive about stock prices.  With the personal savings rate so low the economy has become that much more dependent on the unrealized value of financial assets.  Which is great so long as the values are high and rising….

Does QE Finance Government Spending?

There’s been some good discussion in recent days about QE and whether it is actually legal or not.  Frances Coppola, the Telegraph and researchers at the University of Sheffield have all touched on the topic.  The legality of QE is a very murky discussion and one that only courts have the answers for.  But we can begin to get some clarity here by asking whether QE finances government spending?  I say it depends.

In the USA one could argue that QE is an indirect financing of the government’s spending because the Fed is using the Primary Dealers as a conduit through which it can purchase US government bonds.  In this sense, QE very much looks like a backdoor financing operation.  Then again, that’s how monetary policy is primarily implemented – by having the Central Bank purchase bonds to alter the private sector’s balance sheet.  QE is just a big time version of what the Fed has always done.  So there’s no reason why this debate shouldn’t have occurred long ago except that people care more about the debate now because QE is so much more publicized.

But there’s a more important point here.  The idea that the Fed is financing the deficit implies that the US Treasury could not otherwise sell the bonds at the current rates.   I find this very hard to believe given that demand for US Treasury bonds actually INCREASED before QE was implemented during the financial crisis and the fact that inflation has remained extremely low in the USA.  Could there come a time when inflation is spiraling out of control and demand for US government bonds declines to a point where the Fed must intervene just to bolster demand?  Of course.  But that time is not now and hasn’t occurred in the last five years.   So, until then, I am inclined to say that QE in the USA is just a big time version of monetary policy and not a direct financing of US government spending.

As for Europe – well, none of the nations in the Euro are actually issuers of the Euro so in this sense the ECB’s OMT backstop and any form of outright QE is even murkier.  It would be very similar to the Fed buying municipal bonds in the USA which I do not think would go over well as it would be viewed as direct financing of state governments.  So there’s a much stronger argument to be made, that, in the case of Europe, the OMT and QE walk a very fine line that makes the deficit financing and illegality argument a much more reasonable one.