CREDIT SUISSE: WHY QE2 WILL WORK
Credit Suisse was out with an interesting piece of research earlier this week describing the merits of quantitative easing. As we previously detailed, QE is ineffective in times of a balance sheet recession, however, CS notes 5 different ways that QE can work (according to them). Let’s take a look at each:
“QE works via five routes:
(1) It pushes up asset prices (holders of government bonds or other bonds have cash and are forced to make an asset allocation decision in an environment where real bond yields are artificially low). Indeed, Charlie Bean, Bank of England Deputy Governor, highlighted that this was the key rationale behind the MPC’s QE in 2009.”
This is an arguable point. In a deflation investors will drive bond prices higher regardless. This, in theory, will make equities more attractive, however, a case study in Japan debunks this thinking as equity prices continued to decline regardless of the move lower in yields. I have argued that QE has inherent deflationary tendencies as we remove an interest bearing asset from the private sector and replace it with cash which could actually put downward pressure on prices as a whole.
“(2) The rise in asset prices has a wealth effect on the consumer and corporates (it becomes more expensive for corporates to buy, so they build!);”
This goes back to the old cash on the sidelines argument. Companies don’t build just for the sake of building. They build when there is demand for some particular goods and/or services. John Hussman has debunked this more than a few times in recent weeks. The problems in the US economy remain demand side problems. Companies will not build just for the sake of building something.
(3) Lower real bond yields/ credit spreads help to improve housing affordability;
There is almost no evidence showing that lower interest rates will spur the housing market in this environment. Japan is Exhibit A, however, we’re seeing similar evidence here in the US. Since interest rates peaked in 2007 the real estate market has plummeted. Despite a full 2% decline in mortgage rates existing home sales have fallen 27% while housing prices have fallen 30%. I would argue that interest rates are a small factor in the current housing outlook (see my full outlook for important details).
“(4) Low bond yields give governments more discretion on fiscal policy and might encourage a looser fiscal policy (as otherwise they might be forced into premature tightening by high and rising bond yields)-it is worth noting that in the last 3 weeks the US have de facto eased fiscal policy slightly as a result of lower bond yields (we saw $32bn of further unemployment benefit being renewed and more recently $26bn of help to states/local governments);”
The argument that low interest rates are an effective government refinancing is simply not true. As the sovereign issuer of currency the US government can always fund its interest payments on bonds. Government spending is not a function of bond markets. In fact, it is the opposite. The bond market is a monetary tool that the Fed uses to control the overnight rate which is done by controlling excess reserves in the banking system. The US government did not spend more because borrowing rates declined. The government spent more because it decided that there were idle resources worthy of expenditures (the effectiveness of said spending is highly debatable and for another discussion, however, for this discussion I believe CS has the cause and effect entirely wrong). Low interest rates do not make spending more affordable just like high interest rates did not restrain Ronald Reagan from running high deficits in the 80′s.
“(5) Weaker currency. A weaker dollar in effect will export US monetary policy (if the Yen were to for example strengthen dramatically further, then the BoJ would probably resort to more aggressive QE).”
First off, the BoJ realized many years ago that QE was an exercise in futility (they have said so themselves). Second, there is no reason why QE should result in a weaker currency as the Fed is not creating net new financial assets via this policy. The currency argument is an extension of the inflationist misconception regarding QE and as we saw in Japan, is simply not true.
Credit Suisse is one step ahead of me, however, and says Japan is not an applicable example:
“In Japan’s case, we believe QE did not work because it was very late (it happened four years after deflation started) and also not sufficiently bold. Our Japan economist, Hiromichi Shirakawa, believes that buying JGBs did little to affect price expectations and that the BoJ needed to buy risk assets such as property-related securities, bad loans or equities. We have always thought that the end game to the current situation was an extended period of low real bond yields. If real bond yields in the US are zero, then fiscal tightening of 4% of GDP is required to stabilise government debt to GDP (assuming a normal economic recovery). If real rates are 3%, then fiscal tightening of 7% of GDP is required.”
I believe CS misses the whole point here. In times of a balance sheet recession the problems exist on the demand side, not the supply side. Adding more apples to the shelves does not change consumer behavior. QE did not work in Japan because the private sector was deeply indebted and there was no demand for debt. Therefore, adding reserves to the banking system did not influence private sector demand for debt.
As I have maintained (and the BoJ concluded several years ago) quantitative easing (and monetary policy in general) is highly ineffective at a time when the private sector is paying down debts. In my opinion, QE remains the most overhyped non-event in recent history.
1. It may be arguable, but it’s the whole point of QE. Read PIMCOs comments today. Whether it works is simply a function of how big the QE is. This has very little to do with bank lending, and everything to do with creating a perceived wealth effect for asset holding consumers. They are desperately trying to increase velocity without triggering a full blown currency collapse, that’s why the QE is so half-hearted.
TPC said:
“The argument that low interest rates are an effective government refinancing is simply not true.”
Disagree a touch. I think lower Bonds yields help quite a bit. Let me make my case.
Given that the GAO still accounts for interest on publicly held debt in the budget, lower rates do give more fiscal flexibility I would argue. We are “paying”, for lack of a better term, almost 3% of GDP (and a healthy chunk of the deficit) in interest payments, for fiscal 2010 (estimated at 8% of GDP for 2030 with generous revenue growth) Now YOU, might not worry about that, MMTers might not worry about that, but the GAO themselves does – and congress does, so maybe it matters.
http://www.gao.gov/new.items/d10468sp.pdf
So I’m not disagreeing with what you say regarding debt interest payments in the technical sense as you have laid out, but rather in a perceived sense of fiscal flexibility. Would it not calm the deficit hawks? As longer dated Treasuries roll off and are “refi-ed”, if you will, at lower rates. Would this not shrink the “deficit”?
Does the FED swallowing Treasuries ad infinitum not lower Treasury yields, and thus our “debt payment stream”? Thus giving Congress more leeway on spending?
Don’t know if I have made my point clearly but am I off my rocker?
(SPu’s down 16.00 bucks – look out bumpy day coming
But debt interest payments are only 4.63% of the federal budget, so it wouldn’t provide that much leeway.
“Within 12 years…the largest item in the federal budget will be interest payments on the national debt,” said former U.S. Comptroller General David Walker. “[They are] payments for which we get nothing.”
Comments like these get people riled though..
http://abcnews.go.com/Politics/national-debt-budget-deficit-scary-forecast-taxpayers-obama/story?id=9854459
We certainly do get something. Anyone buying a bond gets a low risk interest bearing asset. And the central bank gets to maintain control the of bond markets….Those are not minor events. They are ENORMOUSLY important events.
The US government did not spend more because borrowing rates declined. The government spent more because it decided that there were idle resources worthy of expenditures (the effectiveness of said spending is highly debatable and for another discussion, … TPC
A bailout of the debtors and an equal sum to the savers would directly address the problem. And as for government “debt”, that shell game should be abolished by the US Treasury simply spending into existence new legal tender fiat. No sovereign government should ever have to borrow money.
As Pettis has discussed in China, it is possible that lowering interest rates, even with healthy consumer balance sheets and high savings rates do nothing to stimulate consumer spending, but it does a good job of creating poor quality fixed investment and asset speculation. Will we see this in the US with rising savings rates? I think the biggest negatives for the US is still demographics and the changing asset allocation that goes with that … people talk about the better demographics for the US, but the truth is that the asset-weighted age is increasing in the US. Let’s face it, outside of the government directly managing consumer accounts and the economy, there is not much it can really do. The only thing managing monetary policy can do successfully (in the long term) is to set the basic conditions to create “working capital” for the economy. The only other thing a government can do to bring out latent consumption is to reduce long-term perceived economic/income volatility.
TPC,
Great article. I liken QE to the paradox of thrift – effective in any state of the economy except in the state that its actually needed – namely when there is a ‘balance sheet’ recession as there is currently.
This is what everyone and their mother seems to be misunderstanding. This is not your typical recession. The private sector is sunk. It’s a demand side issue. No one seems to get this. Especially Bernanke.
TPC,
I like the press you’ve been getting lately. It’s deserved and good for business. But Altucher? Not so much.
Why QE will not work:
http://www.bloomberg.com/news/2010-08-11/u-s-is-bankrupt-and-we-don-t-even-know-commentary-by-laurence-kotlikoff.html
I always like a good fear mongering article. We are in one heck of a mess, but bankrupt we are not….
>(3) Lower real bond yields/ credit spreads help to improve housing affordability;
While household balance sheets still show too much debt, their debt service ratio is already back to what it was in 2000.
http://www.federalreserve.gov/releases/housedebt/
With a 6% savings rate, it will continue to improve quickly.
Let’s hope that trend continues. The savings rate has been awfully volatile….
Japan is not particularly comparable to the US, as it is export-dependent and has policies and regulations that serve to restrict consumption.
Japan had a good run when the yen was cheap and it was able to use its once-cheap currency and growing reputation as a value producer to build strong export growth. But that whole thing sputtered out once the yen leaped in value and wages went up. Even Japan’s low unemployment rates could not fix it, as consumption and investment flattened out.
In contrast, the US is not export dependent, has an aggressive consumption culture and better demographics, and still has relatively high unemployment, all of which provide it with more upside potential than Japan ever had. The US can fix itself with consumption and, over the long run, job growth in ways that Japan cannot, given its fixation on maintaining an export-based economy.
The US does share the same debt overhang problem, but that debt will eventually be written down to the extent that asset inflation doesn’t fill the gap. Those charge offs have already happened with credit cards, and it’s a matter of time before banks start charging off more mortgages. (Their excess reserves will make it possible to do the latter.)
How will their excess reserves help them charge off more mortgages?
How will their excess reserves help them charge off more mortgages?
For one, their balance sheets are improving, which allows them to recognize these losses without tanking their stock values.
For another, my bet is that the Fed is encouraging the larger banks to stockpile reserves in part so that they can use those funds to eventually acquire the smaller troubled banks. Since those loans in the bad banks will be acquired below par, the new lender will have more incentives to work many of those out or charge them off.
You’re confusing capital with reserves again….They’re not the same thing.
You’re confusing capital with reserves again
No confusion here. You’re allowing your views on MMT to cloud things so that you miss my point.
reserves can only be used for interbank lending and government bond purchases.
Excess reserves are, by definition, excess — they aren’t required. The official Fed explanation is that they expect those reserves to eventually be turned into consumer and business loans, but the money could be put to other uses, such as M&A (particularly when the deals are brokered by the FDIC.)
I’m not sure what MMT has to do with any of this. You seem to fall back on that every time you’re caught in a bind. MMT is not a theory. It is the actual way our monetary system works. The amount of reserves would not change if the bank *uses* them. The amount of reserves in the system is set by the central bank. My experience with regulators is that there are laws that restrict what banks can and can’t do with their reserves. I could be generalizing, but I think you’re making the same mistake that Bernanke is by assuming that excess reserves somehow improve the potential standing of banks. The whole point of my argument(s) has been to show that increasing reserves has very little impact so long as there are no borrowers.
I’m not sure what MMT has to do with any of this.
Your interest in it seems to interfere with these discussions, such as your position that reserves and capital are unrelated, when they in fact go hand in hand. Just because banks aren’t “reserve constrained” in a strict sense does not mean that banks and the Fed aren’t interested in increasing reserve balances.
The fact that the Fed would have begun paying interest on excess reserves in late 2008 tells you that the Fed wants banks to increase them, whether or not you personally believe that it isn’t necessary. They’re setting the policy, so to understand what motivates them, you need to understand their perspective.
And this is without even mentioning the insanity of encouraging M&A in the banking sector.
I’m not offering an opinion on whether they should or shouldn’t do it. (For these purposes, my opinion on what should or shouldn’t happen is irrelevant.) Rather, I am trying to predict what they will do.
The FDIC has not seized nearly the number of institutions that it could have, despite staffing up for such an event. You should ask yourself why that is. I suspect that it’s because they want to handle it using the Washington Mutual/ Chase model — create a “bad bank” that is eventually liquidating, and having a large- to medium-sized player acquire the “good bank.” I am going to guess that the original plan was to use TARP for these purposes, but when TARP became politically unpopular, they decided to generate some headlines of TARP repayments while the Fed simultaneously helped the banks to amass cash, which they could use down the road for expansion.
The trend of the last 30 years has been to create larger banks. The theories are that (a) US banks need to grow in order to compete in a global banking market and (b) it is logistically easier to handle a crisis comprised of a few larger banks than it is to grapple with hundreds or thousands of tiny banks. You may not like it, but my guess is that you’ll be seeing more of this sort of brokering occurring quietly over the next few years. Community banking isn’t dead, but the ongoing creation of banking conglomerates is inevitable.
You act as if this is theory though. You talk down to me for utilizing MMT in my explanations of the monetary system because you think it is a theory and nothing more. You have soaked up your textbook explanations and trust them at face value without reservation. But the real world is not a textbook world. Banks are not reserve constrained. That is not theory. It is a fact. A stone cold fact. You seem to believe that Ben has succeeded to some extent by adding reserves and promoting such policy, but the facts point to the exact opposite. You’ve fallen for this textbook idea that adding reserves is some silver bullet – the whole money multiplier hogwash that we all learned in school and only now realize is nonsense.
Banks are not reserve constrained. That is not theory. It is a fact.
It is a fact that banks in the US do have reserve requirements.
It is a fact that the Fed began paying interest on excess reserves in late 2008, in response to the financial crisis.
It is a fact that the major banks have built these excess reserves, with the full knowledge of the Fed.
Those statements are purely factual, with not one iota of theory and nary a hint of a textbook attached to them.
You may believe that reserves don’t matter. But Ben Bernanke and his team obviously don’t agree with you. And since he’s the one who is in charge of policy, I’m going to be accounting for his viewpoints when I’m trying to decipher what is happening and attempting to forecast likely outcomes.
It is no secret that Bernanke was a student of the Great Depression. And the conclusions that he reached from his studies is that the banking system has to be preserved in order to prevent a collapse. If we are going to prognosticate about likely policy actions, we need to remember where he is coming from and what keeps him up at night. For him, it’s mostly about banking.
You rely on Bernanke (who has been entirely wrong about everything thus far). I’ll stick to more reliable and accurate sources.
I haven’t been here in a while. I was hoping you had headed back to the YAHOO boards. I guess not. You YAHOO!
Reading through Credit Suisse remarks make me laugh. It sounds like the logic our lawmakers use. Total nonsense.
We are entering a phase when the FED is going to be making a lot of noise. Noise is all it will be. The Fed can not do anything at this point. Somebody needs to remind Ben that the sub-prime borrower is gone, checked out, broke, taken to the cleaners and gone fishing (while receiving unemployment of course).
The markets aren’t going to respond favorably to the FED this time. Jokes on you Washington, oh and Ben. What comes first, the consumer spending money or the producer producing goods? The consumer or at least the stupid spenders (sub prime) are broke, broke, and broke. It is this segment of stupid spenders that artificially kept the US economy on auto pilot for a long long time. It’s kind of like the tulip, beanie baby, ostrich, lama and the grand daddy of them all the Tech investor craze of the late 1990’s and early 2000’s.
See, the stupid spenders fueled these phony businesses and now each business is dead and has been for a long long time. Welcome to the “New Normal”. Get used to it.
You rely on Bernanke (who has been entirely wrong about everything thus far).
How exactly is it “wrong” to analyze Bernanke when the goal is to predict what Bernanke is going to do?
If you want to understand Bernanke, then study Bernanke. The pragmatic thing to do is to observe the policy makers and how they decide to make policy. Your opinion (or, for that matter, mine) on what the policy should be has nothing to do with what it is going to be. (Ben doesn’t exactly take my calls — if he takes yours, then let me know.)
@ MBA,
That’s the whole problem though. We’re all trying to figure out where assets might move and if we subscribed to your thesis (or Mr. Bernanke’s) we’d all be out buying equities based on the belief that he can generate an economic recovery by stockpiling reserves. It’s sheer nonsense to believe that his policies will work and that anyone should buy into the idea that he has the silver bullet. Everything he has said, believed and did has been wrong or has not worked. You seem to really believe in this man…..
We’re all trying to figure out where assets might move and if we subscribed to your thesis (or Mr. Bernanke’s) we’d all be out buying equities based on the belief that he can generate an economic recovery by stockpiling reserves
My thesis is to study macroeconomics and policy, and then try to use those facts and personalities to figure out what is going to happen next (and to hedge the downside in the event that I’m wrong.) If you have a better idea, let me know.
You seem to really believe in this man….
I’ve been saying here for ages that monetary policy has limited usefulness when rates are at the zero bound. I’m not sure what there is to “believe” in here, when the Fed is fairly powerless during times like these. The Fed can (and did) prevent collapse, but relying solely on monetary policy now is bound to be slow and expensive.
You want to vilify Bernanke for things over which he has no control. Blame the Congress and, to a lesser extent, the president — the former controls and the latter influences fiscal policy, and as far as I can tell, there isn’t one.
And this is without even mentioning the insanity of encouraging M&A in the banking sector. Do you really think too bigger to fail needs to become too too bigger to fail? It would be mind boggling to me if the Fed encouraged more M&A….
Good discussion TPC and Angry MBA – MMT aside. I tend to agree with Angry MBA’s analysis on what the Fed is driving towards. The FDIC is broke, and there are more bank failures to come, so what’s to be done about those banks? More banks should have failed already, but I believe this has been delayed as Angry MBA has stated to allow the larger banks to accumulate excess reserves for the purpose of acquisition – even if it costs them nothing to acquire the banks other than guaranteeing their losses via those excess reserves. It also explains why Bernanke was so eager to have the Fed be able to pay banks interest for excess reserves. The question is when will this start to happen and how to play it. Angry MBA any ideas on that?
TPC, great post also, Credit Suisse’s analysis is clearly wrong.
MBA lives in a textbook world where banks are reserve constrained and the money multiplier is the truth. This whole debate has nothing to do with MMT. I have no idea why MBA keeps bringing it up. A new Fed paper came out this afternoon that debunks the textbook world that MBA and most other economists have been living in all their lives. Will post some time soon.
and no offense to MBA. He’s a very bright guy clearly, but I think he gets this one wrong….
The FDIC is broke, and there are more bank failures to come, so what’s to be done about those banks?
That’s one of the issues in using MMT as a filter for these discussion — in the world of MMT, the FDIC can’t be insolvent, as we could theoretically swap some assets to fix it.
In real-world practice — not a textbook, but reality — the feds can’t just overtly dump a ton of money into the FDIC to “fix” it. That would spook the markets and provoke real fears (not just the chattering on internet forums, but credible fears from credible people) of inflation.
Instead, a good deal of juggling is required, hence the various methods of pumping cash into the banks in a variety of forms, and the ultimate desire to move bad small banks into the hands of better larger banks. If the world operated on MMT, all that drama wouldn’t be necessary, but since it doesn’t, it is.
The question is when will this start to happen and how to play it
It has actually already started, it’s just a slow process. (Just look at how the FDIC deals with these bank seizures; they almost always involve a handoff.)
I don’t see how to play it, other than the fact that I tend to like financial stocks as a class. It’s not everyday that you find stocks that won’t be allowed to go to zero, and not every business gets the sort of government support that the banks receive…
MBA lives in a textbook world…
I honestly don’t know where you get that from, being that I tend to subscribe to behavioral theories that aren’t found in standard econ textbooks. My graduate-level econ courses were steeped in Chicago School monetarism and supply-side, and never once mentioned the likes of Mandelbrot, Minsky and Fisher.
Really? We can’t just dump money around whenever we want? You really think the market would panic if we rescued the FDIC? You probably thought the same thing about the states as well at some point, but it’s no different. We just dumped $26B into their coffers and I don’t see anyone panicking. The Federal govt dumps money around all the time. Where is the mass hysteria? Where is the currency collapse you imply? That is a what a UNITED states does. The Federal govt should issue currency and rescue its vital components so that its citizenry can access that currency and try to lead productive lives in a world that isn’t dominated by turmoil.
MMT has never said you can just print money to rescue everyone. MMT has never said that a currency can’t be destroyed. You’re just making the same sweeping false allegations about MMT that everyone makes when they first confront it – “oh sure, land rovers for everyone!” It’s absurd and shows that you have not only not studied MMT thoroughly, but that you also have not absorbed it.
You really think the market would panic if we rescued the FDIC?
Sure, the market would panic. If the market came to believe that FDIC protection was compromised, there would massive bank runs and good old fashioned panics, ala the Indymac shutdown: http://articles.latimes.com/2008/jul/15/business/fi-indymac15
http://www.time.com/time/interactive/0,31813,1823864,00.html
It is critical that the markets and public believe that the FDIC will continue to insure and protect their deposits. So far, so good. The world would be a very different place if that wasn’t the case, and that’s not a world that any of us would want to live in.
No, we don’t even want to have a whiff of a hint of a problem with the FDIC. If the FDIC were to simply seize all of the questionable institutions en masse without buyers in the wings, it would have to take down a massive funds infusion, which would make the news, which would create panic. You could make the case that insolvency was impossible, but that would not keep the markets from freaking out.
That isn’t from a textbook, either. We’ve had bank runs before, which is why we have an FDIC. During times like these, that insurance is critical, and we don’t need anything that possibly compromises the integrity of that institution.
reserves can only be used for interbank lending and government bond purchases. these are legal requirements. a bank cant take your deposit and go spend it on M&A.
TPC said: ‘there is no reason why QE should result in a weaker currency as the fed is not creating new financial assets’ Where is the fed getting the assets with which it is expanding it balance sheet? in the last two years the fed’s balance has grown by somewhere close to $2 trillion as the fed has purchased assets from the non fed sector of the economy. The only way i can see for them to do this is by creating new money. Pleae explain how that is not creating new financial assets?
banks can create money if they lend the reserves out. That’s the whole problem though – there are no borrowers.
i understand the money multiplier effect of banks lending money, but that is not what the fed is doing. they are buying bonds on the market with money they created. no other US bank can do that.
you never answered the question of how the fed can grow its balance sheet without creating new financial assets ie money?
I think you’re having trouble understanding when the govt actually creates money. The monetary base is not money. Hoisington had a decent discussion of this the other day (see pg 4) http://www.hoisingtonmgt.com/pdf/HIM2010Q2NP.pdf
How does govt create money? I wish I had a fancy explanation. They just do. When the government wants to buy up private sector resources they just do. When the government wants to spend they just walk into a room and press a button (quite literally). In the case of QE the Fed is effectively buying back money that it has already spent. It is not creating new money. The assets that they are swapping were already spent into existence. The fact that they buy them back (per se) is really of no consequence at all. At some point those assets the Fed owns will mature and the Fed balance sheet will shrink. Big deal. It was not inflationary. It was really a whole lot of nothing besides some misguided attempt to force the private sector into doing something….
TPC, again the mother of all questions : are you net-long or net-short on your equity positions now
any leaning towards any specific sectors?
I am largely cash now in the macro strategy. All of my indicators have rolled over though this is not the same “fat pitch” environment in which I went short in April. I am not doing anything too sexy right now. I wish I was. Sorry. I’m sort of that boring old “lay in the tall grass” mode….
This article is rubbish. We’ve had 30 years of this bs….just inflate the financial assets to build a base for recovery. Forget about deploying fixed assets to put citizens to work so they can build a more secure future. Nope nope lets create another bubble off the financial assets so more volatility, uncertainty and fear exists..good for trading and bs for the citizens.
The government needs to give the major financial institutions in this country a choice, either they divest themselves over the next 6 months of their proprietary trading arms or the government will take them over and do it.
QE won’t work when (all) asset prices are falling. However it will increase the demand for T-bonds. Currently banks aren”t willing to lend. So, they buy Treasuries. So, the FED is effectively propping up the banks and the Federal Government with QE. But that propping up the banks will only help until the banks are going belly up in droves as well. Then all those Treasuries will be released into the markets and the yields WILL rise.
More lies from the people who created the problem to begin with.