QUANTITATIVE EASING: “THE GREATEST MONETARY NON-EVENT”

The topic of quantitative easing (QE) has rapidly become the most important discussion in the investment world.  As deflation becomes the obvious risk and the economic recovery looks increasingly weak investors are again looking to the Fed to save their skin from a Japan style deflationary recession.  The irony here is so thick you could choke on it, however, like some sort of sick masochist, investors continue to return to the trough of the Federal Reserve so they can gorge on half-truths and misguided policy responses.

There is perhaps, no greater misunderstanding in the investment world today than the topic of quantitative easing.  After all, it sounds so fancy, strange and complex.  But in reality, it is quite a simple operation. JJ Lando a bond trader at Goldman Sachs has eloquently described QE:

“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”

Some investors prefer to call it “money printing” or “stimulative monetary policy”.  Both are misleading and the latter is particularly misleading in the current market environment.  First of all, the Fed doesn’t actually “print” anything when it initiates its QE policy.  The Fed simply electronically swaps an asset with the private sector.  In most cases it swaps deposits with an interest bearing asset.  They’re not “printing money” or dropping money from helicopters as many economists and pundits would have you believe.  It is merely an asset swap.

The theory behind QE is that the Fed can reduce interest rates via asset purchases (which supposedly creates demand for debt) while also strengthening the bank balance sheet (which entices them to lend).  Unfortunately, we’ve lived thru this scenario before and history shows us that neither is actually true.   Banks are never reserve constrained and a private sector that is deeply indebted will not likely be enticed to borrow regardless of the rate of interest.  On the reserve argument the BIS explains in great detail why an increase in reserves will not increase borrowing:

“In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.

The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 – by far the most common – in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively.

The main exogenous constraint on the expansion of credit is minimum capital requirements. By the same token, under scheme 2, an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. This is true in both normal and also in stress conditions. Importantly, excess reserves do not represent idle resources nor should they be viewed as somehow undesired by banks (again, recall that our notion of excess refers to holdings above minimum requirements). When the opportunity cost of excess reserves is zero, either because they are remunerated at the policy rate or the latter reaches the zero lower bound, they simply represent a form of liquid asset for banks.”

The most glaring example of failed QE is in Japan in 2001. Richard Koo refers to this event as the “greatest monetary non-event”.  In his book, The Holy Grail of Macroeconomics, Koo confirms what the BIS states above:

“In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession.  If there were many willing borrowers and few able lenders, the Bank of Japan, as the ultimate supplier of funds, would indeed have to do something.  But when there are no borrowers the bank is powerless.”

In the same piece cited above, the BIS also uses the example of Japan to illustrate the weakness of QE.  The following chart (Figure 1) shows that QE does not stimulate borrowing (and the history of continued economic weakness in Japan is coincidental):

“A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly.”

(Figure 1)

Koo goes a step further in describing the failure of QE to promote private sector recovery.  His simple example is one I have used often:

“The central bank’s implementation of QE at a time of zero interest rates was similar to a shopkeeper who, unable to sell more than 100 apples a day at $100 each, tries stocking the shelves with 1,000 apples, and when that has no effect, adds another 1,000.  As long as the price remains the same, there is no reason consumer behavior should change–sales will remain stuck at about 100 even if the shopkeeper puts 3,000 apples on display.  This is essentially the story of QE, which not only failed to bring about economic recovery, but also failed to stop asset prices from falling well into 2003.”

Koo continues by emphasizing how ineffective monetary policy is during a balance sheet recession:

“Even though QE failed to produce the expected results, the belief that monetary policy is always effective persists among economists in Japan and elsewhere.  To these economists, QE did not fail: it simply was not tried hard enough.  According to this view, if boosting excess reserves of commercial banks to $25 trillion has no effect, then we should try injecting $50 trillion, or $100 trillion”

After years of placing more apples on the shelves the Bank of Japan finally admitted that the policy had been a failure:

“QE’s effect on raising aggregate demand and prices was often limited” (Ugai, 2006)

That all sounds too eerily familiar, doesn’t it?  No, no – Mr. Bernanke hasn’t failed.  He just hasn’t tried hard enough….But perhaps the reader believes Japan is different and not applicable.  This is a reasonable objection.  So why don’t we look at the evidence from the last round of QE here in the USA.  Since Ben Bernanke initiated his great monetarist gaffe in 2008 there has been almost no sign of a sustainable private sector recovery.  Mr. Bernanke’s new form of trickle down economics has surely fixed the banking sector (or at least bought some time), but the recovery ended there.  It did not spread to Main Street.  We would not even be having this discussion if we were in the midst of a private sector recovery.  The surest evidence, however, is in the Fed’s own data.  We can also look at the Fed’s recent Z1 to show that households remain hesitant to borrow (see Figure 2).  Friday’s consumer credit data was yet another sign of contracting consumer credit and a lack of demand for borrowing.  Despite the Fed’s already failed attempt at QE (see Figure 3) we are convinced that Mr. Bernanke just needs to throw a few more apples on the shelves.  The historical evidence is clear – QE will do little to stimulate borrowing and help generate a private sector recovery.

(Figure 2)

(Figure 3)

In addition, there is one great irony in all of this misunderstanding.  The hyperventilating hyperinflationists and those investors calling for inevitable US default are now clinging to this QE story as their inflation or default thesis crumbles before their very eyes.  The new hyperinflationist theme has become a story of “if this, then this, then THIS!” – the ludicrous 3 step investment thesis that the economy will become so fragile that the government will pile on with more stimulus, which will worsen matters and force them to stimulate further which will then result in hyperinflation and/or default. Most investors have enough trouble predicting what the next event will be – connecting the dots two or three steps down the line is not only ill-advised, but is hardly even worthy of consideration….Let’s just call a spade a spade – the inflationistas have been wrong and the USA defaultistas have been horribly wrong.

What is equally interesting (in addition to the fact that QE is not economically stimulative) with regards to this whole debate is that this policy response in time of a balance sheet recession is not actually inflationary at all.  With the government merely swapping assets they are not actually “printing” any new money.  In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits.  This might have made some sense when the credit markets were frozen and bank balance sheets were thought to be largely insolvent, but now that the banks are flush with excess reserves this policy response would in fact be deflationary – not inflationary.  Why would we remove interest bearing assets from the private sector and replace them with deposits when history clearly shows that this will not stimulate borrowing?

All of this misconception has the market in a frenzy.  Portfolio managers and day traders can’t wait to snatch up stocks on every dip in anticipation of what they believe is an equivalent to the March 9th 2009 low that was cemented by government intervention.  As I have long predicted Ben & Co. have failed.  If there is one thing that we know for certain over the last 24 months it is that Mr. Bernanke’s monetary policy has done very little to get the private sector back on its feet.  This man failed to predict the crisis (was in fact oblivious to its potential), initiated the wrong trickle down policy response and yet now we turn to him to save us from a double dip and his Committee responds with more discussion of QE?  Will we ever learn?

In describing the negligence of such monetary policy Richard Koo uses the analogy of a doctor who simply tells his patient to take more of the same medicine he originally prescribed:

“At the risk of belabouring the obvious, imagine a patient in the hospital who takes a drug prescribed by her doctor, but does not react as the doctor expected and, more importantly, does not get better. When she reports back to the doctor, he tells her to double the dosage. But this does not help either. So he orders her to take four times, eight times, and finally a hundred times the original dosage. All to no avail. Under these circumstances, any normal human being would come to the conclusion that the doctor’s original diagnosis was wrong, and that the patient suffered from a different disease. But today’s macroeconomics assumes that private sector firms are maximizing profits at all times, meaning that given a low enough interest rate, they should be willing to borrow money to invest.. In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession.”

Dr. Bernanke has misdiagnosed this illness one too many times.  At what point does someone tell him to put the scalpel down and step away from the table before he does even greater harm?

References

BIS (2009) https://www.bis.org/publ/work292.pdf

Koo, R (2009) The Holy Grail of Macro Economics

Ugai, H (2006) Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses.  Bank of Japan Working Paper Series no 6-E-10

This paper is also available for download in PDF format at SSRN:  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1655039