Warren Mosler — Warren Mosler: Consumer Borrowing Has Kept Economy Afloat, but for How Much Longer?

Yves here. Warren Mosler, who is one of the leading writers on Modern Monetary Theory, circulated an e-mail with his assessment of the state of the economy and the impact of quantitative easing and agreed to letting me publish it.

I’ve only got one area of difference with his assessment. He thinks thathaving ended QE will be more positive economically than some might believe because savers will have more interest income. However, like many, I have my doubts about the adjustment process. The Fed and the Administration have relied heavily on the confidence fairy (supported by a recovery in wealth levels due to super low interest rates) and as he details, deficit spending and consumer borrowing. Past tightenings have always been gradual and on the short end of the yield curve, which means the effect on long-term bond yields has similarly gradual. Here, we’ve had a sharp move in a month. ZIRP and negative real yields gave investors incentives to go for riskier assets (indeed, some argued that was the point of QE). 

And even though Mosler speaks of eventual benefits for investors in terms of income (ie, assets will be priced to provide decent income), they are going to suffer mark-to-market losses getting there. The wealth effect isn’t as strong for stocks as for housing, but there has to be a wealth effect for bonds as well. How will retail investors react in a world where Vanguard and Schwab give them intraday prices to bond losses (many investment advisors recommend a 50/50 or 60/40 stock/bond allocation, although Mandelbrot would have told you that was way too high)? Even if they hated the lost income under the ZIRP and QE regimes, I find it hard to believe they did not see themselves as having more wealth when their computer screen and monthly statements told them so. How will they react to Uncle Ben’s bond market whackage, particularly since the stock market should also pricein higher required returns (ie, start assigning lower multiples to earnings)?

Mind you, I’m not arguing against a QE exit; I was never a fan in the first place. It’s the idea of exiting when the impact of deficit-cutting is grinding through a not-so-hot economy that gives me pause. While Mosler argues that investors have reacted to QE incorrectly, their reaction to its reversal can’t help the underlying dynamic he describes.

Wall Street acted irrationally to QE — work of the "confidence fairy" and "expectations imp" —  so it's likely that it will react to QE ending in either a similarly irrational way as the artificially stoked confidence fades and inflated expectations are deflated, or else it will wake up and realize that asset appreciation was really asset inflation without basis in fundamentals. In both cases, there is the possibility of a Wiley Coyote moment in a rush for the door and a reversal in the "wealth effect."

But I miscalculated the degree of euphoria on the way up, and hopefully I will be wrong about a Wiley Coyote moment as the way down. Maybe markets will stabilize quickly as the Fed begins to take away the punch bowl or hints at doing it, but given consumer reluctance to borrow on the previous scale, the political dysfunction that persists in the US, and the precarious global context, caution seems warranted.

Naked Capitalism
Warren Mosler: Consumer Borrowing Has Kept Economy Afloat, but for How Much Longer?
Warren Moser