I really dislike QE because I have theories about how it actually does work. I think the main channel through which QE has effects is via asset prices. To the degree that QE is taken as a signal of central banks “ease”, it communicates information about the course of future interest rates (especially when paired with “forward guidance”). Prolonging expectations of near-zero short rates reduces the discount rate and increases the value of longer duration assets. This “discount rate” effect is augmented by a portfolio balance effect, where private sector agents reluctant (perhaps by institutional mandate) to hold much cash bid up the prices of the assets they prefer to hold (often equities and riskier debt). Finally, there is a momentum effect. To the degree that QE succeeds at supporting and increasing asset prices, it creates a history that gets incorporated into future behavior. Hyperrationally, modern-portfolio-theory estimates of optimal asset-class weights come to reflect the good experience. Humanly, momentum assets quickly become conventional to hold, andmanagers who fail to bow to that lose prestige, clients, even careers. So QE is good for asset prices, particularly financial assets and houses, and rising asset prices can be stimulative of the economy via “wealth effects”. As assetholders get richer on paper, they spend more money, contributing to aggregate demand. As debtors become less underwater, they become less thrifty and prone to deleveraging. Financial asset prices are also the inverse of long-term interest rates, so high asset prices can contribute to demand by reducing “hurdle rates” for borrowing and investing. Lower long term interest rates also reduce interest costs to existing borrowers (who refinance) or people who would have borrowed anyway, enabling them spend on other things rather than make payments to people who mostly save their marginal dollar. Whether the channel is wealth effects, cheaper funds for new investment or consumption, or cost relief to existing debtors, QE only works if it makes asset prices rise, and it is only conducted while it makes those prices rise in real and not just nominal terms.I think that the asset prices the Fed was targeting was residential housing. A price correction that wiped out the gains from the bubble would have left many bank insolvent and greatly exacerbated the crisis. So the purpose of QE was to prevent liquidation. This had the collateral effect of driving the price of risky assets such as equities higher than they would have been otherwise, adding to the wealth effect. However, I think that supporting housing price was the real aim of the program rather than a broader wealth effect, which the Fed did not mind since it would likely add to spending as a counter to deleveraging.
Interfluidity
Some thoughts on QE
Steve Randy Waldman
I generally consider SRW to be one of the smartest and most articulate writers around. But when he writes stuff like this it drives me crazy. Basically, he's endorsing QE for its value in setting expectations, ignoring the fact that it sets unrealistic expectations.
ReplyDeleteIf we adopt Warren Mosler's proposals ... leave fed funds at zero and only issue short-term securities .... wouldn't that be the same as permanent QE?
ReplyDeleteSo whatever market allocations/behavior become the norm in such conditions we should be ok with, assuming we support his proposals, yes?
Well, the Fed was caught between a rock and hard place, since the monetarist view holds that monetary policy is superior to fiscal policy and therefore the cb is in the control seat rather than the fiscal authority, in the US, Congress, and specifically the House, since that is were appropriation bills are introduced. Add to that the adoption of fiscal austerity, and the burden was left to the Fed.
ReplyDeleteCorrectly, the fed realized that it could not let the financial system implode. Lehman proved that. So while it was late getting out of the starting gate, it came in with ZIRP and the various other programs in addition to QE. To make a long story short, the financial system didn't implode, so in that sense the Fed's strategy was successful.
Could or should the Fed have acted otherwise. Many think so including most MMT'ers. But that's history now.
As I said, I think that SRW is only partially right about QE as a confidence builder through expectations. I see it more in terms of supporting asset prices to prevent a collapse, which could very well have happened. Previous to the crisis I saw this as a real possibility and was advising closing out all positions and going to cash and buying gold after Bear Sterns, when it was becoming obvious how shaky the edifice was. That turned out to be a good call.
The low rates that supported risky assets, the revision of the accounting rules to permit mark to model, the Fed purchase of dodgy MBS and CDOs all contributed to shoring up the system, but leaving the problems in place and in fact increasing systemic risk through further consolidation.
So while I would have done it differently, I can see why the Fed acted using unconventional policy. If team Obama had gotten the stimulus right, then the Fed would have had to do less but that too is history, and a lot of that can be written off to a recalcitrant opposition whose stated goal was to break the president.
So in the end, I blame the politicians for the mess much more than the Fed. Given the political restraints, I'm not sure that the Fed could have done things too much differently. What was needed was true helicopter money, but the Fed is not permitted to do that. Could or should it have requested permission from Congress. Or at least leaned much more heavily on Congress to loosen the fiscal stance. I think so, but again that's history.
It would have been better to incorporate reform right away, too, but I can understand why they didn't want to risk anymore than they absolutely had too in order to stabilize a precarious situation that was not only contagious domestically, taking down the real economy, but also going viral globally, threatening to take down the global economy.
The sad part is that if Warren Mosler's recommendations were adopted and Bill Black listened to, most of this would have been unnecessary and the system would have already been reformed. Instead, we are talking about the next one.
If we adopt Warren Mosler's proposals ... leave fed funds at zero and only issue short-term securities .... wouldn't that be the same as permanent QE?
ReplyDeleteSo whatever market allocations/behavior become the norm in such conditions we should be ok with, assuming we support his proposals, yes?
Not really, since that is only a part of Warren's proposals. Using sectoral balance analysis, functional finance, and the MMT JG go along with it, as well as reforming the financial system.
Well, I understand there are other policy things that should happen as well, on the fiscal and regulatory side, but as far as monetary policy goes,it would be the same situation.
ReplyDeleteIn fact, it would be like even more "intense" QE, since the gov't right now issues securities on the long end of the term structure, and QE is buying up a lot of them, but not all of them. Never issuing at the long end should have the same effect as a QE program that purchased them all up.
So whatever effect the QE policy has on financial market behavior would be the same as now under QE, or even more pronounced.
That's part of the reason for Warren's proposal of ZIRP. It would make investment, including housing, less costly to finance and reduce the amount of rent collected by FIRE.
ReplyDeleteThe reduced cost of leverage in other asset markets could be addressed by upping margin requirements and taxing capital gains as ordinary income.
Financial reform should be directed at reducing economic rent and non-productive "innovation." Capital markets should function to provide capital, not generate rents. The institutional arrangements need to reflect that priority rather than incentivizing rent-seeking.
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ReplyDeleteKen,
ReplyDeleteYou’re right: Warren’s permanent zero interest rate proposal equals permanent QE. Effectively he is advocating the abolition of government debt. Milton Friedman also advocated that, and I agree.
Also, while I can’t speak for Positive Money, they effectively advocate the same far as I can see: that is, they argue that when stimulus is needed, the state should just create new money and spend it, and/or cut taxes. Plus most MMTers have no quarrel with that idea, far as I can see: that is, most MMTers have no quarrel with the idea: “in a recession, create fiat and spend it”.
Ken,
ReplyDeleteYou’re right: Warren’s permanent zero interest rate proposal equals permanent QE. Effectively he is advocating the abolition of government debt. Milton Friedman also advocated that, and I agree.
Also, while I can’t speak for Positive Money, they effectively advocate the same far as I can see: that is, they argue that when stimulus is needed, the state should just create new money and spend it, and/or cut taxes. Plus most MMTers have no quarrel with that idea, far as I can see: that is, most MMTers have no quarrel with the idea: “in a recession, create fiat and spend it”.
Do you have a ref on Friedman advocating something like this? I haven't seen that.
ReplyDeleteI find that even some pundits sympathetic to MMT bring this up a lot ... the supposed ill effects of QE. For example Philip Pilkington.
ReplyDeleteBut ZIRP, which many MMT followers advocate, is permanent QE, in a sense.
So I think more discussion of this point would be a good thing.
Ken The MMT position on why QE is irrelevant to macro growth is pretty straightforward.
ReplyDeleteHere it is:
Step 1: The Govt spends 100 and taxes 90 (deficit), which leaves 10 in the hands of the private sector as net income
Step 2: The extra 10 is the "debt" = Govt liability = ~"money". It doesnt matter to the economy what form of liability this 10 units take. the 10 units can bounce back and forth between reserves and securities infinitely and not make a difference because the 10 never changes.
Thats it. The deficit adds the income and monetary policy just changes the liability type, it does not add any more income
Thanks ... I get that ... but there are those who suggest there is a channel ... namely, that by sucking up the US Treasury issued "safe" assets, QE encourages savers, in search of some yield, to make riskier bets on stocks or bonds, thus "artificially" inflating those markets.
ReplyDeleteThis feeds back into the real economy via wealth effect.
Even Warren Mosler says there are psychological channels that can affect markets ... investors betting on what they **think** the consequences of the Fed's actions are, or what they think others will think they are, etc.
I have no idea how much, if any, these factors have contributed to the stock boom in recent years, but I know there are commentators who apparently understand MMT who would still say they are basically responsible for all of it.
If we move to permanent ZIRP policy, it implies we need to be OK with whatever market allocation or behavior becomes the "norm" under those conditions (or change the rules of the game via regulation, as Tom suggests).
On the other hand, analysts observe that the rise in equities simply reflects the increase in corporate profits and the fundamentals support the price rise, although share buybacks instead of new investment has also been a factor. Without new investment, it's difficult to see how corporate profits can keep rising. However, optimists hold that this is just the beginning of a recovery so there is still a long way to go and that investment will kick in.
ReplyDeleteYet, the Fed itself admits that QE has driven the value of risky assets higher than it would be otherwise. My view is that this has been due to low rates making leverage cheap, and the historically high level of margin use seems to bear that out.
OK, assuming that's true ... if "the natural rate of interest is zero" ... then the valuations are in some sense "correct", as well as the level of margin use.
ReplyDeleteBecause positive risk-free rates of interest, which were the norm up to a few years ago ... and the market valuations that went with that ... are "unnatural".
My view is that borrowing cost should be kept low and skin in the game high, I.e., down payments, margin requirements, etc.
ReplyDeleteThe choice is between low rates and less leverage, or high leverage and high rates. Low rates and high leverage is asking for trouble.
Ken-- I see what you're saying and it makes good sense, especially--
ReplyDeleteI find that even some pundits sympathetic to MMT bring this up a lot ... the supposed ill effects of QE. For example Philip Pilkington. But ZIRP, which many MMT followers advocate, is permanent QE, in a sense. So I think more discussion of this point would be a good thing.
This gets back to my basic disagreement with SR Waldman. The problem is not with low interest rates, and Fed programs to accomplish these. The problem is in expecting this policy to raise asset values and thus give a trickle-down boost to the economy. When expectations are divorced from reality, prices rise more than fundamental values, and bubbles grow. When bubbles burst, the economy is devastated and bailouts of undeserving entities may follow.
The problem is not with the central bank buying bonds. The problem is that this is being used to set expectations inappropriately, resulting in serial bubbles and crashes.
Wouldn't the bubbles and speculation tend to settle down to some kind of norm, though, once it became clear that the ZIRP policy was permanent? That would remove speculation based on what the Fed may or may not do in the future.
ReplyDeleteWouldn't the bubbles and speculation tend to settle down to some kind of norm, though, once it became clear that the ZIRP policy was permanent? That would remove speculation based on what the Fed may or may not do in the future. [Ken]
ReplyDeleteRight. It's the whole phony expectations game that is causing the bubbles. So now the Fed is removing QE so that it will have "ammunition" left when the next downturn comes. Waldman endorses this (as a last resort) and also the even worse "NGDP targeting".
In reality, central banks tie interest rates to inflation and that is a reasonable alternative to the Mosler-style zero natural rate of interest. The important point is that the central bank interest rate does not drive employment or inflation, and we should get away from pretending it does.
In reality, central banks tie interest rates to inflation and that is a reasonable alternative to the Mosler-style zero natural rate of interest.
ReplyDeleteMosler argues that raising interest rates will actually cause a bump up in inflation because it raises producer costs (to the extent that their activities require financing).
If that's the case it's easy to imagine them chasing their tail on that one.
The whole NGDP targeting thing seems based on the notion that they can guide the economy smoothly along some phillips curve to get the desired tradeoff between employment and inflation.
ReplyDeleteI think it's probably just as much a fantasy as the so-called "money multiplier".
Well said on both points, Ken.
ReplyDeleteI read a book several years ago about the Great Depression ("Lords of Finance: The Bankers Who Broke the World", by Liaquat Ahamed). Right up until the end (crash and continuing plunge), the public thought the central banks would fix things. Some more recent economists (e.g. Milton Friedman) still believe that the central banks could have stopped the Great Depression. But it was only actions beyond the power of central banks that proved effective -- things like getting off the gold standard, guaranteeing bank deposits, implementing state control of industry.