Trepidation About Quantitative Easing, Version 2.0

The Fed made official its move to quantitative easing today, and said it will take no prisoners until it has lowered rates and credit spreads further:

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability…

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

I (literally) have a very bad feeling in my stomach. This move is a sign of utter desperation. And it is on such a massive scale that if it does not work well, we will have a great deal of difficulty containing its effects.

A conventional view of how this plays out comes from Martin Wolf of the Financial Times: the Fed’s extreme measures will of course prevail, but at the risk of considerable inflation:

Central banks may soon resort to their most powerful weapons against deflation: the printing press and the “helicopter drop” of money. It is a time for which Ben Bernanke, chairman of the Federal Reserve, has long prepared. Will this weaponry work? Unquestionably, yes: used ruthlessly, it will eliminate deflation. But returning to normality thereafter will prove far more elusive….

Once inflation returns, the central bank will need to sell assets into the market, to mop up the excess money it has created in fighting deflation. Similarly, the government must reduce its deficit to a size it can finance in the market. Otherwise, deflationary expectations may swiftly turn into expectations of above-target inflation. This may also happen if the debt sold in efforts to sterilise the monetary overhang is deemed beyond the government’s ability to service.

Countries without a credible currency may reach this point early. As soon as a central bank hints at “quantitative easing”, flight from the currency may ensue.

As an aside, I had dinner with some well placed Japanese executives this evening (as in the host, for instance, co-authored papers with Eisuke Sakakibara, aka “Mr, Yen.” and knows other policy officials personally), and all thought that the dollar would continue to be strong until the US economy started to recover, then investors would be more willing to hold riskier currencies. They dismissed the idea of a dollar crisis (there think there will be no substitute for over 20 years) or of the use of gold or commodities as possible substitutes/stores of value (not a gold standard, but increased monetization of “hard” assets), since those markets are small relative to the currency markets. I found the unwillingness to consider other than “business as usual” scenarios troubling.

In addition, one of the executives was interviewing candidates from top schools in China for a US position, and asked what their outlook for the RMB was. To a person, they expect it to fall relative to the dollar. Each had his own reasoning, but the most consistent and compelling theme was that the Chinese government valued preserving employment above all, and was not going to let the RMB appreciate at a time when exports were weak.

Now it is important to appreciate the Fed’s emphasis in its version of quantitative easing, which we will call QE2. The Wall Street Journal Economics Blog gave additional detail from a press conference after the FOMC meeting:

But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did. The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.

What is NOT encouraging is the Fed has already made heroic measures in this direction, via the creation of its alphabet soup of facilities, and the results have been underwhelming. The results have been limited and short-lived (consider the successive acute phases of the credit crisis). Now admittedly, we do not appear to be having a year-end squeeze, which is a victory of sorts, but the Fed also expanded the Term Action Facility to massive size. A1/P1 commercial paper seems to be functioning reasonably well too, although the types not supported by the Fed are still under duress.

Indeed, a Bloomberg story stresses the limited progress to date:

For all their efforts to liquefy credit markets, the Federal Reserve and the Treasury show no signs of ending the 18-month freeze, as evidenced by the unprecedented gap between what banks and the U.S. government pay to borrow money.

The difference between the London interbank offered rate, or Libor, that banks charge each other for three-month loans and Treasury bill rates is six times wider than before markets began to seize up in June 2007. Even though the so-called TED spread narrowed to 1.82 percentage points yesterday from 4.64 percentage points in October, prices of contracts to borrow money months from now show investors don’t expect lending to recover until at least the second half of 2009.

“If you take a full assessment of the credit markets, conditions have certainly eased from their worst, but they still are at extraordinary tight levels, which are far from normal,” said Michael Darda, the chief economist at MKM Partners LP in Greenwich, Connecticut. “Short-term funding spreads are all still very wide relative to historical norms. There is a massive pullback going on in the private sector.”

Several experts also say they expect the new programs will help in six months, with no explanation as to why.

Before we get to the conventional worry, that the Fed will be reluctant to put on the brakes soon enough once the economy starts to recover and wind up with pretty bad inflation. there are other issues that are getting short shrift.

The first is that the prescription presupposes that the problem is a liquidity crisis. It does not take seriously the notion that at least part (if not all) of the problem is that a lot of people and companies took on far more debt than they can afford to repay. Anna Schwartz, who was co-author with Milton Friedman of A Monetary History of the US, which is one of the definitive works on the Great Depression. It argued the Fed erred fatally then by not providing enough liquidity, .

Schwartz took the Fed to task:

Credit spreads — the difference between what it costs the government to borrow and what private-sector borrowers must pay — are at historic highs….

…even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is “the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue….

Today, the banks have a problem on the asset side of their ledgers — “all these exotic securities that the market does not know how to value.”…

[H]e’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. “They should not be recapitalizing firms that should be shut down.”

But the problem goes much further than “toxic securities”. Remember the premise of how the Fed’s program will work. It will buy various instruments to force spreads lower so as to lower cost to borrowers.

The implicit logic is that if you lower rates enough, voila, the debt service cost drops and formerly dud borrowers are now viable.

But how do borrowers get their hands on these new, better rates?

Quite a few borrowers are up to their eyeballs already in debt, and no way to refinance. Take credit cards. Supporting credit card receivables may allow credit card companies to stop slashing consumer credit lines (although both Meredith Whitney and apparently industry sponsored studies agree that banks will cut credit card availability further due to pro-consumer changes that will make the product less profitable). But it does nothing for consumers carrying balances (unless we see a revival of, say, six month teaser offers).

Similarly, for homeowners to get relief, they have to refinance. Now for many, that’s a no-brainer. But the ones with no or negative equity have no ready solution, plus starting in 2009 and accelerating in 2010 are the option ARM resets. Even with low rates, many of these mortgages have enough negative amortization that consumers will suffer serious payment shock.

But then again, we are assuming that lenders have more or less responsible standards. The powers that be may decide to run roughshod over that. As Accrued Interest noted:

The big wild card is government policy. There is talk that Treasury might allow for no-appraisal refinancing, basically lending based on original loan-to-value as opposed to current loan-to-value. Debate the wisdom of this policy as you might, it would case a massive refinancing wave that would make 2003 look like a a splash in the kiddie pool.

And in other areas, stress is starting to get serious in types of debt not yet on the Fed’s target list. From Eric Hovde in Institutional Risk Analyst:

One of the problems that is rapidly approaching is commercial real estate mortgages. Res mortgage are the largest asset class in the banking system. Commercial real estate mortgages are the second largest asset class in the banking system. Unfortunately much of the underwriting sins that started in the res market in 2002 crept into the commercial sector as well by 2004 and 2005, plus you never dealt with the massive excess inventory surplus of commercial office space post the Internet boom. Because financing costs became so low, real estate values kept shooting up and builders kept building more. So you have a national vacancy rate of 15%, which is moving higher every quarter. I think you are going to see major losses coming through the commercial real estate books of the banking industry.

Commercial real estate is not yet on Bernanke’s list. Neither is debtor-in-possession financing, and we and others have lamented that the death of it means that companies that fail and would ordinarily be able to get through Chapter 11 and preserve most of their employment will instead liquidate.

Consider further: the Fed assumes it has no constraints, because it can bloat its balance sheet to any size. But it has limits of staff, focus, expertise that restrict what it can do. For it to succeed in its aims, it is going to have to intervene on behalf of every type of troubled credit and make allocation decisions among them. Going on auto pilot (that is, dealing with the “presenting problems”, the ones that surfaced first, means that they get priority when that might not be the best use of collective resources (it is not desirable from a competitive standpoint to bloat our housing sector back to status quo ante).

Other observers were lukewarm. The Economist questioned whether the Fed could in fact influence credit spreads as much as it hoped to:

….the creation and expansion of an array of lending programmes….have so far no doubt kept the interest rates that are charged to actual private borrowers lower than they otherwise would be, the effect has been difficult to detect, and certainly smaller than what the Treasury achieved through direct injections of public capital into banks.

In theory, purchases of longer-term securities could have more impact by pulling down longer-term interest rates. The 10-year Treasury yield, for example, is 2.3%, and the 30-year conventional mortgage-rate is around 5.5%. But whereas the Fed knows more or less just what it has to do to move short-term interest rates up or down, it is in uncharted territory on longer-term interest rates. Indeed, theory suggests that the purchases would have to be spectacularly large to affect such large, globally integrated markets.

A senior Fed official, briefing reporters after the FOMC meeting, rejected the notion that the Fed was trying explicitly to target lower long-term rates, and rather framed the Fed’s new actions as an extension of previous efforts at restoring liquidity and normal trading conditions. The official said that yields on Fannie’s and Freddie’s MBS, despite the explicit support of the Treasury, are much higher than Treasury yields because of a lack of liquidity. The Fed can narrow that spread, he said, by providing investors with the confidence that a committed buyer is in the market.

Um, MBS have traded at high spreads at least in part due to volatility, which makes the prepayment option worth more, hence higher spreads. No doubt the Fed parsed that bit out. But as I understand it, foreign central banks, which used to be big buyers of agencies, have switched to Treasuries, not comfortable about the lack of a “full faith and credit” guarantee. The statutory authority for the conservatorship extends through the end of 2009, although it is widely assumed it will be renewed, plus Fannie and Freddie are NOT full faith and credit obligations of the US (the Treasury has instead entered into a “no negative net worth” guarantee. The differences may seem semantic, but they are seen as serious in some quarters. If that is the real issue, more Fed buying will not entice the key buyers, central banks, back into the pool.

Jim Hamilton is also doubtful, and suggests that the Fed is working at cross purposes:

Will that strategy succeed if we just do it on a sufficiently large scale? I’m not at all convinced that it would. Our standard finance models treat interest rate spreads as governed primarily by fundamentals such as default risk and only secondarily by the volume of buyers or sellers.

But while the Fed may have little control over the spreads between different interest rates, it does have a significant degree of control over the inflation rate. The 1.7% drop in headline CPI during November, and the -10% annual deflation rate for the last 3 months, should not be viewed as welcome developments in an environment where our primary concern is whether individuals and institutions are going to repay their debts. The Fed should want to generate enough inflation to pull those short-term interest rates above the zero floor. But to target inflation, the Fed would take exactly the opposite strategy from that outlined by the senior Fed official above. The goal would be to get cash into circulation rather than be hoarded by banks, and have the Fed’s assets be ones that could be readily liquidated if the inflation starts to come in higher than desired.

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  1. ndk

    And it is on such a massive scale that if it does not work well, we will have a great deal of difficulty containing its effects.

    We’ll have a great deal of difficulty containing its effects if it does work, as well. I love programs like that.

    The first is that the prescription presupposes that the problem is a liquidity crisis.

    Thanks for repeating this, Yves. Let’s all remember that this didn’t arise as a classical collapse in demand; instead, the system as a whole was so heavily laden with debt that the most heavily exposed players were crushed under the load. Treating symptoms rather than the problem is just inviting problems.

    Consider further: the Fed assumes it has no constraints, because it can bloat its balance sheet to any size. But it has limits of staff, focus, expertise that constrain what it can do.

    As I’ve been incessantly repeating, I don’t believe that’s true, in a sense. The Fed has very strong balance sheet constraints: not size, but solvency. If the Fed is indeed underwater, it’s very difficult for the Fed to recover without a significant direct infusion from the Treasury, which is political unpalatable, or a massive purchase spree.

    As the Fed imperils itself further with this derring-do, the dollar should suffer and risk premiums for dollar-denominated or exposed assets should rise.

    If economic actors respond primarily to real variables that we can’t really affect at this point, as Jim hunches at before handwaving his way to low-but-positive-inflation, we’re exacerbating the problem pretty violently right now.

  2. shayre

    The Fed knows full well that the system is going to crash. There job is to 1)pretend to be surprised when it does, and 2)make it look like they did everything they could to prevent it.

    The rest of the world has picked up on this and what you will see is that oil producers will be reluctant to ship more oil in exchange for worth-less US dollars and US debt holders will take intellectual property currently held by US corporations as reprations.

    The only way for the US to protect its intellectual property and secure its oil supplies will be through millitary might.

    I don’t know how this will turn out in the end, but no matter how these war games play out, it won’t be pretty.

  3. Anonymous

    “all available tools to promote the resumption of sustainable economic growth and to preserve price stability”

    Since the late 90’s, the problem has been unsustainable growth and price instability created by bad trade, regulation, and tax policies. In response and support of bad fiscal policy, the Fed has followed a politically driven, supply side monetary policy and incited and sustained a massive debt bubble, destroying savings in favor of speculation.

    The patient in “crisis” is being administered more of the same medicine. The tentacles of the financial industry democrats and the republicans have rendered the political system disfunctional. The house skirt and the senate whimp do not have the skill set to understand what is going on or the intestinal fortitude to legislate the fiscal remedies. So, by default, the Fed becomes the spackle, covering up the deep cracks (fissures) in the American capitalist democracy.

    I also have an uneasy ache. What about savings and the future ? We are back to propping up synthetic markets in physical and financial assets at the expense of destroying the underlying value. We might as well spend current income and meager savings because they will be worthless tomorrow.

    I hope they know what they’re doing. However, hope is not a strategy.

  4. Anonymous

    Given the dire situation and Fed’s desperation, how come the stock market responded so positively?

  5. bena gyerek

    i suspect that the fed will succeed in trashing the us dollar, thereby converting roubini’s “stag-deflation” into good old 70s stagflation.

    the uk is definitely following this path with the pound. not sure how easy it will be for the usa to pull off given that (a) the rmb and other mercantilist currencies may just follow the dollar down, and (b) the usa is not such an open economy as the uk.

  6. baychev

    The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability…

    The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.

    in 2 sentenses, those fed chaps show complete ignorance of the semantics of the word ‘sustainable’.
    shall we expect them to achieve their goal by any other means than luck or coincidence?

  7. Anonymous

    The stock market responded positively because (1) many have been looking for a reason to buy and move prices up before year end and (2) they have been conditioned to respond to the sound of a rate cut by buying.

    On some level, though, I was expecting the initial jump to be offset by a drop once people realized how extreme the medicine is and what it suggests about the doctors’ assessment of the patient.

  8. JKA on Economics UK

    Welcome to planet ZIRP. Unfortunately, we do not have a handbook, or fully understand the terrain. Our process of quantative easing, the plan to helicopter money may work but as a fire fighting option, it may be like dropping water into a desert.

  9. Anonymous

    It will be interesting to see how readily devaluation will translate to actual inflation, particularly in conditions where the banks are likely to look to hoard capital and other countries will be expected to partake of competitive devaluation.

    I suppose this is where the Fed’s consumer lending facility is likely to come into play. Hard to see, though, how the Fed can realistically implement such a thing.

  10. S

    I mentioned yesterday in the FT post the pathetic medicine proposed in the FT economics forum. Today Wolf sights the Eric Lonergan post which in effect is sending money to people. To NDK point, those with a semblance of enthuisasm for remind me of the footballer who celebrates with a lambo leap only to realize he is still down by 30 with 2 minutes to go. I would suggest reading the Lonergan piece to get a sense of ust how desperate the conventional thinkers have become to paper over reality and pretend that the lesion is unrelated to the internal rot.

    As another poster on CR said:
    currency markets = mensa / biond markets = smart / equity markets = GWB

  11. But What do I Know?

    Yves, this is the best summary/discussion of the problem I have seen anywhere. Kudos to you and your blog.

    There is only one thing I would like to add. Do any of the people cheering this move ask themselves this question: If an interest rate of zero is such a good idea, why hasn’t it been done before this?

  12. ruetheday

    To their detriment, the Fed has a myopic focus on preventing deflation and getting long term interest rates down. Likewise, the only unintended consequence that appears on their radar is the possibility of creating too much liquidity which will need to be mopped up quickly when (not if, in their view) the economy turns around.

    The problem is that there are all sorts of unintended consequences that could crop up and make the Fed’s job more difficult by requiring contradictory policy measures.

    For instance, getting long rates down sounds like a great idea from the standpoint of the borrower, but what about the impact of a flat yield curve on bank profitability when most banks are undercapitalized and unprofitable?

    Or – what if the Fed succeeds in getting long rates on Treasuries down, but this causes risk premia to spike and drives long rates on private sector debt up?

    Or – and this one really concerns me – what if “inflation” is not the monolith that the Fed assumes it to be? That is to say, what if we see a huge spike up in commodities, especially food and energy, concurrent with FALLING wages (and falling profits in the industrial sector)?

    Then there is the assumption that the Fed CAN hit the brakes quickly so long as it spots the turnaround early. What if the real economy turns around quickly (not saying that’s likely) while the financial sector remains fragile? Even if the Fed wanted to tap the breaks, it would risk collapsing the entire structure by doing so.

    The Fed is facing a very complex problem, but seems to be intent on finding a simple solution.

  13. Anonymous

    They still do not get it do they.

    It is a DEBT crisis caused by fundamental imbalances in the world economy. Certain countries, businesses and people have accumulated debts that they will never be able to pay off no matter how low interest rates go because they simply can not generate the earnings required. The only solution is to triage the afflicted and to write off the debts of the mortally wounded.

    This is the message that no one wants to hear and is the reason that Central bankers are wandering around with their fingers in their ears singing La La la at the tops of their voices.

  14. Independent Accountant

    This is just more of the same. Either the Fed destroys the dollar or the banks. It has chosen to destroy the dollar. Any one who thinks the Fed will withdraw “liquidity” later to shrink its balance sheet has been eating too many magic mushrooms. All US dollar denominated assets are a sell. Welcome to worldwide inflation.

  15. CTMM

    I vote scam.

    If they want real liquidity, re-fi all of the student loans out there…

    But at the same time, part of me thinks the “core” issue is economic growth has outpaced actual bricks-n-mortar growth (to say nothing of the stress put on the environment and resource extraction ROI issues).

    In short, the real world inputs to the system aren’t even close to the paper model.

  16. Anonymous


    The details about the Japanese interview is interesting. They recruit Chinese from China for a US position? Hard to imagine the logic behind it. What purpose does it serve to move a Chinese from China to work in U.S for a Japanese company in financial industry? Just curious here.

    Btw, Your BLOG is priceless.

  17. PB


    I think you’ve hit the nail on the head with your comment. The over-financialization of the economy has brought most people to the point where they really have no idea what “bricks-n-mortar” underpin the numbers on their screen- or frankly, don’t care.

    This is because success in the “paper model”, as you call it, allows one to claim very real resources in the real world.

    Even though I work in finance, I’ve often been troubled by this growing disconnect. Maybe this is why I work in clean tech-focused finance. :-)

    The story of 2008 is that finance and the “paper model” economy needs to come back down to earth, fast. Too bad people like the Fed don’t see it that way.

  18. macndub

    Yves, can you say more about this: To a person, they expect it to fall relative to the dollar. Each had his own reasoning, but the most consistent and compelling theme was that the Chinese government valued preserving employment above all, and was not going to let the RMB appreciate at a time when exports were weak.

    How is this possible? China importing US inflation by holding its currency down will not contribute to the workers’ standard of living. It must end at some point. Basically, it amounts to destroying their environment so that Americans can have free plastic toys.

    I support inflating the US debts away, via stimulus and increased public investment, but I have no illusions about the impact on the USD. It will be messy. I simply see inflation as the best of a bunch of horrible options, and reasonable people can disagree about this. Americans have been living above their means, and one mechanism to correct that is to make them poorer by letting the dollar weaken.

    But to suggest that the Chinese can keep their currency weak by fiat, or that Japan anticipates no USD weakness, is mindblowing. Are they just talking their books, or do they actually believe this?

    You’ve terrified me.

  19. Stephen

    They may well be right about there being no immeadiate replacement for the USD as a reserve currency, whatever benefits that brings. But it looks like it will happen.

    Question though….one of the classic signals of a recession was the inverted yield curve. Why has this not happened at all, especially if deflation is the expectation, wouldnt long term rates drop below short term rates? What if anything does it mean?

    WHile I am no fan of inflation, isnt the battle now to prevent deflation. Yes the problem is a debt issue, but deflation just makes that worse. Isn’t above average inflation the way to “help borrowers”.

    What are the options of the world to get China to let their population see a rise in their standard of living, which a currency appreciation would allow. Continual depreciation of the Yuan is hardly a sustainable policy, assuming the USD depreciates, unless growth exceeds depreciation rate, but that isnt an infinite path? Isnt the RMB appreciating a growing boil that will eventually happen, whether the Chinese want it to or not?

    I ask because I honestly don’t know and there is lots of IQ and finanical experience floating around the board, not the least of which is our host.

    I look forward the discussion and comments.

  20. Yves Smith


    They were quite sincere and thought I was an idiot to doubt that the Fed could create inflation.

    A recent piece by Brad Setser, which discussed a World Bank report on China, said they’d still have ample ability to buy US Treasuries in 2009. And mechanically, they can keep buying dollar assets to keep the RMB down. My assumption would be China merely pegs the dollar, or lets the RBM fall relative to it only slightly (1-2%). And if the Fed says it wants super low rates, how can anyone complain? They are just cooperating with what we asked for.

    They were also 100% sincere re no alternative for dollar as reserve currency. One said there’d be no substitute for 50 years. Again, they regarded me as hopelessly unsophisticated here.

    And they think Americans will still buy cars from an automaker if it has filed for bankruptcy. They reason from the example of bankrupted airlines (“people were taking a risk with their lives”). Dunno re you, but I don’t know of anyone who saw flying with, say, Eastern as a safety risk.

    They did say if the US does not buy cars at the 11 m units a year level, the automakers would have real trouble, but they thought it would be OK if that didn’t happen in 2009. Expected auto financing to come back but not leases. One of the assembled lends to the industry and thus considered himself to be knowledgeable.

  21. jonathan

    Compliment: very nice entry. Thanks.

    I think the gauntlet has been placed before the new President and Congress. The Fed has essentially taken monetary policy off the table and everyone knows they need massive cooperation (of whatever form).

    And the Japanese guys were right. As of now, abandoning the dollar means exposing one’s self to destruction.

  22. miguel_swanstein

    Great. Now I have a sick feeling in my stomach as well.

    Yves, thanks not only for the post but for sharing the personal anecdote as its compliment.

    Your Japanese executives seem as incapable of conducting thought-experiments about the potential global dislocations by a failure in U.S demand as their American counterparts.

    But I suppose to even entertain such notions would lead you from being a “well-placed” executive to a “dis-placed” executive. It’s almost impossible to revise a worldview that’s served as a career cornerstone, which is why so many misjudgments get made in (potential?) paradigm shifts as this one…..

  23. ipodius

    Yves, great post as usual! But I’m sort of taken aback by the comments and the on-sidedness. Perhaps that’s just because blogs tend to sort people not cross-sectionalize them, but allow me to give a few thoughts on the Fed’s/government side here.

    Frankly, doing nothing isn’t a political option. Full stop. So any debate needs to have, at the core, the socio-political reality. And here is reality: Congress is going to pass the biggest stimulus package the world has ever seen and they are going to do it quickly. The auto makers will get loans. And the credit makets need to become unstuck. And, no matter how much debt there is out there, consumers will spend with the right incentive.

    So the issue here is how to do spur lending? You make it completely unprofitable to sit on money. How do you do that? One word: Inflation. If you can’t make money by parking it, and you are under the threat of having it eroded, then you put it to work. So the Fed, although they will not say this but you can read it between the lines in the last statement and the observation about inflation, will aim to inflate, as they should. A rate climbing to a max of 5 to 7% ought to scare the bejeebus out of the markets, and so they will react. So what you will see unfold in the next year is the lowering of mortgage rates to the lowest levels ever, the easing of credit standards such that anyone that has property and wants to refinance can as long as they have the means, auto-loan resurgence so that anyone that wants an auto can get one, and massive student loan re-casts/availability to mop up excess unemployment (full-time students aren’t on the rolls) and to spur consumption.

    Now, is any of this bad? No, and totally politically feasible. The only caveat here is tarketing the upper-bound. So I say, let the Fed rock. If they play the game right, it just might work.

  24. Anonymous

    Thank you for this most comprehensive examination of the Fed’s QE strategy and, in particular, its vulnerabilities.

    I still don’t think the Fed or Treasury authorities have grasped the seriousness of our nation’s, households’, and banks’ massive debt obligations and their implications for monetary or fiscal policy. Hopefully some with their hands on the economic throttle will read this and think more deeply about the economic policies we are pursuing.

  25. PB


    So a war on savings is going to fix a problem generated by a profound lack of savings? I don’t get it.

    Is the point to force people to put money to work to preserve finance as a bloated industry? I think instead the industry should be the one to adapt (ie. we might just have to face the fact there will be much less business in financial services in the future).

    Is it just me or does the overriding drive appear to be the preservation of a particular financial system as an end in itself? I think the Fed et al. are just scared to look around the corner and see that grass still grows on the other side- it just might not generating billions in easy fees, that’s all.

    Maybe I’m biased because I’m still young, but I’d rather the band-aid get ripped off now so my generation doesn’t have to wade through this nonsense for decades.

  26. baychev

    2 things you seem to discount in your analysis:
    1. the fed borrows from overseas and most of anything purchased in the US is produced overseas. inflation and devaluation of the currency will have huge adverse impact on the economic activity in the country as a whole. at least if there is any hope that things can cantinue as they are;
    2. you are permanently subscribed to delusional thinking: admitting reality and willing to adjust the mix of economic activity is no longer a politically acceptable option. people should not be asked to earn their money, the government should print it instead for them.

  27. Anonymous

    the most consistent and compelling theme was that the Chinese government valued preserving employment above all, and was not going to let the RMB appreciate at a time when exports were weak.

    Those people need to be listened to.

    The Beijing regime will devalue as necessary to export and they will inflate as necessary to provide employment via domestic infrastructure projects like railroads. The one thing they won’t do is listen to idiotic Ivy League and U-Chicago monetarist theorists.

    For the Chinese the choice is simple: either sustain near full employment or risk civil unrest, political upheaval and even civil war at extrema. This is literally a life and death matter for them.
    China is never more than one month away from a revolution, or more than six weeks away from a collapse into another era of anarchy and warlordism. And the Chinese regime is acutely aware of this at all times.

    Compared to those outcomes buying another $1 trillion in US Treasuries is very economical insurance.

    This knowledge plus collapsing energy prices gives Bernanke a great deal of maneuvering room right now. On that score, the oil market greeted “quantitative easing” falling again.

    The ECB can either follow suit or alternatively see the euro break up. The advantages of the strong euro of the last few years to Europe overall are not obvious. “Industrial wasteland” is a phrase Sarkozy’s started using lately.

  28. Anonymous

    Maybe I’m biased because I’m still young, but I’d rather the band-aid get ripped off now so my generation doesn’t have to wade through this nonsense for decades.

    Hold those thoughts and seek the right course for you and yours. “Trust no one over 30.” And trust none under 30 claiming to be worthy of trust, either.

    The science fiction writer Robert Heinlein once commented that old people are solely interested in clipping their bond coupons, i.e. living off received interest. And that all their influence will be directed to preserving that payment stream.

    On the score of unmitigated selfishness the aged “Baby Boomer Generation” will prove to be 100x bigger assholes than their parents’ generation that they were complaining about so much in the 1960s and 1970s.

  29. S


    “let the Fed rock”

    So how does reflating and bubble economy fiox anything? How many plasma Tv can you jam down people’s throats? As to your socio political analysis, you might want to copnsider the optics to the rst of the world. It is a tough sell to take a nickel fromm everyone to make us all richer. IOt is goignt o be a far greaster challenge henceforthe to convince the world that we need to maintain out superioir standard of living so the rest of you can survive. Somehow I think instant information and media disseminationwill foreclose on the US PR mascheme. As someoner to young than old, I think the finance economy should be driven into the ground and the coffin sealed. Really the only remaining advanatage for the USaside from the worthless tripes about our more flexible economy and “idea” is the military. Eisenhower feared it but Obama should embrace it. It is the final frontier.

  30. Anonymous

    Crude oil has responded to dollar “quantitative easing” and more OPEC production cuts by falling to $40/bbl. Inflation is a potential economic worry in the future. But only if a sufficiently organized economy exists at that time to worry about it. Bernanke is on the right course to the extent paper money is still a useful medium of exchange.

  31. PB

    Fed: the current financial system needs you to keep buying Plasma TVs from China on credit. Don’t worry, we are here to make sure you will.

    Me: I don’t want or need a new plasma tv from China, so maybe the financial system should just adjust. Isn’t that what business is about?

    Fed: the current financial systems needs you to keep buying Plasma TVs from China on credit. Don’t worry, we are here to make sure that you will. Also, buy another house as well.

    Me: But I said I don’t need or want another Plasma TV, and at this point probably can’t afford it anyways. Forget the house!

    Fed: Does not compute. System failure. Reboot. Increase Money Supply.

  32. Anonymous

    I share your sense of unease with this last gasp cut in the Fed Funds rate. I worked as a market economist in Tokyo pre-, post-bubble and watched rates there fall and marveled how little this did to boost aggregate demand. Arguably the major difference between Japan then and the US now is that Japan had savings to fall back on. It seems likely that this insures that our current difficulties worsen before any light appears at the end of the tunnel.

    —–Matt Berlow

  33. Andrew Bissell

    “Frankly, doing nothing isn’t a political option. Full stop.”

    Exactly what would it take for doing nothing to become a political option? If we try bailout after bailout and GDP still gets sawed in half, would that count? What’s the endgame, here? Is there some irrefutable a priori case for DOING SOMETHING!!!! that I’m not aware of?

  34. Andrew Bissell

    “So the issue here is how to do spur lending? You make it completely unprofitable to sit on money.”

    A few years back some Fed apparatchik actually proposed a tax on savings and time deposits. Maybe that will do the trick.

    Better get your offshore account while it’s still an option.

  35. Andrew Bissell

    Correction: he didn’t *propose* such a tax, but floated the idea that it could be a good countermeasure against extreme deflationary environments.

  36. Anonymous

    Yves and fellow party-poopers! Please continue to question QE and QE2. The near-unanimity of the “experts” in the “free” press is very worrisome. Even if (somehow) history defeats you, this is a righteous battle.

    Forget whether it is possible for the US Gov to sop up excess at some point…the immediate question is whether the US Govt has any remaining credibility.

    PS. I have doubts as to whether Bernanke is really calling shots anymore. BB has spoken about why Japan’s policy adventures failed. And these conditions that limit the effectiveness of QE (chiefly the soundness of the banking system) are obviously present. I suspect that BB is chained/bought/paidfor, not a radical theory given the dependence of the US Central bank, or the propensity of US demagogues to engage in, well, demagoguery.

  37. Matteo


    Your comment reads like it should have been written in 2002, when everything you’ve said was first tried after the dot-com collapse. I just have to wonder how it will all turn out 6 years hence, in 2008?

    Nothing but roses, I’ll wager.

  38. Independent Accountant

    This is a variant on Keynes “stamped money” scheme. These guys are monetary crackpots.

    I agree with you and have said similar things for years. Eventually the Chinese will realize their $1.9 trillion in foreign exchange reserves are worthless. When they do, they will buy gold. We’ll be lucky if the Chinese peasants don’t get too angry at us for swindling them. If they do, expect war with China. People worry about our “economy” as if it’s such a big thing. I worry about a war with China, population 1.3 billion. I’m old enough to remember what Mao Ze Dong said in about 1965 to either Brezhnev or Kosygin, this is a paraphrase, “We’re the only country in the world that can lose 300 million people in a war and still win”.

  39. Anonymous

    Before we get to the conventional worry, that […we…] wind up with pretty bad inflation. there are other issues […] the problem is that a lot of people and companies took on far more debt than they can afford to repay.

    What you refer to as a “worry” is in fact the whole plan. The Fed does not intend to provide debt relief by lowering interest rates; they intend to provide it by igniting inflation to levels (20% or 30%) that will melt debt away. Any severely apocalyptic consequences have by now been dismissed as “lesser evils”.

    A recent piece by Brad Setser, which discussed a World Bank report on China, said they’d still have ample ability to buy US Treasuries in 2009.

    In a different article Brad Setser comments: “Finally, I worry far more about a sudden fall in China’s willingness to buy US assets than a gradual reduction…”

  40. Anonymous

    Fredrick Von Hyak’s, “The Road To Serfdom,” is great reading for anyone at this point.


  41. fairEconomist

    So a war on savings is going to fix a problem generated by a profound lack of savings? I don’t get it.

    The war on savings was already fought by the banks, loaning out those savings on wasteful houses, mergers, Chinese toy factories, and SUVs, amongst many other things. Savings lost. Big time. Now perhaps half of those savings are fictitious and need to be erased. Inflation is a good way to do it – the other solution is jubilee; it’s simply to big to do via bankruptcies in the available time.

    Inflation will not particularly harm *new* savers as they can, and will, demand appropriate rates. However, I think direct fiscal stimulus – the government hiring people to do useful things – is far preferable to trying to push interest rates lower. Interest rates are plenty low; what people need now is a reason to borrow and a reason to keep their money in the bank rather than the mattress.

  42. FairEconomist

    Exactly what would it take for doing nothing to become a political option?

    Historically – impossible, that will never happen. In such extreme circumstances the populace will always demand action. And they’re right, because now that we’re in a liquidity trap the market does not function and so if the government doesn’t do something nobody will and the economy will rot away to nothing.

  43. ndk

    However, I think direct fiscal stimulus – the government hiring people to do useful things – is far preferable to trying to push interest rates lower.

    If this worked, and the U.S. had an excess of savings, I’d be all in favor of this. But there’s almost no empirical support for Keynesian stimulus, and even some counter-evidence.

    I’m not in favor of tax cuts either when there is such a high propensity to repay debt. I like bankruptcy and reduction of the total debt burden on the economy.

  44. fairEconomist

    I haven’t looked at Mankiw’s paper, but it’s entirely moot; in a liquidity trap savings and investment both collapse and there’s nothing to crowd out. And that’s what we’re coming to now.

    How does Mankiw reconcile his results with 1933, when Roosevelt raised taxes, raised spending more, and the economy took off like a rocket, recovering GDP as fast as it had been lost in the crash for nearly 4 years?

  45. John D

    The USD will weaken and even the RMB will devalue re: USD. It is the US dollar bloc vs. ROW in beggar thy neighbor fashion. It serves the purposes of the U.S. financial and political establishments in Wall St and Washington; it also serves the purposes of mercantilist China.

    U.S. manufacturing gets hurt, but not as bad as Europe or anyone else who finds themselves outside the US dollar bloc.

    I completely agree with your Japanese hosts that there is no alternative to USD on the horizon. In that sense, this is very different from the 1930’s when USD was ready and able to assume reserve role in lieu of gold/Pound Sterling. There is yet no road, yellow brick or otherwise, that leads from the Emerald City to some new destination.

  46. Anonymous

    We are all on the edge of the abyss, staring into the dark emptiness below…

    That feeling of dread is there for good reason.

    The FED has pushed us one step closer to the edge, not able to change the economy any more than the weather man can change the weather

  47. ipodius

    FairEconomist’s posts are the closet to truth I’ve seen on here, and to reality. Doíng nothing isn’t an option because the political majority will demand government action. So, with the menu of options available, what is the best action choice?

    It’s sort of tiring to hear this “war on savings” talk. Face it, at the level of interest rates now, the war was fought and lost. If you’re thinking deflation is a better option for the savers, think again. Take a look at the basket of prices that aren’t deflating (food and normal hosehold items) and the ones that are (all asset classes). With all the trouble in Detroit and elsewhere, don’t expect autos to deflate either. And green technology is still more expensive than petroleum-based.

    And if you are worried about the rest of the world, think again. There is no one in the same boat that we aren’t, and that includes China. So I’m willing to see if this works, because the alternatives, including doing nothing, are in no one’s best interest. Even all the faux-libertarians. Amd until I see a post that thoughtfully examines all sides of the issue, I have to believe that a bunch of smart guys at the Fed, the IMF, and other central banks probably have a better grasp on the issues than a lot of us.

  48. ndk

    I don’t know what to say, guys. You say we’re distant from truth and reality when we’re the ones bringing forward empirical testing of the theories that are likely to be employed.

    The entire scientific establishment has been spectacularly wrong a number of times in the past, and we’ll be wrong again in the future.

    Our collective resistance to even examining whether our understanding might be incomplete again is worrisome.

    I do think “stimulus” is very popular because it gives the impression of doing something positive to solve the problem, and it seems to give a reason for the government to run larger deficits. It’s a perfect bandwagon, and ipodius is right that the entire establishment is aboard it at this point.

  49. PB


    Fair enough. I do not, however, share your faith in the powers that be- and can you really blame me, given the asset bubble shenanigans that have gone on this past decade?

    The problem is not so much a lack of intelligence (I’m sure there are tons of brains hard at work in there), but just an entrenched regulatory capture which limits real options and outside-the-box thinking. Do you think they can even imagine a world where satisfying the cry and beckon of Wall Street is not their primary task? As far as most of these guys are concerned, finance IS the economy.

    The problem is that current levels of all economic activity have come to depend on the inflated primacy of financial services. And that’s why things can’t possibly be re-balanced without people taking a fair amount of pain. But I just don’t think the Fed can disentangle itself from equating the health of financial services with that of a general economy.

    So Fed action can be frustrating, but I don’t think anyone will ever say it’s surprising. It’s not that they don’t have any other option- it’s just that they can’t imagine one.

    So sure, they are probably doing the very best they can from their point of view. But unfortunately, I’m not so sure they have the right point of view anymore. It seems blinded by the needs of a financial service economy when we desperately need something else.

    Sorry for the rant, but at least it’s nice to see a bit of contrarianism on here for the sake of argument, you are right that most commenters tend to lean in one direction.

  50. wintermute

    fantastic post ruetheday.
    I agree 100%
    You hit the nail right on the head with the Fed’s simple solutions and naive hope that it can mop up inflation when/if the economy turns around. I believe that this is where it will ultimately fail. It will find that reducing money supply takes it from areas which needs it (house prices) – and leave it from areas which don’t (commodity prices).

  51. ndk

    And just as a PS, we should all keep the discussion civil and respectful. Debate and opposing points of view are of immense value to everyone, and name-calling like “ipodtard” isn’t helpful.

  52. Anonymous

    Lets say it can be fixed, all of it. Then what. Blind our selfs for a few years, to only repeat the hole process on a bigger scale down the road. I think we have sailed this river for a very long time now, be nice to pick some Terra to land on. We keep modeling ourselves on old ideas (feel like putting on a Toga to really get in the mood), when are we going to try something new. I would give up every thing I have to try some thing new and would be OK with its failure. Just want off this merry-round of cyclic bubble/crash kiddy ride.

    In my experience hunting as a kid or my time in the military. Showed me to fear the people behind me more than those to my front, I clearly knew the intent of those to the front. Presidents that kick ass and increase the wealth of America are revered, where those that go slow and think long term are reviled, why?

    BTW to anyone trying to get into the head of the Chinese or Japanese mentality. Don’t try, unless you have lived and worked for or with them over years. They have thousands of years of culture behind them compared to our hundreds. I worked for Clarion International Corp in L.A. for 5 years and was aways bemused at my fellow Americans frustration at their business practices, or the land of the never ending meetings that seem to go no where.

  53. john bougearel

    @ wintermute, Consider the timeline of how long it will take b4 the mopping up of the excesses can take place.

    B4 the fed can mop up the excesses a sustainable uptick in manufacturing activity will have to occur. Will this be another 6-18 months or longer? I can not say. But eventually it will happen But even tho we get the uptick in mfg activity, the budding economic activity will still be fragile, so businesses will be reticent to hire. So we will have to add on another 9-12 months b4 business feels comfy adding to their payrolls and expanding their businesses.

    And still the Fed must wait until they are reasonably certain that any shift in their policies will not hinder the fragile economic recovery underway. What will the Fed used to signal the recovery is sustainable – the unemployment rate. When the slack in labor is absorbed by the economy, then they will feel safe to mop up the excesses.

    In the last economic cycle it took almost 4 years for the Fed to normalize short term rates. If we look to Japan they have yet to normalize short term rates.

  54. john bougearel

    @ Yves and
    @ Andrew B

    Marty Zweig defined extreme deflation deflation as occurring when the Producer Price Index declined by 10% on a 6 month annualized basis. On a four month annualized basis through November 2008, U.S. producer prices are declining at a 15.75% rate. And on a 5 month annualized basis, producer prices are declining at a 12.2% rate. We are by Marty Zweig’s definition, one data point (one more PPI report) away from what he considers a measurement of extreme deflation

  55. Anonymous


    Thank you for a stellar posting.

    I agree with ndk who said, “I like bankruptcy and reduction of the total debt burden on the economy.”

    Until the rule of law and consequences are returned to the finanacial world the patient will continue to die.

  56. Anonymous

    As someone (Herbert Simon?) once pointed out, that which cannot continue will eventually stop. This is true even if the exact mechanism that will trigger the transition is murky and hard to foresee exactly.

    During the “golden age of liquidity” in early 2007, people like Chuck Prince had faith that the music would keep playing and they had to keep dancing, for the simple reason that they couldn’t see any definite thing that would bring it to an end. And yet end it did, in a matter of months, for reasons that are much clearer in hindsight. And many people and institutions were shipwrecked in the transition, which isn’t over yet.

    When it comes to the US dollar, we can say with near certainty that it will cease to be the world’s reserve currency. No, I don’t know the exact timing (sooner than we imagine, I suspect) and I don’t know what will replace it or how. But the music will stop and the tectonic plates will shift and we will find ourselves, blinking, in some new era. And when future historians reach a consensus on when the dollar crisis started, the date they pick might be a few days ago.

  57. DanyBoy

    Thank you all for brilliant interchange. I for one will put it right out there that I am always enriched, enlightened, and entreated by what I read on this blog. Thanks, Yves for your leadership!

    I am deeply saddened to read that we’re reduced as a nation to the futile hope that we can return to prosperity through stupid Fed tricks.

    Curing deflation through inflation? As any good investor/trader knows volatility kills everyone, bulls and bears. Recent markets have left a trail of corpses of the once annointed gurus (GS, Harvard and Yale endowment, Citadel, Fortress Oh my!). Now imagine volatilty in the broader economy: the toll of destruction of individual and corporate savings will be devastating. And the very reactions to uncertainty (hedging, derivatives, packaging and tranching) will again exact their devastation.

    Why as a nation have we collectively chosen to forget how to create wealth? Serving burgers and CDOs to one another is a zero sum game. But the numbers bear the trend out: 70% of the economy is “service” and fully 40% is financial services! We are therefore moving away from both diversification and actual production of tangible goods which the world can use. The last vestiges are on their way: autos, films, precision instruments…

    No amount of deflating and reflating can subsitute for actual production. Like many declining dominant societies, we have consented to collective amnesia

  58. wintermute

    agreed John Bougearel,

    Also, one more reason for expecting the multi-year timespan is that there are global systemic pressures working against an uptick in US manufacturing.

    Firstly is that labor is much more globalised so it is very hard to out-compete other countries where the unskilled even medium-skilled labor component is present.

    Secondly, the US is really inefficient in oil use per unit GDP – compared to Japan, UK, France etc. (Tertzakian has a marvellous summary in his “1000 barrels a second”.)
    Peak oil is mainstream now – and will hit the global economy like a train wreck sometime in the next decade.
    The US needs a paradigm shift, like turning hundreds of square miles of AZ/NM into solar collection facilities (various candidate technologies). If Obama’s stimulus package included a serious commitment to energy transition – then it has a chance of working.

  59. Anonymous

    First, we do not need to cover the US with solar panels. Build a few large hydroelectric dams and save some time and money. Solar panels are very inefficient, hydroelectric represents the maximum efficient use of ‘solar power’. But I digress. What deflation are we talking about? We have seen a normal cyclic decline in the values of raw materials, gas, autos, and speculative (stock and real estate) investments. But will any of the following items experience the much-vaunted “deflation” next year: your home utility bills, your property taxes, your cable TV or internet charges, auto repairs, towing, tolls, packaged food, college, insurance in all categories, lawyers fees, parking tickets, alcohol, tobacco, rent, and on and on. When I see a loaf of bread for 50 cents again, then I will believe in deflation.

  60. Greenspan Put Expired

    Yves, thanks a lot for this (and many other) great posts. My stomach agrees with yours.
    By the way, as far as I know US long bond yields in the 1930ies never went below 3.1%, yesterday it was about 2.6% – despite having Helicopter Ben at the Fed!

  61. Douglas

    Many posters have stated that fed induced inflation is the only way out. However the action in the Treasury market is indicating something else entirely.

    Or is the action in the Treasury Market due to something else?

    Expectations of inflation causes fixed income to get kicked in the nuts. That simply isn’t happening.

    So the “inflation” argument seems to be theoretical in nature only right now.


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