The Fed’s Fallacious “QE Lite” Logic

The Fed seems to be exhibiting a pretty bad case of “if all you have is a hammer, every problem looks like a nail” syndrome, particularly when it has (or perhaps more accurately, had) other tools at its disposal.

In case you somehow missed it, global markets got a bad case of deflation heebie jeebies over the last few days. Equity markets had shrugged off piss poor economic news during July, but continued rallying of bonds suggested slowdown fears were rising, and more often than not, bond markets lead equity markets in registering deterioration in economic fundamentals (while also registering some false positives). Yet more disappointing employment data, flat retail sales, unexpected growth in China’s trade surplus and in the US’s deficit (which implies GDP revisions downward), deepening consumer pessimism (and note this list isn’t complete) finally started weighing on markets.

The FOMC meeting was almost textbook “buy on rumor, sell on fact.” Analysts and investors were lobbying for some form of Fed action, and the step the Fed took, holding the line on balance sheet size and signaling concern, looked eminently reasonable if you buy into the “Daddy Fed can’t be too unresponsive” view of the world. Yet that move proved to be somehow not reassuring, and global financial markets fixated on Worries About Growth.

But the worry instead ought to be about debt. And we don’t mean sovereign debt, we mean the refusal to deal with a private sector debt overhang. The lesson of past financial crises is that cleaning up the bad debt on bank balance sheets is on the critical path as far as real recovery is concerned. And by the way, that isn’t merely for the benefit of the banks (although policy thinking does seem to revolve around them); it’s for the benefit of borrowers too. Letting bad debt fester means you have two dynamics going: one is that you get borrower collapse (bankruptcy of businesses and individuals), which if it occurs on a large enough scale, can then pull down affected business partners (banks, customers, suppliers) or to avoid that, you have zombie borrowers, ones who have defaulted, but the loans are not resolved. In Japan, it happened with corporate borrowers; in the US, we see it in residential mortgages, with banks not foreclosing on severely delinquent borrowers.

A Bloomberg story, taking up the current mood of pessimism, notes parallels between the Fed’s actions and failed policies of the Bank of Japan, with the US central bank predictably insisting that it isn’t following the Japanese playbook:

A policy that associates the Fed with the Bank of Japan’s unsuccessful strategy of expanding reserves poses a risk for U.S. central bankers, said Stephen Stanley, a former Fed researcher. Chairman Ben S. Bernanke has called Fed policy credit easing to differentiate it from Japan’s so-called quantitative easing from 2001 until 2006, which failed to spur bank lending in the world’s No. 2 economy….

The Bank of Japan kept its benchmark rate near zero as it used quantitative easing, becoming the first central bank in modern history to embark on the policy. The BOJ targeted the level of reserves and pumped trillions of yen in excess cash into the economy, trying to encourage bank lending to companies and beat deflation.

The policy failed because the BOJ’s funds sat static in commercial lenders’ accounts at the central bank, even though the target was increased by almost nine times to 35 trillion yen ($411 billion) by early 2004. The money didn’t spark business investment and consumption, and deflation plagued the economy through 2005.

The Fed, by comparison, is trying to lower borrowing costs by targeting the level and composition of assets it holds that correspond with bank reserves instead of the actual level of excess reserves, which totaled $1.01 trillion as of July 28.

Yves here. Can you see why this won’t work? The Fed’s implicit reasoning is that the BoJ didn’t shove money into the banking system in a way that would lead businesses to borrow, but the Fed has a better mousetrap. Huh? This is the loanable funds fallacy, that if you make money cheap enough, firms will borrow and invest.

But the cost of money is only one factor in a business’s decision to expand, and outside of financial firms, it’s typically a constraint, not a spur. If you run a dry cleaner, are you going to say, “Gee, my borrowing rate went down a point, I think I’ll open that new store”? The fall in the cost of money would change your action only if it was a critical factor, at the margin, and had restricted you. And for the vast majority of enterprises, the decision of whether to grow or not is based first and foremost on their reading of the environment, which includes the strength of the market for their services, the likelihood of competitor response, whether there are steps they can take to alleviate risk, like securing commitments from prospective customers or tying up critical technology or vendors. (Separately, the Fed has published a paper by Seth B. Carpenter and Selva Demiralp that challenges the existence of the money multiplier and thus disputes the logic of the FOMC’s recent program)

The underlying problem is overreliance on monetary policy, when what is needed is more aggressive measures to force resolution and restructuring of private sector debt, with stimulus to offset the downdraft of the resulting losses (note the losses really are there, but in a reverse Tinker Bell syndrome, if we all quit clapping, the economy might die). But we instead wrote large, close to blank checks to big banks, and provided them with even more backdoor subsidies, and voters have lost patience with fiscal deficits, even if we might finally be getting around to more deserving and useful targets.

Unfortunately, as Financial Times columnist Samuel Brittain reminded us recently, there has been “a shift from an excessive preoccupation by central banks with financial institutions to the other extreme of their becoming virtual econometrics factories.” And that puts them at an even further remove from an operational grasp of how the real economy works.

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  1. Richard Kline

    If the goal of quantitative easing in Japan early in this decade was to float the real economy there off a sandbar of debt, it failed. So far quantitative easing in the US presently has also failed to aid the real economy, and that failure will continue, because it is a policy very poorly designed to achieve that end. If the goal of quantitative easing in Japan was to effect a crypto-bailout of functionally bankrupt zaibatsu and inter-related banking concerns who were disguising that status with all aid and comfort of the Japanese authorities, it was a tepid success. Thus far in the US, quantitative easing as an historically unprecedented gift of money to similarly morbidly failed corporate giants has been a signal success to a handful of robber-baron banks and speculative hedgies, and a functional failure everywhere else. One should project a modest continuance of this state of affairs in the US for a further a la carte size queasing effort by the Fed.

    It’s all in cui bono. Queasing is about all the resources of a nation and people being siphoned off to rescue a handful of super-rich sepeculative oligarchical concerns entirely undeserving of any such direction of resource. Indeed, those concerns are the SOURCE of the failure in the economy (though not the only toxic or problematic vector therein). Quantitative easiny is symptomatic not of an economic policy but of systemic political failure whereby parasitical elites foul the pond and make their society sick. Are we sick of them yet?

    1. anonymous

      Hi, This is a question, rather than an attempt to refute the point. My understanding is that the system of sharing stock among ‘families’ of companies in Japan means that the Japanese get more of a bang from each boondoggle buck, or yen.

      The banks stay afloat which means a number of attendant connected businesses also stay afloat. I live in Japan and have heard so many ‘the Japanese economy is going to sink’ stories over the last few years, I don’t know what to make of them.

      What I have heard, first-hand, is that everywhere outside of Tokyo is really hurting this year. Debt levels have reached a point where governments can’t justify borrowing more for make-work projects.

      Domestic demand is extremely soft, and the people I know who used to have good jobs with top-tier Japanese manufacturers in Japan, say don’t ask, when I inquire how they’re doing. And they mean it.

      I know that this link goes to a man many of us had no trouble blaming for all or most of America’s woes from 2000-2008, but I miss him truth be told, much to my shame.

    2. drb48

      a) You’re right about the cause of the problem.
      b) Yes, way past sick of them. Where’s the revolution?

      1. Gary Anderson

        We don’t need a revolution. As I wrote at my blog, we need debt forgiveness and a major contribution from the top 1 percent to insure bank solvency as that forgiveness is implemented

        1. traderjoe

          I don’t focus on creating solutions in my head any more. I’m not a member of the privately held Fed or the PTB, so it doesn’t matter.

          But I don’t think debt forgiveness and ‘confiscation’ is the answer. It’s just more moral hazard. Rewarding failure. Punishing ‘success’. Our country, a bit romanticized, was built on self-reliance. Hardiness. Community.

          I do however, think debt forgiveness as legal defaults and re-orgs is just fine. Let the banks fail. Let the system reset. It’s too bloated to save.

          1. chris murphy

            contribution from the top 1% is not “confiscation”. it is merely a return of a small portion of the rents they have been extracting from the economy for the last thirty years. the moral hazard lies in allowing them to retain these rents and in policies based on “supply side’ dogma which continues to shovel money into the hands of the very same people (largely that same 1%) who caused the current fiasco

        2. NOTaREALmerican

          Re: we need debt forgiveness and a major contribution from the top 1 percent to insure bank solvency as that forgiveness is implemented

          What’s your definition of revolution?

        3. attempter

          We don’t need a revolution. As I wrote at my blog, we need debt forgiveness and a major contribution from the top 1 percent to insure bank solvency as that forgiveness is implemented

          Trickle down 4evah! Noblesse oblige.

          After all, it wouldn’t have legitimacy if the producers disposed of their own, would it? The gangsters must be allowed to steal it all, and we peasants must be grateful when our exalted betters deign to “forgive” us for our sins and condescend to “contribute” a little bit to cleaning up after their own crimes.

          That’s all we wretches deserve, right? It’s God’s own will.

  2. Steve B

    Let us assume that the Fed is successful in lowering long-term government bond interest rates, to less than 3%. And let us assume that mortgage rates from the various government agencies are reduced to about 3%. Everyone with a mortgage would refinance, and the reduced monthly mortgage payments would lead to a major increase in other real expenditures in our economy, accompanied by inflation. There would probably be lots of turmoil in the dollar exchange rate, the stock market, etc., but Bernanke would indeed be able to stimulate the economy, without reducing the nominal level of mortgage debt.

    1. Yves Smith Post author

      The Fed’s Treasury purchases are in the 2-10 year range. It wants a steep yield curve. Greenspan ran exactly the same program in the wake of the S&L crisis: engineer a steep yield curve to help banks rebuild their balance sheets (via their normal stance of borrow short, lend long).

      Plus mortgages at 3% assures someone takes monster losses if the Fed ever normalizes rates again. No one would refi with mortgages that cheap, they’d probably be unable to sell their houses, you’d get monster negative equity if mortgage rates went from 3% to 5-6%, which is where they’d be with target inflation at 2%.

      1. Ignim Brites

        Maybe Steve B is right and the hidden message of the FED’s action is that they will tolerate minimal deflation (between -1 and 0%) in order to force the resolution of the the housing debt issues. If we assume 10 years of ZIRP then some would refinance houses at 3%. And I don’t think the FEDs actions are all that consistent with generating steep yield curve. Rather the message seems to be to take on risk by moving further out on the yield curve since clearly ZIRP is going to be around for a while.

        1. bob

          I’m with Ignim on this. It’s no longer about the banks. The only way out of the entire mess is to allow everyone to refinance everything at extreme low rates.

          1. Gary Anderson

            The Fed kills two birds with one stone if they allow deflation. House prices remain artificially high but gradually drop, and consumers get a raise. But there has to be some debt forgiveness thrown in since we won’t be able to inflate our way out of debt.

            People must deleverage themselves and walk away from as much debt as they can. Some who need a good credit score may be constrained, but if you can get away with it walk away.

            Remember, the moral failure rests with the lenders. Are you listening Tea Party?

      2. traderjoe

        @Yves – I hope I’m not reading too much into your comment, but that is the exact problem with ZIRP forever. It distorts the economy (once again) thereby merely postponing (and magnifying) the eventual realignment. The lower you push interest rates to float housing, the harder the price adjustment when rates rise.

        What’s so wrong with a correction/recession? Why do we keep working so hard to avoid what is inevitable? Do they really think there is a way out of this, or do they know they’ve painted themselves into the corner? Will there ever be a private mortgage market again? What’s wrong with lower house prices?

        I know, I know, it’s all about the banks…

        1. drb48

          “Will there ever be a private mortgage market again?”

          Not until asset prices stop dropping.

      3. Jim Haygood

        Someone is already going to take monster losses on the multi-trillions of Treasurys and MBS priced at today’s rock-bottom yields. This may be the biggest Bubble on the planet. Knocking mortgage rates down from 4.5% to 3.0% would be just a final fillip in a three-decade secular bull market in debt securities — not a quantitative change from today’s Bizarro World of ultra-low rates.

        Target inflation of 2% is all well and good. But if mortgage rates double, they’re likely to be driven by above-target inflation.

        Consider 1966 to 1974, when mortgage rates popped from (I’m guessing here) 5% to 9%. Thanks to the prevailing inflation, homeowners didn’t necessarily lose equity.

        I would admit, though, that we seem to have no control over whether inflation manifests as asset inflation (which everybody loves) or goods inflation (‘bring back the misery index!’). You pays your money, and you takes your chances.

  3. Chris

    Whenever I read comments about the historical way that Japan attempted to deal with its not dissimilar (heck, actually very very similar) issues in the 1990’s – such as the Bloomberg article Yves referred to, I always get the same tinking bell in my head.

    The bell is a combination of mild xenophobia and pretty overt patronisation. At the risk of sounding like a valley girl, to paraphrase, the usual gist of these articles is something like “gee, those Japanese were so, like, dumb, and their approach sucked wa—y—yyy too much”. Or similar. The underlying assumption is that the Japanese had many marvellous and problem-free solutions to the issues they had/have – the only thing was that somehow they were too thick to actually work out what they were and apply them.

    My take, based on an admittedly outside assessment of the country (although I have conducted not a little business there over the past decade) is that the policies which were implemented were the best of a pretty bad lot. At least to the Japanese. Yves’ assessment that the primary aim of any attempts to tackle the hangover of the bubbles which they —and we – were swept up in (nb. It wasn’t just real estate or stocks – it went deeper than that) must be an honest resolution of the bad debt situation is completely correct. That doesn’t make it easy, and politicians (who are the ultimate decision makers on these questions) cannot help but seek nice-as-pie alternatives. Policy makers in the US are falling into the same trap (“somewhere, somehow, there must be a less painful way here… isn’t there??”) for the same rationales. Yet the commentary is – when looking at the current situation – along the lines of “well, that was the Japanese, you know what they are like, and while we may be floundering around making the same goofs as they did, actually we’re far more knowing and we will eventually come up with much better solutions. Or we can apply the same solutions, but smarter, and get all the good stuff with none of the bad“ (for reasons that are never adequately explained.)

    Until the mainstream media outlets (and perhaps more importantly, policy makers) finally “get it” that they can apply Japanese-style remedies and get Japanese style outcomes or instead take the path of more painful remedies which have the predictable short-term agony but should have long-term pay-offs, we’ll have the same handwringing as in the Bloomberg article.

    For me, the last two years (and the next 10 years, as the crisis plays out through all it’s pretty inevitable stages) isn’t really about the economy. It’s about culture shock. And the culture getting the shock is the western world.



    1. curlydan

      totally agree, Chris. Basically, neither Japanese nor American decision makers (Financial Giants and Govt’s, and particularly the Govt’s) have the guts to eliminate the debt and possibly risk some banks going under. So we lifeline the banks and do ineffective and (as Yves pointed out) “marginal” changes. So Bernanke better get out his old vinyl and put on “I’m Turning Japanese” cuz that’s where we’re headed.

  4. i on the ball patriot

    “The underlying problem is overreliance on monetary policy, when what is needed is more aggressive measures to force resolution and restructuring of private sector debt, with stimulus to offset the downdraft of the resulting losses (note the losses really are there, but in a reverse Tinker Bell syndrome, if we all quit clapping, the economy might die).”

    The underlying problem is that we are dealing with an intentionally broken window. The glass has been shattered into thousands of pieces by intentionally blown super bubbles and corrupt deregulation in the world’s greatest propaganda scheme. The window can not be fixed, it needs to be replaced.

    Unfortunately, there has been a shift from an excessive preoccupation by complacent citizens with watching the boob tube to the other extreme of pan handling their friends and neighbors for basic subsistence on street corners. And that puts them at an even further remove from an operational grasp of how the real economy works. Constantly rousted and hassled by their local cops now, they still believe they live in the greatest country in the world and that their vote makes “Freedom Count”! Meanwhile, their still employed fellow citizens are busy passing Free Speech limiting laws that prevent panhandling and sleeping in public places. Laws that will soon bite them too in the ass!

    Yes, getting these brainwashed now super ignorant masses to overthrow their crooked government is a super maybe swan.

    Deception is the strongest political force on the planet.

    1. drb48

      Clean capitalism – in case you haven’t noticed – has proven to be an oxymoron. How many failures of capitalism need to be experienced before we “get it”?

      1. NOTaREALmerican

        Re: before we “get it”?

        What if “we” can’t “get it”.

        Which I happen to think is the case. Capitalism is just the smartest screwing the dumbest. What percentage of the population thinks THEY are above average.

        History is just the smartest screwing the dumbest. Oh, didn’t I just say that? Which means History = Capitalism. Good luck trying to change the flow of history.

  5. eric anderson

    “And we don’t mean sovereign debt, we mean the refusal to deal with a private sector debt overhang.”

    This is posted by Yves. Has Yves become plural now? The royal “we?” ;) But, to the point, noooo we don’t want to worry about sovereign debt. Perish the thought.

    IMO, we need to clean up capitalism. We need clean capitalism more than we need clean energy. That means the fraudsters start going to jail. The corrupt politicians start going to jail.

    Then, as Yves notes, the bad debts need to be written off.

    I would add tax cuts and less regulation, but make the regulations more sensible and fairly enforced. We do need regulation. So far the regulators have failed us, even when there is regulation — the point becomes moot.

    1. Yves Smith Post author

      1. There is such a thing as an editorial “we”

      2. I have guest bloggers and co authors

      3. I was conditioned at Goldman, “I” is a bad word

      4. I do have a nom de blog, hence two personas.

      1. attempter

        Hmm, I hadn’t thought of it before, but while in Copenhagen your common ground with Kierkegaard, king of pseudonyms, wasn’t just geographical.

  6. Ed Beaugard

    I’m new to this blog, you seem very savvy, but I was surprised when you wrote that the American public is impatient with or worried about deficits, which I think is not true. What’s happening is fiscal austerity is becoming the new orthodoxy with policymakers because of bad economic ideas, not that there’s a clamoring on the part of the public for austerity.
    Otherwise, I agree absolutely about the debt overhang that’s not been dealt with at all.

  7. arby

    This is aimed at helping the banks but the banks are continuing to help themselves to the same ‘investments’ that got them (and us) into this mess. FedL “Here is fifty dollars for Weight Watchers.” Banks: “Thanks. I’m going back to the endless buffet.”

  8. Jim Haygood

    St. Louis Fed president James Bullard has published a paper titled ‘Seven Faces of the Peril’ — the ‘peril’ being a Japanese-style deflation trap, in which a Taylor-rule policy becomes passively helpless.

    Two of Bullard’s seven scenarios consider holding the policy rate at a higher level of 1.0 to 1.5%, to avoid short-term rates which are ‘too low,’ and thus may induce ingrained deflationary expectations. Bullard’s preoccupation is with expectations and signaling.

    In that context, take a look at a two-year chart of the yield on the 5-year T-note:

    The 5-year yield, now below 1.5%, is only a couple of tenths off its Dec. 2008 crisis lows. Ominously, fractional interest rates are starting to infect the entire Treasury yield curve, as in Planet Japan.

    Although the Fed’s Treasury purchases are intended to be stimulative, to the extent that they depress interest rates, they send a deflationary signal. This mixed message is undermining the effectiveness of Treasury purchases.

    If ‘pushing on a string’ isn’t working, the Fed needs to try something else. It isn’t authorized to purchase equities, as far as we know. But the Fed already holds $11.041 billion of monetary gold, carried at a long-ago historic value of $42.22 an ounce. Revaluing this gold to today’s market price would add over $300 billion to the Fed’s balance sheet in one fell swoop.

    Of course, this is mere accounting legerdemain — nothing has actually changed in the basement of 33 Liberty Street; analysts can make this adjustment themselves if they choose. But a reported $300 billion jolt to Benny’s balance sheet would set off a firestorm among goldbugs, conspiracy theorists, and internet crazies like myself. Even the chattering classes of establishment economists would be obliged to interpret ‘what Bernanke really meant.’ And some of them would conclude that his bold gesture was a coup de main against deflationary expectations — the same sort which so worry Bullard.

    Outright purchases of gold would sound a similar inflationary tocsin. Ultimately, ‘aggressive measures to force resolution and restructuring of private sector debt, with stimulus to offset the downdraft,’ a la Yves Smith, are simply not going to happen while gimlet-eyed Austerian mobs menace the streets. By default, monetary policy is the only game in town for now. And inflation of property prices is an alternative way to bail out busted mortgages, requiring no Congressional appropriations.

    So in all seriousness, I call on Ben Bernanke to lay off on the mixed-message, damp-squib debt purchases, and instead have a go at the other asset on his balance sheet: solid gold.

  9. BSR

    I think QE Lite is “too lite” to do much good. We surely need a major devaluation of $ that will reduce real debts, real wages and real prices. A carefully implemented sustained inflation regime is the medicine we desperately need as a nation. If the real value of $ falls to half of its present value, we will start to see some immediate benefits in the area of trade deficits and employment.

  10. christian

    could The fed add wording to boost stock markets as they now have the wiggle room to go from …credit easing discontinuation… QE lite (which they have) ….to supporting broader asset markets …i.e stock indices…..

    because indices look poised to reach the bottom of the trading range….and ???? break thru.

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