By Satyajit Das, author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming in Q3 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
Quantitative easing (“QE”), the currently fashionable form of voodoo economics favoured by policymakers in the US, is primarily directed at boosting asset values and creating inflation. By essentially creating money artificially, central bankers are seeking to return the world to stability, growth and prosperity.
The underlying driver is to generate growth and inflation to enable the problems of excessive debt in the economy to be dealt with painlessly. It is far from clear whether it will work
QE is designed to create inflation, at least just at the correct level. Given that one of the objectives of central banks is to keep inflation under control, it is ironic that they now want to create more inflation. Higher inflation would reduce the value of debt. Inflation may also induce more consumer spending, as people accelerate purchases, anticipating higher prices in the future.
The ability of QE to generate inflation relies on Milton Friedman’s observation that “inflation is always and everywhere a monetary phenomenon.” The quantity theory of money holds that the supply of money multiplied by velocity (the rate at which it circulates) equals nominal income, the product of real output and prices. Increasing money supply increases nominal income, boosting real output and/ or prices.
The role of money supply in inflation and economic activity is complex. Cause and effect is uncertain – does money supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply of money? Central banks control the monetary base, a narrow measure of the money supply made up of currency plus the reserves that commercial banks hold with the central bank. The relationship between the monetary base, credit creation, nominal income and economic activity is unstable.
A significant problem is that velocity of money or the rate of circulation has slowed. Banks are not using the reserves created and money provided to increase lending. The reduction in velocity has offset the effect of increased money flows.
The desire to increase inflation is also driven by fear of deflation. Economists measure the economy’s “output gap”, the difference between total demand and the economy’s potential to produce goods. When demand exceeds supply, inflation rises. When demand is less than supply, inflation falls (disinflation). In the extreme circumstances it becomes deflation, where prices start to fall.
Deflation makes it difficult to manage excessive debt. Cash flows and earnings fall making it harder to service existing borrowing. Debt must be paid back in money that is now more valuable as it gains in purchasing power. Nominal interest rates fall but after adjustment for inflation rates, real interest rates are high, discouraging borrowing. Falling prices discourage non-essential consumption, as the same item is likely to be cheaper in the future. For a central banker in an economy with high debt levels, inflation is the dream, deflation is a nightmare.
Milton Friedman famously argued that “helicopter drops” of money could be used to encourage spending and avoid deflation. A student of economic history and an acolyte of Friedman, Ben Bernanke restated the principle in 2002 arguing that “under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
The Fed justifies QE as insurance against the risk of deflation. But inflation levels remain modest, particularly if the effect of higher commodity prices is stripped out. In practice, creating inflation or even arresting deflationary tendencies is difficult. After many years and several rounds of QE, Japan still hovers on the cusp of deflation.
Ironically, if QE created the necessary inflation or inflationary expectations, then it would push up interest rates, potentially choking off economic recovery.
After the Fed launched QE2, long term US interest rates rose sharply, driven by fears of high inflation in the future. The hoped for fall in mortgage rates and generally lower interest rates did not occur to the extent anticipated. Since the announcement of QE2, 30 Year Treasury yields have increased by around 0.60%. The average 30-year mortgage rate has gone up from 4.25% in August 2010 to over 5% by January 2011.
Criticism of QE has focused on the risk of Weimar like hyperinflation. Debasement of a currency through debt monetisation can lead to very high levels of inflation.
In reality, the low velocity of money, the lack of demand and excess productive capacity in many industries means the inflation outlook in the near term remains subdued. Inflation will only result if bank lending accelerates and aggregate demand exceeds aggregate supply. America’s output gap is between 5% and 10% and considerably more monetisation would be necessary to create high levels of inflation.
QE’s real side effects are subtle. It discourages savings, drives a rush to re-risk, encourages volatile capital flows into emerging markets and forces up commodity prices.
Low interest rates perversely discourage saving, at a time when indebted countries, like America, need to increase saving to pay down high levels of debt. Low interest rates reduce the income of retirees or others living off savings, further reducing consumption.
Individuals saving for retirement received this piece of quixotic advice from Charles Bean, Deputy Governor of the Bank of England: “Savers shouldn’t necessarily expect to be able to live just off their income in times when interest rates are low. It may make sense for them to eat into their capital … Very often older households have actually benefited from the fact that they’ve seen capital gains on their houses.” In retirement, it seems everyone should sell their houses, take up residence on the streets or in a public park and live off the money released.
Low rates have driven a rush to increase risk, in search of higher returns. In January 2011, the difference between interest rates on speculative or non-investment grade corporate bonds and investment-grade debt fell to around 3.50%, the lowest level since November 2007. In 2010, companies sold a record $286.7 billion of junk bonds to investors driven by the need for higher rates. The search for yield extends to stocks and also structured products, where investors take on complex returns in return for additional returns.
The rush to re-risk has reduced general lending standards. Practices that contributed to the global financial crisis, such as “covenant lite” loans with low protection for lenders, have re-emerged. Under-pricing of risk is also evident, creating the foundations for future problems.
Voodoo was originally a religion that developed in America’s South, based on African beliefs syncretised with Christianity. Voodoo incorrectly became associated with exotic superstitions and occult practices. Unscrupulous practitioners made a fortune charging money for fake good luck charms or talismans kept to ward off evil – fetishes.
Voodoo economics, such as QE, resembles fetishes, objects believed to have supernatural powers. Despite evidence to the contrary, these financial fetishes are predicated on the belief that the theories and models are correct, policy makers know what they are doing and the actions will be effective.
In the voodoo belief system, a zombie is a fictional monster, usually a reanimated human corpse with normal appearance but no will of its own, controlled by a powerful sorcerer. Increasingly, the global economy risks entering a zombie phase. The economy appears to be functioning. In reality, it is moribund and stagnant, manipulated by central bankers and policy makers to give the appearance of normality.
In Ferris Bueller’s Day Off , Sloane ask Ferris: “What are we going to do?” Ferris replies memorably: “It’s not what we are going to do! It’s what aren’t we going to do!” As policies fail or prove ineffective, desperate policy makers merely apply them in larger doses or dream up new fetishes. QE2 is likely to be followed by further rounds of QE and other forms of voodoo economics.
If current policies fail to spur growth and inflation, then governments will borrow or print more money to increase spending, transferring funds to households or cutting taxes, building infrastructure or even writing off the face value of mortgages and other debt. If that fails then they can purchase other riskier assets. The Bank of Japan’s strategies now include buying stocks, lending to companies and providing even more money to banks to boost their capital and lending capacity.
In extremis, the central bank could charge people for holding money, forcing them to spend it by placing expiry dates on currency. Policy maker’s actions are shaped by Josh Billings’ observation: “The thinner the ice, the more anxious is everyone to see whether it will bear.”
The economic policy debate, at its core, is about the limits to human knowledge of the economy and the ability to control it. The global financial crisis and the policy response are increasingly exposing the limits to both. As author Richard Collier once remarked: “All motion is cyclic. It circulates to the limits of its possibilities and then returns to its starting point.”
Economists, central bankers and governments reject limits to their knowledge and powers. Their thinking mirrors the following exchange in The Dark Knight (the latest instalment in the Batman franchise):
Alfred: Know your limits, Master Wayne.
Bruce Wayne: Batman has no limits.
Alfred: Well, you do, sir.
Bruce Wayne: Well, can’t afford to know ’em.
Central bankers and policy makers would do well to heed Josh Billings’ advice: “I have lived in this world just long enough to look carefully the second time into things that I am most certain of the first time.”