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). Joint posted with Roubini.com
In the film Ferris Bueller’s Day Off, an economics teacher, played by Ben Stein, launches into an improvised soliloquy: “… Anyone know what this is? Class? Anyone? Anyone? Anyone seen this before? The Laffer Curve. Anyone know what this says? It says that at this point on the revenue curve, you will get exactly the same amount of revenue as at this point. This is very controversial. Does anyone know what Vice President Bush called this in 1980? Anyone? Something-d-o-o economics. “Voodoo” economics.”
In the late twentieth century, US President Ronald Reagan discovered voodoo economics. In framing policy responses to the global financial crisis, central bankers and governments have increasingly embraced more exotic forms of voodoo.
Since the early twentieth century, economics has been preoccupied with the business cycle. Economists, from John Maynard Keynes to Milton Friedman, have developed theories to explain boom-bust cycles. Most importantly, they sought to develop tools to manage these cycles, fostering progress and the creation of wealth whilst reducing the disruption and high cost of periodic crises.
Despite complex doctrinal differences, Keynes and Friedman’s followers believe that the correct policy measures allow a high degree of control over economies. During Le Belle Epoque from the late 1980s to around 2007, economists and policy makers luxuriated in the belief that most major problems of economics and management of economies were well understood, if not entirely predictable and controllable. The global financial crisis exposed significant problems in the state of human economic knowledge and also the ability to control events.
Economics Sine Qua Non
Policy makers have two major mechanisms through which they can influence the economy. Using fiscal policy, governments can adjust the level of spending relative to tax inflows. Using monetary policy, governments or, in modern times, “independent” central banks can adjust interest rates and the supply of money to manage the availability and cost of credit as well as inflation . Ultimately, both mechanisms are designed to influence the level of demand in the economy, creating the economic “nirvana” of the “right” level of growth, unemployment and inflation.
At the start of the global financial crisis, policy makers resorted to age-old remedies, increasing budget deficits and cutting interest rates. The only way out of the problem of excessive debt was strong growth and inflation.
Growth would increase the income and cash flows of indebted individuals, companies and countries enabling them to more easily pay back debt. Inflation would help debt repayments, reinforcing increases in incomes and cash flows, at least in nominal terms. Inflation would also reduce the real (inflation and purchasing power adjusted) level of borrowings, reducing the level of leverage within the financial system.
It was the least painful fix. Banks and investors, who had lent imprudently, would not be punished. Borrowers, who had taken on debt beyond their capacity to repay, would be rewarded. Prudent savers would lose, as the value of their savings fell in purchasing power. Despite recognition that consumption levels needed to be reduced to increase savings and lower reliance on borrowing, spending would be propped up to restore economic growth.
The morality and long term ethics of the actions and effects were not debated. Short term exigencies ruled as policy makers invoked familiar economic incantations: “there is no alternative” or “the alternatives are worse.”
Unfortunately, three years on, the heroic bet on growth and inflation does not appear to be working. Lethargic growth and low inflation rates, especially excluding food and energy prices, are prolonging the adjustment, delaying the anticipated return to pre-crisis prosperity.
Economic policy options are now limited. Fiscal policy entails taxing and spending and/ or borrowing and spending. As tax revenues fell as a result of slower economic activity, most governments resorted initially to borrowing to finance large budget deficits. The European debt crisis highlighted the limits of the ability of governments to borrow and spend. Near zero policy interest rates in the US, Euro Zone and Japan increasingly limits the ability to stimulate the economy through monetary policy.
Policy makers have resorted to unorthodox measures following the advice of English science fiction writer Arthur C Clarke: “The limits of the possible can only be defined by going beyond them into the impossible.” A key element of this strategy is “quantitative easing” (“QE”), another form of voodoo economics. However, QE may not be any more successful than previous strategies, posing other risks.
QE is sometimes parsed as “printing money”. In reality, it is a little more complex.
Normally, central banks regulate the amount of money in an economy, by changing interest rates, the price of money. Changes in rates should change the demand for credit and the supply of money. Where interest rates are already at zero, other means are necessary to increase the supply of money in the economy.
If the economy were entirely cash based, this would just mean printing money. In Weimar Germany, the government took over newspaper presses to print money, such was the demand for bank notes.
In a modern credit-based economy, central banks buy government bonds, which are held on the central bank’s balance sheet. The cash paid for the bonds, usually reserves or low or zero interest rate bearing deposits with the central bank, can be exchanged by banks for higher return assets, such as loans to clients. The purchases also increase the price of governments bonds, reducing interest rates.
In theory, QE lowers borrowing costs and creates liquidity, increasing the supply of money and, hopefully, stimulating demand and inflation.
There are different flavours of QE. It can involve the central bank expanding its balance sheet by buying government bonds, changing its criteria to purchase less liquid and riskier securities or a combination. In all forms, the underlying concern is debt monetisation, that is, the central bank purchasing government bonds with artificially created money to finance tax cuts or government spending, causing hyper-inflation.
Desperate Times, Desperate Measures
In the late 1990s, Japan began using QE on a significant scale in an attempt to revive its stagnant economy. With interest rates at zero since 1999, the Bank of Japan used QE (known as ryoteki kinyu kanwa in Japan) to provide additional money to commercial banks for private lending. Since 2007, the United States, the United Kingdom and the Euro Zone have all resorted to similar strategies.
The Bank of England purchased £175 billion of assets by end of October 2010, primarily UK government securities and small amounts of high quality private sector debt. In November 2010, the UK Monetary Policy Committee (“MPC”) voted to increase total asset purchases to £200 billion. The European Central Bank (“ECB”) has used re-financing operations (a form of quantitative easing) to inject money into the Euro Zone economies. It has expanded the assets that banks can use as collateral for Euro denominated loans from the ECB.
The US Federal Reserve (“the Fed”) has been the most aggressive in using QE, launching several rounds of purchases. The scale of the Fed operation can be gauged from the increase in the size of portfolio. From $700–$800 billion of Treasury notes in 2007, the Fed increased the size of its security holdings to $2.1 trillion in June 2010 with current projections indicating that it will increase to nearly $2.5 trillion.
Initially, between November 2008 and March 2010, the Fed purchased around $1.25 trillion of bank debt, mortgage backed securities (“MBS”) and Treasury notes. After a short halt, the Fed resumed purchases in August 2010 when economic growth fell below expectations. Initially, the Fed committed to reinvesting repayments from its MBS portfolio in QE, around $30 billion a month. In November 2010, the Fed announced further quantitative easing measures, committing to buy $600 billion of Treasury securities by the end of the second quarter of 2011.
Chairman Ben Bernanke has repeatedly sought to distinguish the Fed’s actions from QE, preferring to call it – “credit easing”. Defending his policy, most notably in an opinion piece published in the Washington Post, he has repeatedly sought to reassure critics that QE is not unusual and well within the range of policy options available to central banks. In response, a number of well known economists published an open letter urging the Fed to reconsider and discontinue its large-scale asset purchase plans.
Does it do What it Says on the Can?
Advocates of QE believe that it will lower interest rates promoting expenditure, growth and reduce unemployment. QE, they argue, also enables banks to increase lending, lowers mortgage rates encouraging re-financing and boosts asset prices, further encouraging spending through the effect of increased “wealth”.
In reality, the identified benefits may prove elusive. Lower rates and increasing the supply of money, of themselves, may not boost economic activity.
In the US, many households are crippled by existing high levels of debt, low house prices, uncertain employment prospects and stagnant income. They are reducing, not increasing, borrowing. For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment.
Instead of being lent to customers, the reserves created by QE have persistently sat on bank balance sheets or been recycled into government securities. US commercial banks now have holdings of cash and government securities in excess of loans to customers. This echoes precisely what was observed in Japan when QE was implemented.
The sclerotic credit growth reflects the fact that banks are capital constrained to varying degrees, due to losses and also planned increases in regulatory capital reserve requirements. A fragile financial system and the risk of funding shocks means that banks are husbanding liquidity. The uncertain economic outlook has also made banks cautious in extending credit to entities, other than those that are “too big to fail”.
The general impact on real economic activity has been limited. The Fed’s QE programs to date have reduced long term interest rates, but bank credit has contracted, the housing market remains weak and economic recovery remains tentative. The experience is consistent with that of Japan where a prolonged period of QE did not result in economic recovery, growth, reduced unemployment or inflation.