Wednesday, August 17, 2011

Why QE2 Failed, Part 1

Following last week’s severe volatility and steep drops, equity markets have regained their footing this week. Renewed confidence in the economic outlook has come despite continued weakness in economic data as evidenced by a 30-year low in U.S. consumer confidence, deteriorating manufacturing reports and nearly stalled growth in Germany, as well as the rest of the Eurozone. Some of the confidence may stem from expectations that Eurobonds are becoming a more realistic option, providing support for the Euro. Other investors appear to be holding out hope that Fed Chairman Bernanke will hint at QE3 during the forthcoming economic conference at Jackson Hole. Having previously highlighted aspects of zero percent interest rates and monetary illusions, the operations of quantitative easing can be further explained. Understanding this process will help explain why QE2 failed to have a noticeable impact on the economy or create sustained inflation.

As I noted in Monetary Illusions, as long as individuals maintain confidence in a bank’s solvency, banks can grant credit through fiduciary media that is uncovered by current capital. A bank’s ability to provide loans is therefore never constrained by the amount of capital. Loan creation, however, is constrained by price and demand. To recognize the effects of QE it is important to consider the impact on price, demand and the quantity of “money” within the economy. Before looking into the Fed’s actions, further consideration of non-central banks is necessary.

An obvious function of banks is holding deposits and making loans. A less obvious observation is that most credit is granted without the backing of money. Although this credit is treated equivalent to money, for our purposes it will be considered money substitutes. During normal economic periods, the demand for credit vastly exceeds the money held by banks. Seeking to earn interest income, banks provide loans through fiduciary media to customers. The interest rate (price) on the loan corresponds to market interest rates and the perceived credit risk, or potential of the loan not being repaid.

When banks grant credit uncovered by money, customers simply promise to repay the loan plus interest in the future. Based on this action, the total base money (money and money substitutes) is actually increased. The extra funds are free to circulate through the economy. Since the supply of “money” has expanded, holding the number of goods in the economy constant, the price of goods initially rises. Also, because one person’s spending is another person’s income, total income temporarily rises. In theory this process could continue indefinitely, if production of goods doesn’t exceed growth in base money and confidence in the banking system is maintained. Unfortunately, maintaining this balance has proved elusive throughout history.

At this point it should be clear that banks have the ability to create “money” (money substitutes) out of thin air. Many people seem to believe that the Fed is undertaking this process through quantitative easing. Yet there is a very distinct difference between QE and granting credit through fiduciary media. As stated earlier, when banks provide credit through fiduciary media, consumers only promise repayment in the future. No current assets are exchanged for the loan. During QE it’s true that the Fed created new reserves separate from any capital. The crucial difference is that the reserves were exchanged for another current asset, Treasury notes. Although the Fed’s balance sheet expanded, this process in no different than normal open market operations used to control short-term interest rates and the supply of base money. As for banks involved in the process, their balance sheets were not expanded, but rather the composition of assets was changed.

Many economists and investors have focused on charts that display monetary growth including banks’ excess reserves. Using this definition of “money” has led many individuals to believe that QE will create high inflation as more money chases the same number of goods. This assumption misses the critical point that bank lending is not constrained by reserves. Net financial assets in the real economy (excluding the Fed) remain unchanged. Since no base money has been added to the real economy, the long-run exchange value also holds steady.

These concepts are certainly clear to the Federal Reserve Board, so an interesting question is, why would the Fed perform QE? As stated by the Fed, a primary goal was to reduce interest rates. Through QE2, the Fed swapped short-term reserves for longer-term Treasury notes. This process reduced the number of Treasury notes freely traded in the economy, lessening the amount of effectively risk-free securities. With the demand for risk-free securities expected to remain relatively constant, reducing the supply drives up prices and lowers interest rates.

The Fed also intended to generate a positive wealth effect through QE2. This expectation stemmed from the belief that the remaining supply of risk-free securities would not satisfy demand. Funds resulting from this excess demand would be invested in slightly riskier securities rather than simply held in cash. By increasing demand for riskier securities, asset prices would be pushed higher. Ultimately, increasing paper wealth should reduce the desire to save and increase spending.

Despite the Fed’s best efforts, unintended consequences of their policy resulted in failure on the first goal and only temporary success on the latter. Due to a common misconception that the Fed was “printing money, “ inflation expectations rose. Fear of losses in real purchasing power countered the reduction of Treasury note supply and potential decrease in interest rates. These fears, coupled with increasing asset prices, spurred demand for hard commodities rather than finished goods that might require subsequent increases in production. The resulting commodity inflation actually reduced aggregate demand for finished goods, creating a drag on the economy.

At the onset of QE2, the solvency of banks was not in question. Rather than removing illiquid securities from the economy, the Fed exchanged one liquid asset for another. Without altering net financial assets in the system, the main goal was to reduce real interest rates, convincing individuals to increase loan and aggregate demand. Misunderstanding of the monetary system, by much of the public, created outcomes far less stimulative than hoped. Future risks to the system have also been heightened by continued intervention. Had policy makers looked beyond neoclassical economics and considered the impact of private sector debt burdens, it’s hard to envision QE2 having been practiced. A future post will delve further into these unresolved issues. For now, I hope readers will recognize the non-inflationary impacts of QE and invest wisely on any further mention of the Fed continuing these policies.

No comments:

Post a Comment