Fed Policy Is Failing
Many top economists have said that quantitative easing doesn’t help the economy.
But many argue that – without QE – the economy would be much worse.
How do we reconcile those opinions?
One of the main architects of Japan’s QE program – Richard Koo – Chief Economist at the Nomura Research Institute – explains that QE helps in the short-run … but hurts the economy in the long run (via Business Insider):
Initially, long-term interest rates fall much more than they would in a country without such a policy, which means the subsequent economic recovery comes sooner (t1). But as the economy picks up, long-term rates rise sharply as local bond market participants fear the central bank will have to mop up all the excess reserves by unloading its holdings of long-term bonds.
Demand then falls in interest rate sensitive sectors such as automobiles and housing, causing the economy to slow and forcing the central bank to relax its policy stance. The economy heads towards recovery again, but as market participants refocus on the possibility of the central bank absorbing excess reserves, long-term rates surge in a repetitive cycle I have dubbed the QE “trap.”
In countries that do not engage in quantitative easing, meanwhile, the decline in long-term rates is more gradual, which delays the start of the recovery (t2). But since there is no need for the central bank to mop up large quantities of funds, everybody is no more relaxed once the recovery starts, and the rise in long-term rates is far more gradual. Once the economy starts to turn around, the pace of recovery is actually faster because interest rates are lower. This is illustrated in Figure 2.
Fed chairman Ben Bernanke sparked a sharp rise in long-term interest rates at the June press conference by suggesting that tapering could happen later in the year.
The September decision raised questions among observers over whether talking about tapering ended up eventually precluding tapering, because the rise in long-term interest rates sparked by the signal weighed on the economy such that the Fed then felt it couldn’t ease up on the bond buying it does under its QE program.
Richard Koo calls it the “QE trap,” a concept he explained in a notefollowing the September FOMC decision.
Koo has been meeting with clients and officials in the U.S., and he says he hasn’t been able to find anyone to refute the theory that the U.S. economy is currently ensnared in the “QE trap.”
“At the Fed I hoped to hear a refutation of the QE ‘trap’ argument presented in my last report and which I presented using Figure 1,” writes Koo in a note to clients. “However, the official I met with was unable to say anything to ease my concerns.”
(Zero Hedge has also repeatedly warned of a QE trap).
In a sense, quantitative easing is meant to benefit the wealthy. After all, it can contribute to GDP only by making those with assets feel wealthier and encouraging them to consume more.
Postscript: Of course, the Fed’s other major policy approaches have failed as well.
For example, bailouts of the bank. Specifically, a study of 124 banking crises by the International Monetary Fund found that propping banks which are only pretending to be solvent hurts the economy in the long-run:
Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.
Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.
All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.
These are not even new insights. We’ve known for literally hundreds of years that the types of actions which the Federal Reserve, Treasury and White House have been taking would lead to disaster.