An Access Advertising EconBrief:
“QE3: Flying Blind”
Recently, Federal Reserve Chairman Ben Bernanke announced that the Federal Reserve would embark on still another venture in stimulative monetary policy – QE3. Bernanke characterized this sequel as intended to “help Main Street” by fighting unemployment, which “has remained stubbornly high.”
“QE” stands for “quantitative easing.” The meaning of this phrase will seem obscure to all but insiders; it implies that the focus of monetary policy is entirely on the quantity of money rather than something else. Economic textbooks of a half-century ago defined monetary policy according to the tenets of Keynesian economics – the manipulation of interest rates (usually downward) through changes in the quantity of money.
When interest rates are at or near zero, there is little further scope for employing this tool – at least in the orthodox manner. The idea behind quantitative easing is that further increases in the quantity of money may still have stimulative impact when selectively employed. Meanwhile, the increases have the effect of maintaining the Fed’s zero-interest-rate policy (ZIRP).
The third edition of the QE series both conforms to and differs from the first two. The additional money will come from monthly purchases of mortgage-backed securities by the Fed, in the amount of $40 billion. This is both a similarity and a difference. The .Fed has been trying since 2009 to raise home prices by buying mortgage-backed securities – without much success. Prior to QE3, however, this program was segregated from monetary policy as such and marketed as a kind of disaster relief for the housing industry.
The other element of QE3 is a continuation of “Operation Twist,” the revival of a little-remembered 1960s policy aimed at changing the maturity structure of federal-government debt. By buying and retiring long-term government bonds and selling short-term government debt instruments, the Fed has significantly shortened the average maturity of federal debt. Since short-term interest rates are being held artificially low, this has allowed the government to reduce its interest payments on the debt.
The Political Reactions to the QE Series
Technically, the Federal Reserve is an independent institution, neither completely governmental nor strictly private. Its actions are ostensibly motivated by non-partisan considerations and as such should be above politics. In practice, the Fed has become a sizzling hot potato on the election-year grill.
Most defenders of the administration – not all of them Democrats, surprising as that may seem – insist that the Fed’s actions since 2007 have been emergency actions aimed at rescuing us from the abyss of worldwide great depression, a la the 1930s. Since reported U.S. unemployment has not risen to 25% and GDP has not fallen precipitously, the Fed’s actions must have been successful.
Criticism of the Fed has been purely political, its defenders maintain, since its actions have been taken right out of the textbook – or perhaps “script” would be a more precise analogy – of measures designed to combat financial crisis, market crash and incipient depression. Since quantitative easing has been used only in Japan over the last dozen years or so and has been mostly deemed a failure, it is not clear why the Fed has called this play or why armchair quarterbacks tout this playbook so confidently.
Fed critics are aghast at the Fed’s actions and its rationale for them. Massive injections of liquidity and a long-term “zero-interest-rate-policy” (ZIRP) are draconian, unprecedented actions. Their justification can only be an emergency of life-threatening dimensions – to import an analogy from medical crisis management. But unlike the Great Depression that began in 1929, this emergency was never realized, only putative. There were no massive bank failures, no bread lines, no riots, no widespread unemployment. There was the popping of the government-policy-created housing bubble and an ensuing recession – the thirty-third if you believe the long line of U.S. recessions began in 1854, as the National Bureau of Economic Research does. But another decade-long depression was not inevitably in the cards.
Even more telling have been the Fed’s incoherent explanations for its actions. Bernanke says that this QE is supposed to fight unemployment. But each previous QE had the same rationale. Yet results were anemic at best – unemployment fell from almost 10% down to its present 8.1% mostly because the size of the labor force shrunk to a shocking, seldom-seen extent. Actual employment is still less than in 2007, prior to the onset of the recession.
The political camps are miles apart, but even Bernanke’s supporters should acknowledge, as he himself does, that legitimate doubts plague public acceptance of the QE series. Two nagging questions lead the list. First, why should this QE succeed where the first two largely failed? Surely not because the technical details are different; purchases of mortgage-backed securities have scarcely budged home prices previously, so why should they lift the entire economy now? Without saying it in so many words, Bernanke is implying that his intentions are what determine the results of the policy. Previously, the policy now labeled as QE3 was not intended to be stimulative, so it should not be criticized for its lack of punch. But now, less than two months before the Presidential election that will determine whether he is reappointed as Fed Chairman, Bernanke has recognized that need to fight unemployment. So we should expect that the same policies that didn’t work before will work now.
Second, the phrasing of Bernanke’s remarks clearly suggests that previous QEs had a different purpose. What was it and why did Bernanke fail to disclose it then and now? After all, it’s not as if he can be excused for holding political cards close to his vest. The Fed is supposed to be independent of politics and government policy.
And while we’re posing questions, let’s not forget an even more obvious one: How do we know that the QE cure is not worse than the disease it is supposed to fight?
The Curious Rationale for the QE Series
This space has previously addressed what seems to be the true rationale for the QE series; namely, the desire to prop up the banking system by subsidizing banks. Because banks and Wall Street are in bad odor with the public, the subsidies have to be undercover. The QE series has involved purchases of securities by the Fed from commercial banks and payment in the form of deposits credited to bank reserves by the Fed. In order to induce the banks to hold this money as excess reserves instead of lending it out, the Fed began paying interest to banks on their excess reserves in 2010. By restraining bank lending rather than encouraging it, the Fed has itself prevented its policies from stimulating the economy. Indeed, for the last year or so the Fed has even “sterilized” the increases in bank reserves with asset sales so as to hold the supply of base money roughly constant.
We cannot know the reasons for this policy because Bernanke has not even acknowledged it, let alone explained it. Presumably, the Fed believes that too many U.S. commercial banks are at or near the point of insolvency. Normally, the Fed handles insolvent commercial banks by merging them with sound banks, but this is clearly infeasible when a sizable fraction of banks are unsound. Absent its standard form of treatment, the Fed may be putting the banking system in a therapeutic coma until conditions improve. In other words, the Fed may be allowing bank balance sheets to fatten on safe interest payments earned on excess reserves while buying time for housing prices to rise. Housing price increases would increase the value of the mortgage-backed securities that form the bulk of commercial-bank assets.
This is consistent with the form taken by QE3, in which Fed purchases of mortgage-backed securities are the backbone of stimulative policy. This unprecedented policy change reverses age-old Federal Reserve precedent of purchasing and selling only government securities, in order not to favor or harm particular industries or firms in the private economy.
There is an alternative explanation for the QE series and ZIRP. The state of the federal budget is so parlous that by 2020, interest on debt threatens to overwhelm it and comprise almost all the projected total. This would crowd out almost all social spending directly and indirectly crowd out private investment spending by forcing an increase in market interest rates in order to attract the bond investment necessary to finance the projected budget deficits. ZIRP can be viewed as a delaying action designed to hold down federal-government interest payments as long as possible and buy time for Congress and the President to deal with the nation’s fiscal problems.
We should note, first, that these two alternative explanations for the QE Series are not mutually exclusive. Indeed, there reinforce each other. But they are both thoroughly dishonest because, if either or both are true, they mean that Bernanke has been lying through his teeth for years. They also signal the end of Federal Reserve independence from politics. Both involve Fed implementation of fiscal policy as well as monetary policy, even though fiscal policy is supposedly the sole preserve of the Treasury and the political administration in power.
Why Is the Cure Worse Than the Disease?
Judging from the actions of the Federal Reserve since 2008, one might think that the only function served by interest rates is to serve as levers by which the Fed speeds up or slows down the pace of economic activity. This is miles away from the truth. The true function of interest is outlined in economic textbooks and reference books.
In The Fortune Encyclopedia of Economics, Paul Heyne informs us that “interest is the price people pay to have resources now rather than later.” At a consumer-loan rate of 11%, we can borrow $900 for one year and repay $1,000 in one year’s time. Obviously, since we have the wherewithal to repay the $1,000 loan in one year, we could have simply waited one year and enjoyed $1,000 worth of consumption goods. But we chose instead to consume $900 today, and the 11% ($100) premium we paid is the price for our anxiety to consume in the present. It reflects the degree of our time preference, a term suggesting that an inherent human tendency to prefer consumption sooner rather than later is what accounts for a positive interest rate. And it is the ability to utilize capital goods productively that allows us to finance them with borrowed money and use their product to repay both cost and interest on the loan.
This implies that interest is not purely a monetary phenomenon. “The fact that loans are usually made in money leads to the mistaken belief that interest is the ‘price paid for the use of money'” and can be lowered mechanically be by increasing the amount of money in circulation. “But interest would also exist in a pure barter economy where money was not used.”
This is not merely conjectural. In wartime prisoner-of-war camps, prisoners made loans to each other from their limited stocks of ration goods, demanding repayment of a larger quantity of the good. When cigarettes later became the medium of exchange in the camps, these constituted both principal and interest for the loans. The medieval church condemned the collection of interest as sinful, but it purchased annuities to the proceeds of land rents at less than their face value; e.g., it charged interest to sellers.
The fact that goods and money are valued differently at different points in time means that interest rates are key tools of human valuation. “The interest rate enters at least implicitly into all economic decisions, because economic decisions are made by comparing expected future benefits to costs.” The farther into the future a prospective benefit is deferred, the lower its current value. That current or present value is calculated numerically by discounting the benefit using a relevant interest rate.
Every sort of investment decision requires this kind of discounting calculation or its obverse, the future value calculation – both of which require the use of an interest rate. People who want to save for their retirement must do these calculations and supply relevant interest rates for their own use. Businesses pondering fixed investment will probably wish to calculate a “hurdle rate” or interest rate of return for comparison purposes. To do it they will need market rates of return to serve as benchmarks.
The Soviet Attempt to Control the Interest Rate
Soviet Russia virtually eliminated private property and capital markets from the Russian landscape beginning in 1917. In principle, this eliminated both the opportunity and the need for nominal interest rates. But economics predicts that the phenomenon of interest is necessary for people to behave rationally. Sure enough, Communist economic planners eventually tried to invent an interest rate to improve the effectiveness of their own planning. (They couldn’t call it an interest rate, for fear of being shot – they called it the “efficiency index.”)
The Soviet government had the advantage of being able to observe Western financial markets and interest rates in constructing their artificial interest rate. Even so, their attempt failed miserably. Although few realized it at the time, subsequent research and archival disclosures revealed that their economy declined more or less continuously
when its private features were suppressed. Ultimately it collapsed completely, beginning in 1989. One important cause of the collapse was the utter inability to tailor investment to meet consumer wants and needs.
The U.S. Economy Under ZIRP
How would we expect a free-market economy to react when the price signals that customary guide production and consumption decisions are disrupted, garbled and stopped entirely? We would expect confusion and indecision to result. We would expect the pace of economic activity to slow as people groped for substitute decision variables on which to base their actions. We would expect to find extreme reluctance in committing large amounts of resources and money to future endeavors, whether in hiring or investment. In short, we would expect to see an economy very much like the economy we observe all around us today.
The effects of ZIRP are even more pernicious than they might seem at first glance. Although the interest rates most directly (and indirectly) affected by ZIRP are short-term rates, long-term interest rates under ZIRP are also not unhampered free-market rates. Just as with the prices of goods and services, interest rates act through their relative relationship to each other rather than through their absolute magnitude alone. That is, the relationship of (say) six-month to one-year rates is just as important as either rate by itself. Even though the effect of ZIRP on interest rates becomes progressively smaller as the term structure of the rates lengthens, the relative relationship between long rates and shorter rates is still affected by distortions in the latter. These distortions cause changes in the supply of and demand for savings and investment that, in turn, affect long-term rates as well. This is not only acknowledged but welcomed by the Fed – Bernanke expressly claimed lower long-term rates as an intended effect of QE3.
The 1970s Inflation – Comparing Distortions
The last time that widespread distortions in relative interest rates occurred in the U.S. was the late 1970s. They were due to the high inflation that had accelerated thanks to Federal Reserve policies throughout that decade. Although all interest rates came to include an “inflation premium” intended to compensate asset holders for the loss of purchasing power of fixed-income interest payments, this market-imposed version of financial inflation indexing was an inexact science. In practice, the relative relationship of interest rates of differing terms was also distorted by inflation, if only because few if any asset holders had exactly the same consumption patterns. Consequently, inflation had a different effect on the real value of a given interest return for each investor.
An even greater degree of distortion was experienced in 1970s’ consumer goods markets, where rapidly rising prices did not all rise at the same rate. Consequently, relative prices changed dramatically compared to their pre-inflation levels. Consumers’ money incomes also did not rise pari passu with inflation, causing marked shifts in real income away from those on fixed incomes and dependent on fixed-income investments.
Today, the greater distortion is experienced in financial and investment markets. Interest rates are to the future what a plane’s instrument panel is to a pilot. When the instruments are broken or unreliable, the pilot’s navigational horizon is limited to what he can see. ZIRP gives us interest rates that are unreal, phony, untrustworthy. This limits our planning horizon severely, making us unwilling to look very far ahead, hire employees or commit substantial funds to the future. And it even distorts the choices we make in the present.
Flying Blind Under ZIRP
Lower interest rates cause producers to become more future-oriented, shifting production to good with longer production processes using more capital-intensive methods. Under normal circumstances, when lower interest rates are the result of an increase in saving by the public, this is appropriate. The public’s increase in saving is a signal that it wants more consumption in the future and less now. This insures an adequate volume of purchasing power to buy the volume of future goods produced, while changes in the prices of goods and services insure that the right amounts of particular goods and services are produced.
But when the low interest rates are contrived artificially by the Fed instead of organically by private saving, there is no assurance that the future volume of consumption spending that consumers have planned will be adequate to purchase the goods produced by producers. Producers of slower-gestating goods will suffer losses because their prices will have to fall to unremunerative levels to clear the market. This will lead to business failures, layoffs and unemployment. Ordinarily this cycle would be reversed by changes in interest rates – unless interest rates cannot rise to cut it short. Then producers are in a quandary. The market signals they have come to rely on are now telling them to do things that have just failed. On the other hand, government regulators are telling them they can’t do many of the things they want to do. So they do nothing, or as little as possible.
Free markets have evolved a delicate and complex system of price signals to guide producers and consumers. Prices of goods and services guide us in our purchases from day to day and over very short time horizons. Interest rates guide our planning decisions over significant lengths of time; they are the instrument panel that helps us to navigate a cloudy and uncertain future. But when this system of prices fails or is hamstrung by government, as happened in the Soviet Union and in 1970s America and now under ZIRP, we find ourselves flying blind.
QE3: The Substitution of Politics for Markets
Fed Chairman Bernanke’s justification for QE3 is impossible to take at face value and difficult to rationalize in any favorable way. Evaluated as economic policy, it further accelerates the trend first kicked into overdrive in 2008; namely, the substitution of bureaucratic and political criteria for those of markets. The verbal cosmetics applied to beautify these actions do not mask their flaws. And the emergency rationale invoked to justify them cannot overturn the verdict of history and logic.