Why Quantitative Easing Hasnít Worked
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Last Week’s Unemployment Report
2. Quantitative Easing Has Been Massive
4. Conclusions & Some Parting Thoughts
While there have been some encouraging economic reports over the last several months, the fact is the US economy is still growing at a rate below 3%. As discussed last week, there’s a fair chance the economy will reach and maybe exceed 3% growth in the second half of this year. Yet by any metric, this economic recovery is far below most post-recession recoveries over the last 100 years. Historically, we should be growing at rates of 5-6% or better at this point.
The standard answer is that the recession was the worst since the Great Depression, and we had a severe credit crisis on top of that. Bank lending collapsed and has yet to recover. Only when the credit markets and bank lending do recover will we see this economy get back to “normal,” so we are told.
In light of all this, in 2008 the Fed embarked on an unprecedented campaign that is called quantitative easing (“QE”) in an effort to jump-start the economy and head-off deflation. The QE process has involved the Fed ballooning its balance sheet exponentially by buying various securities ranging from troubled home mortgages to Treasury securities.
Through late last year, the Fed admitted to making $2.3 trillion in such securities purchases with the goal of getting the banks to lend more money to stimulate the economy. Yet as we all know, the banks have not responded as was expected. Nevertheless, Fed Chairman Ben Bernanke said last week that the Fed will continue QE until at least the middle of this year.
All of this leads us to wonder why QE is not working, or at least is not working as expected. This week, I will reprint one of the best articles I have seen on the subject of QE and why it hasn’t worked. I think you will find it very interesting.
But first, I will offer a few comments about last week’s unemployment report which surprised many with the unexpected drop from 9.8% in November to 9.4% in December. Following those observations, we will jump right in to the main topic this week – quantitative easing and why it has not worked as expected.
Unemployment Rate Falls More Than Expected
Last Friday, the Labor Department reported that the official unemployment rate fell to 9.4% in December, down from 9.8% in November. This came as a big surprise since the pre-report consensus was for a modest decline to only 9.7%. President Obama was quick to cite the better than expected number as more evidence that the economy is improving faster than expected.
But as usual, the better than expected headline unemployment number masked several troubling underlying components. First, the internals of the report noted that non-farm payrolls increased by only 103,000 last month, well below expectations. Most pre-report estimates suggested that non-farm payrolls would increase at least 175,000 in December.
Second, the number of “discouraged workers” – identified as those who have not looked for work in the last four weeks – surged to 1.3 million in December. Those who have not looked for work in the last four weeks are not counted as among the unemployed. Thus, it is no surprise that the official unemployment rate dropped more than expected last month.
The bottom line is, if the economy continues to improve, more and more people who have given up looking for a job may start looking again. If so, this could serve to increase the unemployment rate in the months ahead. So I would not put much faith in last Friday’s surprise drop in the official unemployment rate.
Now on to our main topic this week – quantitative easing and why it has not worked as expected.
Quantitative Easing Has Been Massive
To put QE in perspective, in January of 2008 the Fed’s balance sheet stood at $739 billion. Yet as of October 2010, the Fed’s balance sheet had exploded to $2.3 trillion! Supposedly, these mass purchases of securities were going to increase the money supply significantly. Yet the money supply rose only marginally last year, despite a 300% increase in the Fed’s balance sheet.
Banks, that were supposed to lend this cheap money they were getting from the Fed to take bad assets off their books, decided instead to invest this money back with the Fed for a small – but safe – profit. As a result, small businesses were, and still are, starved for credit, and the unemployment rate remains above 9%.
At the end of the day, the question remains: Why hasn’t the Fed’s massive quantitative easing worked? Last Thursday, I ran across an excellent article that tackles this very subject by John Tamny, the editor of RealClearMarkets.com and Forbes Opinions. Mr. Tamny has a distinctly different view of QE than you see in the mainstream press and the White House. I have reprinted most of the article below, and I think you will find it very interesting.
With the US economic rebound still slow relative to past post-recession recoveries, the majority opinion within the Fed (as evidenced once again by this week's minutes) is that further expansion of its balance sheet will boost lending on the way to increased output and employment in an economy that is falling short.
Despite a dollar that continues to test new lows versus gold and a broad range of foreign currencies, the Fed presently fears deflation. By one argument, monetary ease will increase currency in circulation, and the inflationary effect will induce consumers to buy goods in advance of looming price increases.
While some might laud the Fed's efforts to aid an economy that is presently performing sub-optimally, its Treasury purchases have potentially destructive investment implications and will prove superfluous at best. The individuals who comprise the US economy would be better served if the Fed were to float the money-market rate that it sets, and then let the economy heal itself free of further intervention.
Monetary ease. Economic commentators across the ideological spectrum have been impressed, alarmed, or both, by the substantial increase in the Fed's balance sheet that began in 2008. In January of 2008 it stood at $739 billion, but as of late October, it had expanded dramatically to $2.3 trillion.
Empirically, the Fed's mass purchase of assets from money-center banks was largely superfluous when it came to increasing the amount of money in circulation. While circulation amounted to $829 billion as 2008 dawned, it had only increased to $961 billion as of October  despite assets on the Fed's books having jumped 300%.
Whether commentators approve or disapprove of this expansion, there was then and is today a broadly held view that the Fed's actions were and continue to be inflationary. It's an overused, and perhaps misunderstood concept, but the Fed's expansion of its asset base spoke to the "printing of money" that according to some would end in tears.
Thanks to reduced economic growth, demand for the money and credit necessary to lubricate production and trade has increased more slowly over the last few years. And with money demand weak, the Fed's attempts at monetary ease have not produced the dramatic increase in money in circulation that so many economists expected.
A second look at currency in circulation versus the size of the Fed's balance sheet tells the same tale. From December of 2002 to December of 2007, when the economy was growing at a stronger pace, 90% of the Fed's balance sheet was in circulation against 3% held at the Fed itself.
Fast forward to October . Despite the Fed's strong efforts to increase bank liquidity, the vast majority of dollars exchanged for interest-bearing assets have returned to the Fed where they earn a nominal level of interest paid by the central bank. As of October 20th, only 41% of the Fed's balance sheet represented currency in circulation, while 42% is at the Fed gathering interest.
The low demand for money today mirrors what occurred in the early 1930s. Contrary to popular belief on the left and right which suggests money was tight during the Great Depression, the exact opposite scenario prevailed.
Indeed, as William Greider observed about the '30s in Secrets of the Temple, "banks found themselves floating in an excess of reserves - a pool of surplus lending capacity - because they could find no customers who wanted to borrow." It sounds like today... the Fed cannot push into circulation money that otherwise isn't desired by productive economic actors.
The saying that you can lead a horse to water, but not force it to drink, perhaps applies here. Staffed by individuals who naively believe that money creation itself is a source of economic energy, the Fed has overloaded financial institutions with dollars that are now back at the central bank.
To put it simply, the Fed has put the cart before the proverbial horse. Money supply, or money in circulation, isn't the driver of economic activity as much as economic activity is the driver of demand for money and credit. Production increases money in circulation, not the other way around as so many assume.
In short, the Fed's actions have been superfluous at best. As economic individuals, we trade products for products. The sole purposes of money in the process are to facilitate exchange and serve as a measuring stick so that investors can place value on capital goods and labor.
If superfluous, where's the harm?While the Fed's balance-sheet expansions haven't led to any major increase in the amount of dollars circulated, the evidence suggests that its actions could have been economically harmful. Though it would be difficult to place a value on the damage, and nearly impossible to distinguish between cause and effect, classical theory says that the Fed's actions must be hurting the U.S. economy…
Quantitative easing.Turning back to the Fed's plans to purchase $600 billion in longer-dated Treasury securities during existing and future rounds of quantitative easing, this too will be economically problematic. Indeed, in telegraphing its future actions, the Fed is telling investors in government debt that their purchases will be subsidized by the central bank.
Governments have no resources other than those they extract from the private sector, and so long as it's known that Treasury investments will be bolstered by the Fed's own purchases, owners of Treasuries will have greater incentive (notwithstanding the recent rise in Treasury yields) to fund government rather than more productive private sector pursuits. In a world of limited capital, the Fed's attempts at ease will on their face subsidize the growth of government.
Of course it's important to remember how the Fed has arrived at its latest policies in favor of buying up longer-dated Treasuries. Having taken the Fed funds rate down to zero, our central bank has moved on to the seemingly exotic notion of "quantitative easing."
But there lies the problem. The Fed shouldn't be setting the short rate for money, or any cash rate for that matter, and it's arguable that its decision to reduce the funds rate to zero has exacerbated our present economic situation.
Rates of interest are - other than the dollar - arguably the most important prices in the world for matching supply of, and demand for, credit if left alone. The Fed's actions in this very real sense are blurring these incredibly important price signals.
Ultimately, all of the Fed's actions are treating symptoms rather than causes. Indeed, it was irresponsible lending that helped cause the financial crisis of not long ago. Higher, market-driven rates of interest would have been curative by virtue of creating incentives for savers to replenish capital, while being rewarded with higher rates of interest paid on capital invested.
Unwilling to let the economy heal itself through rewards for the prudent, the Fed is essentially doubling down on a decade in which faulty lending to property and nosebleed spending in Washington led to some highly trying times for the financial markets. If it didn't work the first time, it is the height of naiveté for the Fed to subsidize the same mistakes once again.
Ultimately economic policy needs to move beyond what is seen, and gravitate to what is less visible. Fed activity has given us nominally low interest rates, but unseen is what the economy has lost through penalties placed on the very savers whose replenishment of the capital stock at higher rates of interest would have helped fund a more natural, market-driven recovery.
Deflation isn't necessarily bad. Fed Chairman Bernanke feels that another benefit from quantitative easing is increased inflation. Fearful of deflation despite a dollar that continues to test new lows, Bernanke's view is that if the prices of consumer goods decline, consumers will lie in wait before making purchases, and a bad economic outlook will grow worse.
On its face, Bernanke's thinking is unfortunate. Indeed, the last thing governments should ever need to do is to stimulate consumer demand. As humans all, we're wired to consume, and surely we produce to do just that.
Even better for an economy that's still sagging, everything we have today - from computers to cars to life-extending pharmaceuticals - is the result of thrift: the willingness of some to delay consumption in favor of investment. More saving at present would be dynamite for expanding capital on the way to innovation and job creation.
But assuming a further decline in the cost of consumer goods, far from something that would retard consumption, falling prices are widespread in developed-world economies. From long-distance calling, to mobile phones, to flat-screen televisions, declining prices are the norm for much of what we buy.
And far from depressing output, falling prices merely expand the range of goods available to us. As the cost of consumer products declines, we demand formerly out-of-reach goods thereby raising their prices. Absent monetary error, the price level doesn't change; rather price declines in some products are matched by price increases in others.
Fed actions meant to drive up consumer prices serve to starve tomorrow's visionaries and innovators of capital. Simply put, if prices aren't allowed to decline, the ability of consumers to save will similarly be hamstrung on the way to reduced investment in the industries of the future.
Conclusion. As evidenced by the unimpressive increase in circulated money, the Fed's ability to push money into an economy that doesn't want it is highly overrated. While the Fed's actions are largely ineffective, quantitative easing will be economically harmful, essentially subsidizing increased capital flows into housing and government.
Rather than continue its further interventions telegraphed in yesterday's minutes, the Fed would do well to acknowledge that far from something to stave off through monetary machinations, recessions can be a corrective mechanism. They tend to starve activities that waste capital and redirect limited funds to undercapitalized areas that will author any recovery.
It's only when governmental bodies restrain an economy's natural, recuperative abilities that short downturns turn into painful and prolonged depressions. At present the Fed is trying to shield us from economic hardship; but far from helping us, its actions merely ensure that the recession's negative effects will remain with us even longer. END QUOTE
Conclusions & Some Parting Thoughts
The above discussion goes a long way in explaining why the Fed’s quantitative easing isn’t working to jump-start the economy. Until loan demand increases, the Fed can put all the money it wants into the system and not get much return in the form of increased economic activity.
Of course, the economy will eventually turn around and is, hopefully, in the process of doing so right now. That, in turn, will likely lead to Bernanke and company taking credit for the turnaround and pointing to QE as the primary reason. Ditto for the Obama Administration that will claim that its ineffective stimulus spending turned the economy around. My readers, however, know better.
There are a couple of thoughts I’d like to bring to light from the above article. First, it notes that the notion of deflation being bad is not necessarily correct. Think about it, did you pay more or less for your last DVD player than you did your first one. I’ll bet it was less. The same goes for computers, phones and a myriad of other electronic goods that are cheaper now than they’ve ever been.
Mr. Tamny very deftly makes the point that lower prices for such goods do not restrict consumption, but rather increase it by making these goods available to a broader range of consumers. Some point to Japan for a comparison showing how its citizens would rather save than consume, supposedly putting off purchases thinking lower prices will come soon. However, I think such comparisons miss the point.
It has been shown that the Japanese are, by nature, a nation of savers. When given the choice between saving and consuming, most Japanese will choose saving. That’s why they don’t have as much of a problem with their huge debt-to-GDP ratio, since an estimated 93% of this debt is held domestically.
US citizens, on the other hand, are consumers by nature. That means they’ll consume when given the opportunity rather than save. In many cases, US citizens will consume more than they make, which created the huge consumer debt burden that now afflicts many households. While savings rates have increased in the short-term, I don’t expect this to continue for very long into the future. At some point, US consumers are going to regain their appetite for spending and economic growth will follow, albeit at lower rates than normal.
The second point worth bringing out in the above article is that the Fed is intentionally attempting to engineer inflation. While some prices are already starting to rise as I have recently written about, the “official” inflation gauges are still very mild. My fear is that the Fed will try so hard to engineer inflation by printing money and keeping interest rates low that it will eventually get its wish, to the detriment of us all.
Just one final point: Did you notice the sentence about the curative properties of recessions? Here it is: “They [recessions] tend to starve activities that waste capital and redirect limited funds to undercapitalized areas that will author any recovery.” Knowing that recessions typically decrease tax revenues, I couldn’t help but chuckle at the thought of a recession starving the biggest waste of capital of all – the federal government.
I could write several more pages about how the government wastes our tax dollars, but you probably know this as well as I do, plus it’s time to hit the send button for this week. Lastly, I’ve included a link to one of the funniest videos I’ve ever seen; this one is on the subject of Quantitative Easing – get ready to laugh out loud!
Hoping your New Year is off to a great start,
Gary D. Halbert
What is Quantitative Easing?
Fed's QE2 Traders Buying Bonds by the Billions
Quantitative Easing – A Hilarious Video!!
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.