Sunday, September 23, 2012

Costs of Quantitative Easing

The law of unintended consequences haunts economic policy.  The Federal Reserve's quantitative easing program, now in its third phase, is meant to provide economic stimulus.  However, it also drags on the economy.  Let us count the ways.

Reduced Interest Income.  Hundreds of billions of dollars of interest income have been lost because of the Fed's longstanding campaign to drive down borrowing costs.  Losses of this magnitude undoubtedly have dampened consumer demand.  Even though QE likely sprung loose some personal income by providing lower mortgage rates for homeowners to refinance, tight standards applied by banks making mortgage loans have limited the refi impact of lower rates.

Reduced Retirement Savings.  As bond yields shrivel up like corn in today's drought-ridden Midwest, many retirements look bleaker.  Even though the stock market has boomed, large numbers of shell-shocked savers abandoned stocks after the 2008-09 market crash and haven't participated in the gains.  Instead, they ducked into bonds.  Although the improbable bond rally of the past few years generated capital gains for many bond holders, the basic return sought by bond investors comes from interest paid.  That has been paltry.  As retirements look bleaker, many workers cut back on current consumption in order to save more.

Pension Pain.  Despite appearances from some recent press coverage, pension funds cannot take large risks, overall, with their portfolios.  However much publicity pensions' alternative investments may generate, a large part of pension assets must be invested in high quality bonds.  As returns on these puppies shrink, employers corporate and municipal confront the necessity for greater contributions.  Workers may be laid off, citizens may receive fewer public services, state and local taxes may be raised, shareholders may endure lower returns, and those workers still employed may have to make greater pension contributions.  All of which would further discourage current consumption.

Insurers Backpedal.  Insurance companies' returns on their investments are falling.  This means policies that depend on long term returns, such as annuities and long term care policies, become more expensive or even impossible to buy.  Or else, they offer fewer benefits.  Policy holders suffer.  Those people who want to provide for themselves, through long term care policies, annuities, whole life and similar products, have a harder time.  More people end up having to rely on government programs like Social Security, Medicaid and so on.  That's not good in an age of serious federal deficits.

Yield Curve Flattens Bank Incentive to Lend.  Back in the days when they made loans, banks would borrow short term (usually through demand deposits, interbank loans via the fed funds market, and savings accounts) and lend longer term.  The difference between short term interest rates (historically lower) and longer term interest rates (historically higher) provided profits for the banks.  But the yield curve (the graph of interest rates from short to long) has been flattened by the Fed's monetary policies.  There isn't that much difference any more between short and long term rates.  Potential profitability for banks has been squeezed.  Banks have less incentive to lend, and fewer loans means less potential for economic growth.

The Fed has sworn on a stack of printed money to keep short term rates darn near invisible until at least mid-2015.  It may achieve some of its objectives.  But it will also create unintended consequences.  The impact of these opposite reactions to the Fed's actions may be greater than the central bank foresees.  There are few real life experiments in economics.  But if we look at the most obvious example of the impact of a central bank squashing interest rates for years at a time, we can see that Japan has remained moribund for two decades since its financial and real estate crashes in the early 1990s.  The Bank of Japan has ruthlessly stamped out any positive upswings of interest rates in that nation.  But that hasn't produced the spark needed to revive Japan's economy.

It now looks like the Fed will keep rates unnaturally low for the better part of a decade.  Given Japan's experience, one wonders what is in the Fed's playbook.  If it's a sensible fiscal program from Congress and the White House, the next question would be what is the Fed smoking?  But if the Fed is acting on the reasonable assumption that we will have fiscal dysfunction for the foreseeable future, only the arrival of Godot, it would seem, would offer reason for optimism.

Friday, September 14, 2012

The Fed's QE3: An Old Dog Pulling An Old Trick

Since the financial crisis of 2008, the Federal Reserve has striven to show that an old dog can learn new tricks. Its grab bag of novel programs have at various times propped a variety of financial markets, ranging from commercial paper to asset backed securities to U.S. Treasury securities, as well as banks and other financial institutions. Its aggressive use of quantitative easing has in particular stood out from Fed monetary policy of yore, in which discount and fed funds rate adjustments, along with changes in bank reserve requirements, were the only flavors of monetary policy served up.

The recently announced QE3 looks innovative: it's permanent until the labor market is doing 70 in a 35mph zone, will involve $40 billion of purchases per month, and is focused on mortgage backed securities. The Treasury securities market isn't targeted (although it's still being stage managed through Operation Twist to push down yields on long maturities). But QE3 is really just an old trick performed in a different way.

Going back to the new paradigm days of Chairman Alan Greenspan, the Fed has believed that the real estate market leads recoveries. One of the Fed's major frustrations with the Great Recession has been the moribund housing market. It remains badly hung over from over-indulgence in leverage, and battered consumer balance sheets make it difficult for many wannabe buyers to qualify for loans. QE3 is a direct shot of liquidity into the housing market, made with the hope of lowering mortgage rates, stimulating buyers and boosting the economy.

But we've heard this song before. After the 2000 tech stock crash and the 9/11/01 stock market swoon, Chairman Greenspan squashed interest rates with the intention of goosing real estate in order to keep the economy growing. It worked. Already in recovery mode from a downturn in the 1990s, real estate skyrocketed in the early and mid-2000s. The economy grew. Employment levels were good. Everything was peachy.

Until the bubble burst. Since 2007, we have paid the price for the Fed's campaign ten years ago to use the housing market as a way to foster economic growth. Too much of America's wealth was invested in real estate, and the resulting losses continue to choke the economy. One would think the Fed learned a lesson--that concentrating America's capital into a single market sector is risky and when that market sector turns down (as all markets do from time to time), the losses are exacerbated by the over-concentration.

But perhaps old dogs fall back on old tricks. There is serious concern that the Fed has run low on ammo. It can't push interest rates much lower. It can't keep distorting the U.S. Treasury market and give the federal government a very low cost way to run up the deficit. And banks don't want to lend no matter what the Fed signals, because loans are risky and the banks could take losses. So the Fed has decided to directly finance the mortgage markets by purchasing $40 billion per month in the MBS market. In other words, it's going to goose the housing market in the hope of stimulating the economy.

Some people like roller coasters. Others find them nauseating. The last time we got on this roller coaster, the ride ended badly. Nevertheless, the Fed is getting on again. Short term, it may enjoy success, just as the Greenspan Fed enjoyed success--for a while. But long term, the Fed faces a dilemma. In order to prevent another real estate bubble, the Fed has to maintain prudent lending standards. But prudence won't lead to the euphoric exuberance that could launch the economy into the dramatic rise that the Fed seems to be seeking. Will the Fed use its supervisory powers over the financial system to loosen up lending standards, with the concomitant risk of a housing bubble and bust, followed by a Greater Recession? Aroma of rat drifts into the ambient environment. QE3 may not really work unless it fosters really large risks. And we know what can happen when there's a lot of risk around.

Monday, September 10, 2012

Why Doesn't the Fed Fix Facebook?

By all indications, the Federal Reserve has taken up the job of keeping the stock market happy. It's high time the Fed fixed Facebook. There may be good reasons why Facebook has lost half or more of its IPO value. But there are also good reasons why the the economy is in the doldrums. Just as the Fed has fired off numerous weapons to stimulate the economy and make the financial markets feel better, the Fed should make Facebook investors happy. They'll increase their consumer spending if their stock goes up and that will boost the economy. Everyone will be happy because QE is the source of all happiness these days.

The Fed should announce QE-Facebook: it will buy up FB shares, not at the current market price but at the original IPO price. After all, the point is to boost confidence, and bailing FB investors out of their losses is a good way to boost confidence. Nothing better than a do-over when you made a boo boo. Better yet, the Fed should buy FB shares at double--no wait, triple--no wait, quadruple the IPO price, or $152 a share. That way, investors would get the benefit of the IPO pop they were all expecting. That would really give the economy a zing.

There's no logical reason to stop with FB. The Fed could also buy Zynga and other IPO stocks at pop prices. Indeed, the Fed could simply announce QE-stocks and stand as a ready buyer in the stock markets for all stocks at whatever price investors expect however unreasonably.

Throughout this summer, the stock market has moved up as the world economy has deteriorated and the U.S. economy has slowed. This rise was all because of central bank easing and the expectation of continued central bank easing. Unlimited central bank easing is the best kind, and the ECB just served it up (kind of, see the preceding blog The days when central banks would take away the punch bowl just as the party was warming up are long gone. Now, the central banks host the parties, which always have open bars. If the Fed wants a good party, it should open up the taps and let them flow freely. QE-Facebook. QE-Zynga. QE-all stocks.

Saturday, September 8, 2012

What's Behind the ECB's Unlimited Bond Buying Program?

It's kind of hard not to smell a rat in Mario Draghi's proposal for the European Central Bank to make "unlimited" purchases of sovereign bonds of troubled EU member nations. According to the proposal, the ECB will buy an EU member's bonds if the member requests assistance and submits to fiscal oversight by the EU. The latter, however, has been the problem with Greece. It doesn't want to submit to the EU's fiscal oversight. And when it did agree to terms demanded by the EU, it failed to comply with them. In return, Greece has been given break after break after break. It effectively defaulted months ago, but the EU papered the default over with a loan workout that forced creditors to sustain losses (which they may have recouped via credit default swaps, so the losses actually fell on the writers of the CDSs or their unfortunate direct, secondary or tertiary counterparties who held the ultimate risk of loss). Stated otherwise, the EU has supported Greece without Greece having to do the full austerity dance it was supposed to do.

The two countries that Draghi's proposal was aimed to help, Spain and Italy, insist that they will not submit to fiscal oversight by the EU (for domestic political reasons). If they really mean it, that means they won't get bond buying assistance from the ECB. Possibly, their hardline insistence that they won't ask for help (and thereby submit to central oversight) is a bluff, meant to get Draghi to drop the fiscal oversight condition. They could simply let market forces push their bond yields higher. That would shove the EU closer to the brink. Draghi might then drop the fiscal oversight condition when the markets threaten to go haywire. Of course, the bluff isn't really aimed at Draghi, who seems amenable enough to U.S. Fed-style money printing, but at the Germans and other northern Europeans of the frugal persuasion. The Greeks have proven themselves adept at brinksmanship with Germany and its economic allies. Spain and Italy have little incentive to be any more austere.

Germany may be wealthy enough to bail out Greece. But it can't bail out both Spain and Italy, which have much larger economies. So a move by Draghi to drop the fiscal oversight condition could lead to German withdrawal from the EU. That could be catastrophic. But writing blank checks to Greece, Spain and Italy could be catastrophic for Germany, and one can't expect Germany to knowingly sign up for a catastrophe. Mario Draghi may be playing a most dangerous game, and he'd better play it well or the abyss will beckon.

Monday, September 3, 2012

Ignore the Election. Try a Little Science.

As far as economic growth goes, forget about the Presidential election. Neither party is focused on what really matters: basic scientific research. All great surges in economic growth have resulted from scientific advancement. When humans acquired enough scientific knowledge to engage in agriculture, they were able to grow large surpluses of food. These surpluses were used to support the development of settled societies, with cities, specialized workers, the centralization of knowledge through educational institutions, and control over resources like rivers and their floods. Human populations increased exponentially, as did human wealth.

The leap from a largely agricultural world to an industrialized world began with the development of the steam engine at the end of the 18th Century. The steam engine allowed humans to harness very large quantities of power derived by burning wood, and later fossil fuels. The vast increase in power offered by the steam engine led the way to the railroad, steam ships, giant factories that provided economies of scale, and even a few early cars.

In the 19th Century, the harnessing of electricity led to the telegraph, telephone, small and large scale lights and lighting systems, and all manner of machinery and equipment. New technologies for extracting and utilizing fossil fuels like coal, oil and natural gas vastly increased the amount of power available to humans, especially through the use of the internal combustion engine that powers almost all motor vehicles today. With that great increase in power came an enormous improvement in living standards.

In the 20th Century, advances in knowledge of electromagnetic radiation gave rise to the radio, television, cell phones and the wireless computers used today (variously called smart phones, tablets, etc.). Advances in agriculture have eliminated a great deal of the hunger that plagued much of the world before World War II. Developments in material sciences led to the semiconductor revolution, which is the foundation of all modern computers. The Internet, invented by [fill in the name of your favorite politician], has revolutionized communication.

In short, the big score comes when humans make major scientific advances and find ways to exploit them. Money printing and interest rate manipulation by the Fed, supply side tax cutting, deficit spending, scorched earth treatment for Medicare and Medicaid, and just about all the other hooey that politicians can't stop talking about don't amount to jack compared to the effectiveness of scientific advance in fostering economic growth. Much and perhaps most of today's political debate revolves around how to split up a seemingly inadequate pie. But the supposed conflicts between the 1% vs. the 99%, older folks vs. younger ones, taxpayers vs. beneficiaries of the social safety net, and so on all become less consequential if the pie expands at a faster rate.

Don't expect private financing sources to support basic scientific research. Private capital wants to reap its profit within a few years, and concentrates on applied science. But applied science doesn't provide lasting prosperity (ask the Japanese, masters of applied science, about this point). Support for basic scientific research is essential to long term prosperity. If there's one item in the federal budget that should be boosted, this is it.