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.

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