This Is Why, To An Economist, QE Refuses To Work

Tyler Durden's picture

There is practical, everyday common sense... and then there is economics. Because when it comes to explaining why a square peg won't fit into a round hole, only an economist will tell you, over and over, that it will eventually happen, one must just tweak the theory a little first, and then reality will promptly follow. And while even economists have enough of a frontal lobe (and realize there is little grant money) to pursue intractable pegs and hole problems, when it comes to the theory at the heart of their beloved Keynesian voodoo religion, namely Quantitative Easing, the answer is always one, and it is very simple: we need more! Yet even economists are not naive enough to not recognize that QE has not worked in any of its 4 previous iterations (logically, as if it had there would be no need for a fifth, open-ended one). Where it gets fun is watching them come up with amusing yet convoluted, involved and outright demented explanations, some even in chart format, why QE keeps on failing. Below, we present just such a graphic explanation which only an economist could love, or care about.

First, this is how an economist will trace, visually, courtesy of Bloomberg, the monetary "pathway" starting with the policy rate, going through financial conditions, and ending up with output and employment. Not there is no mention of the real pathway: if print trillions, then stocks go up. But economists have never been known to actually simply things if there is grant money to be made from writing research papers on intellectual dead ends.

The above chart is how in an ideal economist world, i.e., that which is 100% disconnected from reality, QE should work.

Now, because even economists realize the deranged theories they concoct in their ivory towers sometimes need defending, especially since billions of lives are at stake, and may die a painful death of starvation once food becomes so expensive it results in food-based genocide, they try to come up with explanations why the chart above explaining the work of QE may, just may, not quite work.

The first reason for this is shown in the chart below.

This is how Bloomberg explains it:

In Figure 20 we plot two different financial conditions schedules in Quadrant B—an elastic schedule corresponding to a Risk-On financial environment (FCON1) and an inelastic  schedule corresponding to a Risk-Off financial environment (FCON2). When investors’ appetite for risk is high, i.e., the market is in Risk-On mode, a decline in the real yield on relatively safe assets should signifi cantly raise the demand for risky assets and, in the process, significantly boost the level of overall fi nancial conditions along the elastic Risk-On financial conditions schedule (FCON1). A signifi cant rise in overall financial conditions should then, in turn, give rise to a signifi cant boost in output and employment (from Y1 to Y2 in Quadrant C).

 

If, on the other hand, the level of risk appetite was low and the market was in Risk-Off mode, then the financial conditions schedule would be relatively inelastic, which we show as FCON2 in Quadrant B. Because of this relatively inelastic financial conditions schedule, the response of output and employment to a change in the policy rate would be modest at best, increasing only from Y1 to Y3 in Quadrant C.

 

What Figure 20 indicates is that in order for monetary policy to be effective in boosting output and employment, the real policy rate not only needs to be lowered significantly, but that central bank communication needs to play an equally important role in fostering an environment in which  investors’ appetite for financial risk is high. It would appear that the Fed’s latest open-ended asset purchase program coupled with its forward guidance as to the expected future path of its policy rate is playing an important role in creating a more risk-friendly (Risk-On) financial-market environment (i.e., Federal Reserve communication is helping to contribute to a more elastic financial conditions schedule), which is required for monetary policy to be effective in boosting output and employment.

 

A relatively elastic financial conditions schedule represents only half the story for the successful implementation of monetary policy, however. For monetary policy to be ultimately successful, output and employment must respond favorably to the policy-induced change in financial conditions. This latter half of the story is depicted in Figure 21, where we shift the focus from financial-sector risk taking to real-sector risk taking.

Or, to paraphrase, one of the lines is crooked. And that is how reality for an economist can be simply reduced to just a line that is angled askew.

But just in case one angled line is insufficient to explain the failure of QE, economists have a Plan B: a second crooked line.

'Explained':

In Figure 21 we illustrate the impact of economic uncertainty on output and employment decisions by comparing the response of output to a change in financial conditions under varying conditions of economic uncertainty. In a world where the level of uncertainty is comparatively low, the output-response schedule will tend to be steeper (shown as IS1 in Quadrant C) and output and employment will tend to respond more favorably to a change in financial conditions. But in a world plagued by high levels of uncertainty, the output-response schedule will tend to be relatively fl at (IS2). Under such circumstances, easier financial conditions might not elicit much change in the level of output and employment, increasing only from Y1 to Y3 in Quadrant C.

 

From the market’s and policymaker’s vantage point, the success or failure of a central bank’s policy actions will hinge on what the slopes of the financial conditions and output response schedules look like in the real world.

So there you have it: It's all about the slopes. And the economists in charge of the world will continue repeating the same mistakes over and over and over, until the first of two events occurs: i) the slopes of the lines end up "just right", or ii) everyone dies from a hyperinflationary genocide or war, or both.

And now you know how economists "think"