Submitted by Jeffrey Snider of Alhambra Partners, via David Stockman of Contra Corner blog, [20]
Janet Yellen has essentially confirmed QE’s demise; good riddance. Unfortunately, I don’t think that is the final end of QE in America, just as it hasn’t been the end time after time in Japan (and perhaps now Europe treading down the same ill-received road). What’s interesting is really watching these central bankers talk themselves in circles about why that is. At the start of each program, there is no ambiguity, largely because of both inordinate faith in regressions and rational expectations theory that posits central bankers’ greatest work is in self-fulfilling prophecy – QE only works if you get people to believe in it.
But believing and acting are two separate and distinct functions that follow very different lines even for some of the same reasons. The premise of QE is rather dastardly, going all the way back to IS-LM and Samuelson (who admitted later how ill-suited such an academic framework was for anything outside of a classroom). What matters is the rate of interest next to the natural rate of interest. But in a real world where 0% represents a very real boundary, all that is left if interest rates at zero remain above the “natural” rate is to shift expectations toward “inflation.”
To gain a foothold below the natural interest rate, in IS-LM, is to shift focus to the real interest rate, and thus make the primary variable inflation. But that isn’t what really happens, either, as it is not inflation that moves but inflation expectations – again rational expectations theory. QE debasement seems to conform to what economists model of lay interpretations of inflationary sourcing, so the idea passes cursory logic, though, as Samuelson noted, only in a basic, low-variable and static environment.
The “markets” (or at least mainstream commentary seeking to provide post facto causation) seem preoccupied with “hawkishness” vs. “dovishness” when in fact QE was already on its way out as early as February 2013. When Fed Governor Jeremy Stein openly stated [21] the “reach for yield” conundrum it was an implicit reference to the idea, long denied, that QE has very real costs.
Nevertheless, I want to urge caution here and, again, stress how hard it is to capture everything we’d like. As I said, ideally we would total all of the ways in which a given asset class is financed with short-term claims. Repos constitute one example, but there are others. And, crucially, these short-term claims need not be debt claims. If relatively illiquid junk bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or by exchange-traded funds (ETFs), and if investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt.18 One is naturally inclined to look at data on short-term debt like repo, given its prominence in the recent crisis. But precisely because it is being more closely monitored, there is the risk that next time around, the short-term claims may take another form.
In other words, less than two months after expanding QE3 to QE4 (UST “buying”) Jeremey Stein was essentially describing the downside of the crowded trade in a system with very narrow [22], potentially, exits. And while he was right to look for other possible exit bottlenecks, the repo market, despite all its new “monitoring” has not been very encouraging of late [23].
A few months later, Ben Bernanke began talking taper, referencing repeatedly that the FOMC was seeing recovery in the economy and stressing the improvement in labor. The global dollar disruption caught the Fed unaware, staggered their commitment to the straight-line ending of QE, but did not, ultimately end it. In fact, when in September 2013 the FOMC “shocked” expectations by not tapering the FOMC simply noted it was awaiting “confirmation” that the economy was still on track, as they were undoubtedly intimidated, but ultimately unphased, by the dollar episode and credit market selloff.
That came sometime in October and November, apparently, as the FOMC tapered last December.
That, I think more than anything, clarifies this entrenched trend. Supposedly the economy provided confirmation at the very moment of the worst Christmas shopping season since 2009, a very noticeable inflection in capital goods investing (with companies for “some reason” shifting cash to financialism instead) and what would turn out as a very severe contraction in GDP by Q1 (even though initial expectations and estimates were for a positive number, it was still near-zero and looked pretty bad in its own right initially).
A Federal Reserve policy that is committed to a data-driven approach, as proclaimed repeatedly in the past two years, would have further paused under such observations. Even the vaunted Establishment Survey stumbled in the winter, which had to be very unnerving to anyone actually committed to the data instead of pre-programmed monetary deceleration.
And that is what I think has been ongoing again since at least February 2013. QE is on autopilot to its end, not because of “incoming data” but because of secular stagnation. This is an idea that has infected nearly every facet of central banks since Mario Draghi’s euro promise (and perhaps even before then in a more quiet and reserved fashion). This is certainly been a topic for some time given Japan’s persistent failure, and the longer the US and Europe, indeed the world, goes without recovery the more it looks as if the theory holds consistency with observation.
It should go without saying that I pretty much disagree with nearly everything that Paul Krugman says, writes and thinks, but there is surprisingly enough room to see and observe where we do agree and the implications of that. Writing in the New York Times back in November 2013, Krugman noticed [24]:
We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.
So far, so good.
But as Larry [Summers] emphasizes, there’s a big problem with the claim that monetary policy has been too loose; where’s the inflation? Where has the overheated economy been visible?
The closed economy theory strikes again, whereby Paul Krugman efficiently describes the symptoms of the problem and then immediately denies the most logical, intuitive and consistent explanation for it because asset bubbles do not conform to the economist’s definition and consideration of inflation?
That is not some trivial distinction, as everything that comes thereafter is corrupted by that blindness. Where this all becomes most relevant (and there is a lot here that is really important, but consumes far too much space, even more than this already long exposition) to “dovishness” vs. “hawkishness” in the current circumstance is the implications for “secular stagnation” in terms of policy. The inability to see the economy as it is causes the Krugmans and Larry Summers of the world to theorize that economic growth “needs” asset bubbles to take place. And part of the reason for that is a downshift in the natural rate of interest, even to the point of being negative on a persistent basis.
Therefore, in the IS-LM worldview, the Fed has no choice but to push interest rates down with the natural rate, causing serial and perpetual bubbles along the way. Instead of seeing financialism as the primary reason for the “declining natural interest rate”, such that it actually exists in any form, they put the cart before the horse, instead remaining unquenchably curious as to why economic potential is mysteriously eroding and thus “needing” asset bubbles. That is where the most comedy is observed, as they try to come up with various reasons for that and even more wild desires for getting out of it.
Krugman again:
This is the kind of environment in which Keynes’s hypothetical policy of burying currency in coalmines and letting the private sector dig it up – or my version, which involves faking a threat from nonexistent space aliens – becomes a good thing; spending is good, and while productive spending is best, unproductive spending is still better than nothing.
Others have posited equally ridiculous ideas, including a distinct “lack of war” [25] in the past few decades as “explaining” why the natural rate of interest may be falling so consistently. That is all pure nonsense as it contours far too closely to short-term thinking at the expense of the long-term, a Keynesian impulse at the heart of far too much folly. What bends lower the productive trajectory of the economy is unproductive spending taken in the name of such short-term consideration. Wasting resources is a net negative, not neutral as Krugman and the monetarists simply assume. They see these resources as otherwise idle, and thus opportunity cost is greater than profitable considerations.
Where monetary policy comes in is that it has the unique ability to allow unproductive spending and investment to remain undiscovered far longer than it should – through exponential debt. You can fund “bad” ideas for a long time when the “reach for yield” reaches itself for extreme levels. You get exactly what the Keynesians want, “several years of much higher employment” and investment, but the net cost is not zero as they imply, it is at the expense of future growth as so much unprofitable waste demands reversion to the mean or a return to productive balance.
This is what Stanley Fischer so conspicuously missed [26] in his speech last week, as the flow of wasted resources is not simply raw materials and labor, but financialism as well.
Currently, even policymakers who are willing to concede that the liquidity trap makes nonsense of conventional notions of policy prudence are busy preparing for the time when normality returns. This means that they are preoccupied with the idea that they must act now to head off future crises.
And so QE is on autopilot to its end, regardless of incoming data. The secular stagnation theory, that I think has been fully absorbed in certainly Yellen’s FOMC, sees little gain from it because, as they assume, the lackluster economy is due to this mysterious decline in the “natural rate of interest.” Therefore QE in the fourth iteration accomplishes far less toward that goal, especially with diminishing impacts on expectations in the real economy, other than create bubbles of activity (“reach for yield”) that always end badly. What Krugman and Summers call for is a massive bubble of biblical proportions that “shocks” the economy out of this mysterious rut, to “push inflation substantially higher, and keep it there.” In other words, Abenomics in America.
While Yellen’s FOMC and Paul Krugman and his acolytes may differ on specific prescriptions, they are very much just different sides of the same coin. To them, an economy is generic activity that must be obtained because the opportunity cost of doing nothing is positive and their view of wasting resources in that paradigm is of zero consequence. That is nonsense, because an economy is the creation of wealth that is axiomatically tied to profitable enterprise, which indisputably is ruined by so much waste.
In the end, secular stagnation might unite orthodoxists and those opposed to them as an observation, but certainly not how and why that may have come about. Japanification is becoming universal, and the more these appeals to generic activity and waste continue, the tighter its “mysterious” grip. For now, though, QE is done (for now) in the US no matter how bad the economy gets.
