Wednesday, September 19, 2012

Ben Bernanke and QE3: The Magnificent Obsession

The following primer may be useful in interpreting yet another round of Quantitative Easing (QE) by Ben Bernanke and the Fed. 
What exactly is “Quantitative Easing”?

Students of macroeconomics know that increases in the money supply caused by central bank purchases of government debt (T-bills and bonds) result in drops in short-term interest rates (Federal Funds rates).  This, in turn, can then stimulate economic growth (and jobs) by virtue of greater borrowing by firms for capital investment for new plant, equipment, and housing.  Since 2008, however, instead of buying the safe and reliable US government debt, the Fed has embarked on a highly controversial policy of buying tons and tons of the “toxic” assets left over from the subprime crisis.  Interest rates fell to zero as monetary growth was relentlessly increased, but the Fed still persisted in this unprecedented buying spree. 
We now have yet another round of toxic purchases. Interest rates cannot normally* fall below zero, but yet the money in circulation has increased exponentially.  This phenomenon has euphemistically been labeled by the Fed as Quantitative Easing, but the Rutgers EMBA class correctly identified this (in 2008) as a “stealth monetization”.  (Monetization = rampant money creation to finance nonsustainable deficit spending)

But won’t an infusion of more money help growth—after all this is Ben’s objective, right?

Yes, this is Ben’s goal, but this infusion and the ones that preceded it, and the ones that are sure to follow thanks to Ben’s magnificent obsession with creating liquidity, are not likely to stimulate growth.  This is due to a version of the “liquidity trap” that we find ourselves in.  A Liquidity Trap occurs when investor confidence is so low that even when interest rates are very low (at zero), there will be no demand for borrowing for capital investment. One can lower interest rates until the cows come home, but if the future looks bleak, then capital investment will remain dead in the water---as was the case in Japan over the last decade. 

Why is investor confidence low?

Confidence is low due to the prospect of a return to higher taxes (business) from January 2013 (the Fiscal Cliff looms), increases in levels of government regulation, Eurozone blues, hard landings in China and India, political gridlock in Washington, and a lack of confidence in government, to name a few.
But wait—shouldn’t the huge increase in money have resulted in a sharp spike in inflation?  But we do not see any significant inflationary pressures!

Flooding the economy with liquidity and not seeing inflation is akin to flooding your basement with gasoline and not seeing an explosion.  There will be none until there is a spark.  In macro, that spark—investor and consumer confidence—is missing.  As long as investor and consumer confidence remain dormant, we will not see inflation.  If and when the confidence indexes revive, we will see a rapid surge in prices; the ‘velocity’ of money (the rate at which a dollar bill changes hands) will take-off.

So we should suck-in the liquidity when the economy gains traction, right?

Right, but this will be very hard to do.  I have been calling this monstrous surge in liquidity “toothpaste money” as in easy to get out, but difficult to put back. 

So this is all gloom and doom?

Not really.  I am hoping that Winston Churchill knew what he was talking about when he said that we in the United States eventually get it right—after trying everything else first.  If Obama makes it, then the next round of government spending should be aimed at long-term productivity—none of the consumption-based “cash for clunkers” variety.  If Romney makes it, then business tax cuts and a peeling back of some of the layers of recent government regulation would be in order.
Farrokh Langdana, Ph.D.
* Note:  Certain "safe-haven" European yields have fallen below over recent months as the crises among the Euro periphery countries has persisted.

(These views are not to be interpreted to be necessarily those of Rutgers Business School, but attributed solely to Prof. Farrokh Langdana.)

Friday, December 3, 2010

Cave Theory, continued…

"When the entire world is running into their caves, the country with the best cave wins." – Farrokh Langdana

Shomail Malik (REMBA ’12) brings our attention to the following article on Bloomberg:

Dollar Rises Most in 3 Months on Concern at European Debt, Korean Conflict

Shomail writes:

A perfect example of no matter how bad things get in the global economic landscape, "our cave is still better than they other guys' cave". Europe's debt and tensions in Korea causing people to run to the dollar. Although on the surface it would seem that we have reached the point of unsustainability, the rest of the world still views the U.S. as a "safe haven".

The US Dollar Index provides illustration:

US Dollar Index (DXY) September-December 2010

Europe staggers, the Koreas simmer, warships steam at battle speed in Asian seas....and we have Flight to Safety. Cave Theory [click link for earlier post] still holds.

The US still has the best cave - for the moment...

Thursday, November 25, 2010

Pegs on Fire!

Two recent articles brought to our attention the currency peg stress being experienced by the Hong Kong Dollar (HKD):

Sinking Feeling for the Hong Kong Dollar, Craig Stephen, Marketwatch, October 17, 2010
QE2 pressures Hong Kong asset markets, Craig Stephen, Marketwatch, November 7, 2010

(H/T Martin Wagner)

Basically, HK has a "hard" peg with the US Dollar. This means that its currency must always be locked to the USD. To ensure this, HK's central bank MUST do exactly what the Fed does with its interest rates. If the Fed increases M (Money Supply), HK must too, no matter what the consequences for HK. If it does not, then the interest rates in the US would dip below those in HK and capital would rush into Hong Kong thus making the HKD stronger and thus violating the hard peg.

So now, HK MUST increase M to match the Fed's crazy increase in M - - it must lower its interest rates too. As it increases its M, it will put further pressure on its SAPs, and since its interest rates drop, the HK dollar will weaken against the Yuan and against other currencies, as it has been.

The HK peg is on fire, and one wonders how long it will last.

Farrokh Langdana, Ph.D.
Rutgers Business School

Monday, November 15, 2010

QE2: Will it work?

The market shot up 200+ points the day following the news that the Fed was printing money ($600 billion) like there was no tomorrow. What happened?

Investors expect that this huge dose of monetary growth, "M", by the Fed on the order of $600 billion, will shift the AD to the right over a Keynesian Aggregate Supply (AS) curve and propel the economy to a nice Stage 2 recovery (at AD2 below)—or who knows, maybe even overheating in the future (at ADoh)! Hence, the rush back into stocks and into commodities which (in their thinking) will undoubtedly put commodities (rubber, copper, oil, silver, rhodium, etc.) in great demand.
Current state of Economy:
Economy suffering from weak Aggregate Demand (AD1)
Increased Aggregate Demand from Monetary stimulus:
AD2:  Demand has increased, leading to recovery in GDP
ADoh:  Demand has been pushed too far, leading to Overheating
AD3:  Severe inflation due to Overheating.

 What's with the hike in precious metals prices?

The expected Stage 2 and overheating will be inflationary, thus warranting a nice inflation hedge such as precious metals. Investors want to get-in on this expected run-up in prices in commodities and precious metals and they jump into these markets today, thus driving up the prices even further and faster.

These investors are typically Keynesians who believe that in this last-gasp Keynesian fling of massive spending and monetization, the Obamists have pulled off a last-minute macro recovery.

Gold Prices Jan-Nov 2010

Regarding precious metals, there is another group that also loves them. These are the "inflation-vigilantes" who understand well that the increase in money growth M is simply a gigantic monetization of government debt and dubious mortgages (yes, billions are still around).

They know that monetization is ALWAYS followed by very big inflation---the only reason we do not see the inflation now (according to this group) is that depressed housing and jobs markets have crushed consumer and investor confidence. This is why (they would point out) the "long end" of the yield curve is very steep—the "smart money" is expecting inflation in the future.

These investors are largely non-Keynesians. They are not buying that large "wasteful" doses of government spending or simply printing of money to finance the deficits will jump-start the economy.

These are mainly supply-siders who are insisting that until taxes and government regulation come down, and until investors and businesses see tangible rewards to absorbing more risk, they will not increase capital investment and employ any additional workers.

In our language, until their C-bar and I-bar (consumer and investor confidences) increase, we are not going anywhere. All that we will get (according to this group) is more inflation.

The Wealth Effect

The Fed is also seeking to increase Aggregate Demand through another channel:  The Wealth Effect.

Bernanke's statement last week that he is targeting stock prices raised many eyebrows:

"…And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

Here Chairman Bernanke is referring to the "Wealth Effect", by which consumers and investors who feel their wealth increasing will be more likely to spend and invest.

Recall that Consumer Spending is a function of C-bar, Output, and Wealth:

The Consumption Function:  C = C-bar + bY + dW

By inflating "W", Chairman Bernanke seeks to "help increase confidence", boosting consumption and investment.

Positive Wealth Effect:  Increase in Wealth boosts Confidence

With Ben Bernanke now playing the role of Dick Whitney, investors must surely be wary of betting against the Federal Reserve!

However, we must also remember Mr. Whitney was only able to stave off disaster temporarily, as the market's decline resumed two days later, with a vengeance.
Dick Whitney
Staved off disaster on Black Thursday, October 25, 1929
by loudly buying huge blocks of shares
It is interesting to see that in the days following the initial burst, the market has lost some ground. 

Source: Yahoo! Finance

However, the full effect of QE2 on Stock prices must be measured from the time it was first anticipated, starting earlier this year.  The run-up is impressive.

Source: Yahoo! Finance

So who is right, the Keynesians or the Supply-Side skeptics?

We should know by early next year!

Farrokh Langdana, Ph.D.
Rutgers Business School

Friday, November 5, 2010

QE2: All Aboard!

The Queen Elizabeth II

The Federal Reserve made its long-expected announcement earlier this week regarding "QE2", the name investors have given to his program of buying assets other than short-term Treasuries in an attempt to spur economic growth.

What is "QE2"?

The "QE" stands for "quantitative easing", and the "2" denotes that this is the second (the first being in late 2008-early 2009) round of the Fed implementing this type of policy.

Traditionally, the Federal Reserve attempts to manipulate short-term interest rates by buying and selling short-term Treasury Securities, in it's Open Market Operations:

When the Fed wants to reduce interest rates, it buys short-term Treasuries, which puts cash into circulation and pushes their price up and interest rates down. This policy is known as monetary "easing", and is seen as a catalyst to spur economic activity.

Conversely, when the Fed wants to raise interest rates, it sells short-term Treasuries, which removes cash from circulation and pushes their price down and interest rates up. This policy is known as monetary "tightening", and is seen as a brake on potential economic overheating which would lead to inflation.

Breaking out our graphs, the increase in the Money Supply is intended to work as follows:

The Fed applied traditional Monetary stimulus as the financial crisis proceeded, culminating on December 16, 2008, when the Fed dropped its target interest rate to zero (0 to 0.25%), where it has been ever since.

Once rates are near-zero, the Fed's traditional policy tools are of no use, as rates have nowhere to go down from zero. [For an interesting discussion on why, see this post from Greg Mankiw].

If the Federal Reserve believes that economic conditions warrant further action, it has many rarely used tools at its disposal, designed primarily to encourage economic activity by bringing down longer-term interest rates. Here is where non-traditional policy comes into play.

Ben  Bernanke
Federal Reserve Chairman
Chairman Bernanke presciently outlined his playbook on this in a 2002 speech before the National Economists Club.  Highlights (the entire speech is well worth reading):

"Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity."

"However... a central bank... retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is zero.'

"To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys."

On November 25, 2008, the Fed announced that it would purchase $100 Billion in GSE debt, and up to $500 Billion in Mortgage Backed Securities.


This was a significant departure from traditional policy. Prior to the financial crisis, the vast majority of the Fed's Assets (which on its balance sheet support its Debt – which is the currency in circulation) were shorter-term Treasuries.

However, this was not the first instance of new and unusual actions by the Fed – these began with Liquidity-related actions as the Financial Crisis unfolded starting in the Spring of 2008. A summary of these actions follows, by way of background:


The first radical departures from traditional policy related to Liquidity – providing credit for otherwise-solvent* institutions which found themselves holding assets that were hard to sell during a crisis. (*This description of Citibank, et al. as otherwise-solvent at the time may be questioned; we are simply describing the Fed's policy).

During the financial crisis, the Fed undertook a number of controversial actions and instituted a number of unusual emergency lending programs to provide liquidity to financial institutions. 

Federal support programs as of November, 2008
Federal Reserve Programs at top of chart
[Click chart to expand]
 These included:

* The guarantee of $30 Billion of Bear Stearns' (BSC) worst assets, provided to J.P. Morgan as incentive for it to acquire BSC. This pool remains on the Fed's balance sheet as "Maiden Lane I".

* TSLF (Term Securities Lending Facility) – created in March, 2008 to support Primary Dealers with $200 Billion in Mortgage-Backed and other securities

* Loans to AIG collateralized by (at par value):- $40 Billion in RMBS (Residential Mortgage-Backed Securities), under "Maiden Lane II"- $60 Billion in CDO's (Collateralized Debt Obligations), under "Maiden Lane III"

* CPFF (Commercial Paper Funding Facility) – designed to bail out companies (primarily GE) who rely heavily on Commercial Paper for their financing, with a commitment theoretically in excess of $1.5 Trillion, instituted in the Fall of 2008

* ABCPMMMFLF (yes, that's Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility – thankfully shortened to AMLF in common usage) – supporting Money Market Funds which were threatened by a run in September 2008 with the collapse of Lehman, a commitment theoretically exceeding $1 Trillion

* TALF (Term Asset-backed securities Loan Facility) – the purchase of securities backed by consumer loans (such as credit cards and auto loans) designed to revive the stagnant market for these securities in November, 2008, a commitment of up to $200 Billion

* Foreign Currency swaps exceeding $700 Billion with Central Bank counterparties at the height of the crisis in the Fall of 2008

* Nearly $150 Billion credit extended through the Primary Dealer Credit Facility in the Fall of 2008, which extended the Fed's Discount Window to all qualifying Financial institutions (not only the Primary Dealers who normally are the only entities which may access the Discount Window)

* Guarantee of up to $300 Billion to support Citibank's toxic Tier III Asset portfolio.

* Guaranteeing over $100 Billion of Merrill Lynch's (ML) assets to support Bank of America's September 2008 purchase of ML

The total liquidity commitments ran into the several trillions by early 2009, and the Fed's balance sheet ballooned with a hodgepodge of unusual assets (including, among other things, empty shopping malls).

These actions were designed to stave off what the Fed saw as the imminent collapse of the Financial system itself.

We discussed these actions in earlier articles, click to link:

What's that Smell?  September, 2008
The Garbage Barge  October, 2008
The Garbage Mega-Ship  February, 2009

The Mobro, the original "Garbage Barge", in 1987
Did the Fed's balance sheet become the new Garbage Barge?

These policies do not fall under a narrow definition of "Quantitative Easing", as their purpose related to the emergency provision of liquidity, but we outline them to give a sense of the Fed's willingness, prior to its initiation of Quantitative Easing, to embark on bold and unusual policy initiatives.


At the height of the crisis, with interest rates already at zero, the Federal Reserve perceived that the "real economy" (as opposed to its financial plumbing, which was addressed through its liquidity measures) was in danger of a severe and deep contraction.

As noted above, with rates already near-zero (during the crisis, rates actually fell below zero as terrified investors around the world scrambled to hold Treasuries, the one asset considered universally safe), the Fed found itself without access to the policy levers it normally uses to prod economic activity (the purchase of short-term Treasuries to lower short-term rates).

QE1 (and QE 1.5)

The RMS Queen Elizabeth, launched in September 1938

QE1 - The November 2008 announcement of $600 Billion in GSE and MBS securities indicated that the Fed would now target interest rates further out on the yield curve – that is, it would attempt to encourage economic growth by lowering medium- and long- term interest rates through the purchase of large quantities of longer-dated bonds. This is the "quantitative" in "quantitative easing": the injection of quantities of money into the economy that takes place through the process of buying longer-term bonds and securities.

QE1.5 - The November 2008 announcement was followed in March 2009 by the announcement of massive ($1.2 Trillion) additional purchases of:

* Up to $750 billion of additional agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion

* Up to $100 billion of additional agency debt bringing the total up to $200 billion

* Up to $300 billion of longer-term Treasury securities

The March 18, 2009 Federal Reserve statement included the dismal report that:

"Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. And despite almost two years of near-zero interest rates, economic conditions have remained poor."

By way of explanation for its now $1.8 Trillion quantitative-easing program, the Fed stated that;

"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability."

And so it did!

The effects of QE1 are controversial, but if it is true that "Bonds Don't Lie", the effects are visible in the path of the yield curve leading up to and after QE1, but are more muted after QE1.5:

Treasury Yield Curve May 2008 - December 2009
Source: Mish's Global Economic Analysis, August 2010

A year and a half after the last round of QE1, with the economy still in the doldrums, the Federal Reserve has determined to take additional action with a new round of Quantitative Easing.

Citing ongoing adverse economic conditions:

"…the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed."

The Fed has determined to:

* Purchase $600 Billion in longer-term Treasury securities, and

* Reinvest what analysts indicate is approximately $300 Billion additional from principal repayment on existing securities held by the Fed into the purchase of new securities.

The total Quantitative Easing between QE1 (and QE1.5) and QE2 thus falls in the range of $2.8 Trillion. For perspective, going into 2008, the Fed's balance sheet consisted of between $800 and $900 Billion of Assets, primarily short-term Treasury Securities.

The recent and projected expansion of the Fed's balance sheet is illustrated by the following graph, from Zero Hedge:

Past & Projected Federal Reserve Balance Sheet
Source: Zero Hedge


To answer this question we must go back to the question of whether QE1 "worked".


Certainly the yield curve responded across the board at a time coincident with the original policy, and it is not unreasonable to assign causation to the Fed's actions.

This allowed homeowners facing rate resets to refinance at more beneficial rates than would otherwise have been the case, and also permitted companies to refinance their existing debt also at favorable rates, perhaps ameliorating an incipient funding crisis.


However, there are several criticisms which must be considered:

* It is reasonable to note that the real economy has only returned to anemic growth, which may or may not be ascribed to Monetary policy, and of late has stalled and remains below the threshold at which employment can stage a meaningful recovery.

Data Source: Bureau of Economic Analysis

Real economic activity remains below the level of three years ago, with the only increase among the components of GDP (aside from a small reduction in the trade deficit) being Government Spending:

Real GDP and components, Fourth Quarter 2007 versus the most recent Third Quarter 2010
Data Source: Bureau of Economic Analysis

One criticism aimed at Monetary Policy as a means of stimulus is that it does not, in fact, promote real economic growth at all.

If business conditions are such that firms are unwilling to expand, then there will be no demand from "Main Street" for the excess funds provided by the Federal Reserve to the banks.

However, these funds must go somewhere.

Where have they gone?

* The lack of demand for credit from businesses can be seen by the large buildup of bank reserves during this period. While the Fed can make credit available, it cannot force unwilling entrepreneurs to take risks by borrowing.

* The yields on Junk bonds have shrunk to levels generally last seen near their peak prior to the crash. Money is obviously flowing to these higher-yielding, and risky, assets instead of its intended target of business expansion, as investors who are facing negligible returns on Treasuries chase higher yields.  The chart of Barclay's junk bond ETF (NYSE: JNK) illustrates the effects:

Barclay's high-yield bond fund (NYSE: JNK) Nov 2008 through Nov 2010

* One also must note that the Stock market bottom roughly coincided with QE1.5 in March 2009. Here also, one might reasonably conclude that the money not being borrowed by individuals and businesses is instead inflating a risky asset class.

SO, QE2…

Evidence that the excess money will inflate asset bubbles rather than real economic growth has accumulated in advance of and immediately following QE2:

* Stock prices surged through the fall in anticipation of, and accelerated in the two days following, the Fed's November 3 announcement

S&P500 ETF (NYSE: SPY) Aug-Nov 2010
* Commodity prices have skyrocketed, with Gold reaching all-time highs, and many other basic commodities up 30% or more year-over-year

Gold Prices Jan-Nov 2010
* Emerging market economies are facing hot capital inflows – as evidenced, by way of one example, by the boom in Indian equities. The financial officials of these countries have expressed concerns.

The India Fund (NYSE: IFN) 1-year Nov '09 through Nov '10

In a remarkable moment of candor for a Central Banker, Federal Reserve Chairman Ben Bernanke actually confirms that it is targeting Stock prices (emphasis ours):

"…And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

Here Chairman Bernanke is referring to the "Wealth Effect", by which consumers and investors who feel their wealth increasing will be more likely to spend and invest.

There are two poignant counterarguments (among many) that may be offered against this notion:

1) The "Wealth Effect"

The most recent manifestation of the "Wealth Effect" led to homeowners using their houses as ATM's, withdrawing home equity to spend on consumer items and actually saving at a negative rate (why save when your home value is growing by leaps and bounds?).

This did not end well. 

The Wealth Effect works both ways - on the way up, and, in reverse on the way down.

2) Stock prices

Consider a share of IBM stock. A share is essentially a claim on a company's long-term stream of cash flows. These cash flows are determined primarily by industry conditions, the company's competitive position, and its sales, marketing, operating, and financial policies.

Fundamentally, a share is "worth" only the present value of its long-term stream of cash flows.

The price of the share, however, is determined entirely by investor sentiment. If you bought a share of IBM in August at $125, and today, thanks in large part to easy Fed policy, the bid is $146, Chairman Bernanke would like you to feel more wealthy and spend some of that extra $21 on… well on pretty much anything except your savings account or your credit card bills.

However, while the price of the share has changed, IBM's long-term stream of cash flows have changed not at all.  The fundamental drivers of IBM's long-term success are the same as they were.  The share still represents the same claim that it did before.

All that has changed is that there is more money chasing risk – driving the premium for risk down (and the price of stocks and high-yielding bonds, up).

Post-crash, investors are painfully aware of the potential for a reversal. And so with many analysts already viewing share prices as overvalued by fundamental metrics, encouraging them higher may reasonably be questioned as a proper goal of the US Federal Reserve.

Is QE2 a dangerous and potentially hyperinflationary "Monetization"?

This concern has been articulated loudly by many critics.

The answer is:  Yes and No.

Yes, the Federal Reserve is directly buying Treasury securities, which is the definition of Monetization.

No, in that the Monetizations that precede Hyperinflationary episodes generally occur when the Central Bank buys Government Debt that no-one else will buy.  The Fiscal authorities go to the Central Bank as a last resort when their creditors desert them, which leads to a hyperinflationary spiral.  This was the case in Weimar Germany, post-war Hungary, and most recently, Zimbabwe.

Hyperinflation in Zimbabwe, 2008
In the case of today's Federal Reserve, the Central Bank is purchasing the debt with the explicit goal of lowering interest rates and deliberately triggering some level of inflation.  There has yet been little evidence of a serious slackening of demand for US Government securities among the usual buyers (although concerns have been expressed).

And, the Fed has repeatedly indicated confidence in its ability to ultimately withdraw the excess Money Supply from circulation in an orderly manner.  (This claim also has come under criticism.)


Some have argued that QE2 amounts to a deliberate, competitive debasement of the currency with the goal of manipulating a change in the USA's current account imbalances (by increasing exports), and/or an attempt to inflate away the value of the national debt.  We take the Federal Reserve at its word that these are not its deliberate intentions.

But the question remains:  Will QE2 create the inflation desired by the Federal Reserve, and will this inflation spur economic growth?

Both parts of this two-part question are subject to a high degree of uncertainty.

Will QE2 create the inflation desired by the Federal Reserve?
Fine-tuning the transmission of Monetary growth to inflation is a risky enterprise. Very often, inflationary forces build up for a period of up to two or more years unseen, only to explode with a vengeance – too late to put the Monetary genie back in the bottle.

If so, will this inflation spur economic growth?
And the question of whether inflation spurs economic growth was in the United States most recently answered "no" in the 1970's Stagflation episode.

So what should the Fed do to spur growth?
"What is do be done?", you ask? 

Lenin asked: "What is to be done?" in his seminal 1902 pamphlet

This is the eternal question raised by bureaucrats, central planners and central bankers of all stripes ever since the rise of the modern state. The underlying premise, of course, is that something must be done – the question precludes the notion that doing nothing is an option.

Here, several schools of economists diverge:

* Keynesians would argue that something must indeed be done, and would support precisely the sorts of Monetary policies that the Federal Reserve is undertaking (indeed, they are currently running the show), as an increase in Money will boost economic growth.

* Supply-siders would concur that something must be done, but would argue that Monetary policy is ineffective at promoting real growth and instead only creates inflation, and that Fiscal and (De-)Regulatory policies to encourage business activity are the way to go.

* Classical Economists would follow the advice of President Hoover's Treasury Secretary Andrew Mellon, whose counsel on what to do about the Great Depression was:

"Let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate... It will scourge the rottenness out of the system. High costs of living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people".

* Austrian Economists might suggest that instead, doing nothing is indeed an option, and that the best thing the Federal Reserve can do (besides disband!) is to simply preserve the value of the currency, providing some certainty to businesses and individuals as they make economic decisions.

Andrew Mellon:  Liquidate Everything!

The results of QE2 will unfold over time, although as with all economic policies, the extremely complex nature of the system will likely allow advocates of all points of view to plausibly claim vindication. Such is the nature of the "dismal science"!

In any event, QE2 is underway. "ALL ABOARD!"

[Click here to play]

- Peter T. Murphy, November 5, 2010

Thursday, October 14, 2010

Keynes… Vindicated!

No, we're not talking about the economic theory which bears his name – Keynes' vindication this week comes with the news that the 'Huns' have finally paid off their war reparations, ninety-two years after the armistice.

Halt the Hun!
Poster for WWI Liberty Bonds
John Maynard Keynes represented the British Treasury at the Paris Peace Conference in 1919.

As a first-hand participant, Keynes saw the promise of a just peace with, in President Wilson's words "no annexations, no contributions, no punitive damages…" transformed into a brutal, Carthaginian regime of precisely annexations, contributions, and punitive damages.

The Paris Peace Conference, 1919

Keynes' reflections on the conference, including his recommendations for a rational and lasting settlement, were published in book form as The Economic Consequences of the Peace, published in November, 1919, as the Reparations Commission was still formulating its policies.

The work is an unsung masterpiece of 20th Century literature – unsung perhaps because it does not neatly fit into a category:  its masterful prose demonstrates Keynes' worthiness as a leading light among the Bloomsbury set (particularly in his cutting descriptions of the main participants), while at the same time, it is essentially a comprehensive and highly detailed macroeconomic report, replete with figures and tables, on the productive capacity of Germany and Europe as a whole.

Keynes outlines how any chance for a generous peace was corrupted from the outset.

The Paris Peace Conference

David Lloyd George
British Prime Minister
In Britain, an ill-advised early election call by Prime Minister David Lloyd George backfired as he found himself hemmed in by his opponents and forced to follow public opinion, egged on by the tabloid press, in demanding impossible and brutal terms.

Georges Clemenceau
French Prime Minister
The French, who then viewed (and may someday again…?!) their relationship with Germany as an eternal, Manichean struggle, defined only by the balance of power between two irrevocably hostile foes, would have salted every inch of ground from the Rhineland east if they were so permitted.

Keynes characterizes Clemenceau's position:

"… the German understands and can understand nothing but intimidation, that he is without generosity or remorse in negotiation, that there is no advantage he will not take of you, and no extent to which he will not demean himself for profit, that he is without honor, pride or mercy. Therefore you must never negotiate with a German or conciliate with him; you must dictate to him."

U.S. President Woodrow Wilson
returns from Paris, 1919

And Wilson, to the surprise of many (remember, this was 1919 - international travel at this time was by steamboat and there was no television!) turned out to be, contrary to the hyped expectations invested in him by the welcoming crowds of Europeans, completely out of his depth. He was outmaneuvered easily by the far more cunning British and French negotiators, his grand ideas for a world of post-war harmony left in tatters.

Again, we turn to Keynes' description:

"There can seldom have been a statesman of the first rank more incompetent than the President in the agilities of the council chamber."

 "The Old World's heart of stone might blunt the sharpest blade of the bravest knight-errant. But this blind and deaf Don Quixote was entering a cavern where the swift and glittering blade was in the hands of the adversary."

Proposals for reparations exceeding $100 Billion were bandied about prior to the conference by various officials quoted in the British and French press; meanwhile, Keynes calculated in exacting detail that a high-end estimate of the actual economic damage incurred against the allies during the war would be in the range of $10.6 Billion.

"The Economic Consequences of the Peace"

Keynes, disgusted with the proceedings as they moved inexorably toward a cruel victor's justice, quit the conference and returned to England to write his treatise, which became a surprising best-seller.

Keynes' brilliance was to base his case not on the moral injustice of the draconian terms being imposed, which given the tenor of the times would have fallen on deaf ears, but rather on a straightforward economic argument: there exists a figure that Germany can pay, and any amount exceeding this simply will not be paid.

"There is a great difference between fixing a definite sum, which though large is within Germany's capacity to pay and yet to retain a little for herself, and fixing a sum far beyond her capacity… The first leaves her with some slight incentive for enterprise, energy, and hope. The latter skins her alive year by year in perpetuity…"

Keynes' key insight was to understand the interconnectedness of global trade: by devastating Germany economically the victorious powers would eliminate a huge market for their own goods (as well as a major source of imports), the consequences of which would boomerang upon themselves.

Among the many figures and tables in the work is this one, showing annual German imports and exports by country – clearly the destruction of this major trading partner would deal a crushing blow to the world's economy:

Keynes then set out to determine the highest amount that might be reasonably extracted from the vanquished. He assembled an inventory of the pre-war and post-war assets and productive capability of Germany and its neighbors, looking at Europe as a whole. He determined that that the absolute maximum that Germany could bear to pay, without destroying the global economy, was on the order of $8.5 to $10 billion.

Keynes' recommendation for reparations was the sum of $7.5 Billion ($10 Billion less $2.5 Billion credit for assets and territory already transferred), paid without interest at $250 million per year for thirty years. He also called for mitigating some of the more severe territorial and in-kind appropriations, and establishing a Free Trade Union in Europe (another prescient idea…).

Ignoring Keynes' warnings, the final terms dictated by the Reparations Commission in 1921 were for $32 Billion in reparations, plus draconian appropriations of productive assets.

Less than 1/8th of the total sum would be paid before a new German Chancellor, risen to power on the resentment universally felt by the German people to the injustice of the treaty and the economic cataclysm which it created, suspended payments outright in 1933.  Grave consequenses would ensue for Germany, the Allies, and the world.

So, with reparations now paid in full, 92 years after the Armistice, we salute the genius of John Maynard Keynes, whose policy prescriptions, if not ignored in 1919, may have forestalled the worst of the 20th century's savagery.

The Contrarian Brilliance of Lord Keynes

Keynes' hallmark was to challenge the conventional wisdom – to take the facts as they are and look at them from new, unexplored directions.

This was characteristic of his next work on policy: A Tract on Monetary Reform, published in 1923, where he argued for the abandonment of the gold standard (another set of recommendations that would be ignored, but in this case belatedly thrust upon the major economies by the force of events in the coming years).

Likewise, Keynes' 1920 A Treatise on Probability was a thorough, 480-page exploration of the cutting-edge of probability theory at the time, which Keynes brings to life with his characteristically original criticisms and insights.

And in 1936, Keynes published his magnum opus, The General Theory of Employment, Interest, and Money, which challenged the conventional economic models of the time.

His object was:

"…to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which I was brought up and which dominates the economic thought"

'Keynesianism' Today

We have earlier explored the limits of Keynesian policy as applied to our present world, and have concluded that Keynes is Tired.

In fact, today, the view widely held by all but the most rabid Keynesian dead-enders is that 'Keynesian' fiscal and monetary policy has failed to perform as advertised:

- $1 Trillion of Stimulus spending has failed to dent the unemployment rate or spur any economic activity outside of "G" (Government), as "C" (Consumer Spending) continues to retrench and "I" (Investment) is hibernating.

- Legislative acts intended to spur lending have instead increased business uncertainty, and have focused solely on credit supply, ignoring the fact that this supply is being met with little demand as businesses remain loath to expand.

- $Trillions in an alphabet soup of Fed Support programs, near-zero interest rates for 2+ years and counting, an unprecedented expansion of the Fed's Balance sheet, 'Quantitative Easing' have failed to spur economic activity or even to create monetary velocity, as bank and corporate cash reserves have reached record levels.

Keynesian High Clergy:  Christina Romer, Alan Blinder, Paul Krugman, and Joseph Stiglitz
And yet, opining from deep in their epistemic bunkers, proponents of 'Keynesianism' continue to insist that our problem is that we need more fiscal and monetary stimulus:

"The only surefire ways for policymakers to substantially increase aggregate demand in the short run are for the government to spend more and tax less."
- Economist Christina Romer, speech to the National Press Club, 1-Sep 2010

"The urgent need is for government to replace the lost purchasing power of the unemployed and their families and to employ other tax-cut and spending programs to boost demand."- Alan Blinder, Joseph Stiglitz, and other Economists, Daily Beast, 19-July 2010

"Everything is pointing toward the need for more spending."- Paul Krugman, New York Times Columnist, on CNBC, August 31,2010

"…the key problem with economic policy in the Obama years: we never had the kind of fiscal expansion that might have created the millions of jobs we need."
-Paul Krugman, New York Times Columnist, October 13, 2010

Meanwhile, economists not bound to old paradigms, doing new research, are coming out with intriguing findings.

Alberto Alesina, Harvard University
In particular Alberto Alesina of Harvard University has determined that credible and significant budget cuts are often more effective at spurring economic activity than fiscal stimulus:

"Many even sharp reductions of budget deficits have been accompanied and immediately followed by sustained growth rather than recessions even in the very short run. These are the adjustments which Alesina's have occurred on the spending side and have been large, credible and decisive."

His findings provided support for European policymakers' moves toward fiscal restraint earlier this year.

Would Keynes be a 'Keynesian'?

So, with Keynes' vindication on the defining policy error of the 20th Century, we find ourselves wondering… would Lord Keynes even subscribe today to that set of policies which bear his name?

John Maynard Keynes
'Keynesianism' as broadly conceived today consists of applying the principles outlined in the General Theory to current economic challenges – in particular, spurring sagging Aggregate Demand through fiscal and monetary stimulus.

Would one of the most gifted, creative thinkers of the past hundred years dogmatically cling to policies conceived in response to a specific set of conditions some seventy years ago? Or, would he survey the economic landscape, and develop new and original prescriptions based on his observations of facts on the ground?

From a thorough reading of Keynes' body of work, and his biography, we are led to believe that were J.M. Keynes to return for policy consultation today he would be operating at the cutting-edge of economic theory, perhaps expanding on Alesanio's work, or, more likely, coming up with completely new and unconventional paradigms of his own. The idea that this man, especially, would rigidly follow a long-dead economists' prescriptions issued for a specific set of circumstances, in a specific time long past, is highly questionable.

Perhaps it's time to reclaim the word 'Keynesian' from the High Priests of Orthodoxy of a 70-year old set of theories, and inject the word with meaning that Keynes himself would, perhaps, have preferred.

Here is our humble suggestion:

Keynes-i-an [keyn-zee-uhn]
  1. bold, original, unorthodox
  2. brilliant (as in an idea); contrarian, critical of prevailing paradigms
  3. prescient
  1. a bold, original thinker who challenges conventional models with new theories based on observation of current facts

- Peter T. Murphy, 8-October, 2010

Disclaimer!: The above may or may not represent the views of Dr. Langdana, who, on the question of Keynesians vs. Supply-siders remains officially neutral, inscrutable, and enigmatic!

Recommended reading:

The Economic Consequences of the Peace, John Maynard Keynes, 1919

Large changes in fiscal policy: taxes versus spending. Alberto Alesina and Silvia Ardagna, August 2009, Revised: October 2009

Fiscal adjustments: lessons from recent history. Alberto Alesina, April 2010