Saturday, September 8, 2012

QE Only Benefits the Elites, Wealthy

by John Mauldin

Many speculate that the Fed will launch QE3 next week.
But independent economics and financial experts say this would hurt – rather than help – the economy.
Dallas Federal Reserve Bank president Richard Fisher said:

I firmly believe that the Federal Reserve has already pressed the limits of monetary policy. So-called QE2, to my way of thinking, was of doubtful efficacy, which is why I did not support it to begin with. But even if you believe the costs of QE2 were worth its purported benefits, you would be hard pressed to now say that still more liquidity, or more fuel, is called for given the more than $1.5 trillion in excess bank reserves and the substantial liquid holdings above the normal working capital needs of corporate businesses.
William F. Ford – former president of the Federal Reserve Bank of Atlanta – notes:
One of the overlooked consequences of the Federal Reserve’s recent rounds of monetary stimulus is the adverse impact those policies have had on the interest income of savers. The prolonged and abnormally low interest-rate structure put in place by the Fed has made life particularly difficult for retirees and others who depend on conservative interest-sensitive investments. But the negative effects do not stop there. They spillover into the overall performance of the economy.

Our estimates show that these negative effects, resulting from the Fed’s two rounds of quantitative easing (QE1 and QE2), are sizable and may help account for the lackluster character of the current recovery.


By lowering interest rates to historically unprecedented levels, the Fed’s policy deprives savers of interest income they normally would have earned on the interest-sensitive assets they hold. Thus, there is an income channel that no one is talking about, and its negative impact can be powerful.


Table 2 below shows our estimates of the possible losses in spending power, output, and employment generated by the Fed’s artificially low interest rates. Even by our most conservative estimate, which only looks at the $9.9 trillion in assets most directly affected by depressed yields on Treasurys, the losses are impressive. The average yield on Treasurys in June 2010 was 2.14 percent compared to an average of 7.07 percent in the previous nine recoveries, a difference of 4.93 percentage points. The projected annual impact of this loss of interest income on just $9.9 trillion of rate-sensitive assets translates into $256 billion of lost consumption, a 1.75 percent loss of GDP, and about 2.4 million fewer jobs. (Our calculations assume that the recipients of interest income face a 25 percent average income tax rate and consume 70 percent of their after-tax income.)

RR20110704 2 The Fed Is Expected to Launch QE3 Next Week ... Which Would Help the Rich and Hurt the Little Guy

Had these jobs not been lost, the unemployment rate would be 7.5 percent, instead of the current 9.1 percent, and this is the minimal effect we estimate.


As the estimate of the total of affected interest-sensitive assets gets bigger, the negative effects of depressed yields becomes even more striking. Using our mid-point estimate of $14.35 trillion of interest-sensitive assets, a 4.93 percentage point reduction in interest rates annually cost the economy $371 billion in spending, 3.5 million jobs, and 2.53 percent of GDP. This is a sizable effect, given that during this time GDP grew by only 2.33 percent and the economy added only 870,000 jobs.

With the additional jobs that might have been created by higher interest income levels, the unemployment rate could fall to 6.8 percent. And output could grow more than twice as fast as it has. The resulting GDP growth rate of 4.86 percent would then be closer to the average second-year growth rate of the past nine recoveries, and the U.S. economy would be well on its way to a vigorous recovery, rather than struggling as it is now.

This midpoint appraisal is our best estimate of the likely effect of the Fed’s policy. It may still be on the low side.

The numbers do not account for any so-called multiplier effects. Additional spending by recipients of interest income creates revenues for businesses, which in turn increases the income of their owners and employees, who themselves spend more. This, in turn, could boost overall spending and employment by more than the gain in interest income alone would suggest.


The housing market has not even begun to recover since the QE initiatives were created. U.S. auto sales and the stock market also remain well below pre-recession levels. And the sharp decline of the U.S. dollar has not created an export boom. But it has put upward pressure on the cost of our food and energy imports.

And tens of millions of U.S. savers, largely the elderly, still are facing strained circumstances created by Fed-driven abnormally low interest rates across the entire Treasury yield curve.

The negative impacts on output and employment caused by quantitative easing through the interest income effects shown here are large. In fact, they may outweigh the expected, but hard-to-document, positive effects of the QE program.
In fact, it has been thoroughly-documented that quantitative easing is great for the wealthy, but terrible for the little guy.
As the Guardian reported last year, quantitative easing increases inequality:
Quantitative easing (QE) … have contributed to social unrest by exacerbating inequality, according to one City economist.

As the Bank of England considers unleashing a fresh round of QE, Dhaval Joshi, of BCA Research, argues the approach of creating electronic money pushes up share prices and profits without feeding through to wages.
“The evidence suggests that QE cash ends up overwhelmingly in profits, thereby exacerbating already extreme income inequality and the consequent social tensions that arise from it,” Joshi says in a new report.

He points out that real wages – adjusted for inflation – have fallen in both the US and UK, where QE has been a key tool for boosting growth. In Germany, meanwhile, where there has been no quantitative easing, real wages have risen.
The Washington Post reported last month:
How might a third round of quantitative easing (QE3) affect the already-wide levels of inequality in the United States? Across the Atlantic, the Bank of England has come in for some criticism this week after it released a new report showing that its own quantitative easing efforts have disproportionately benefited the wealthiest:
The richest 10% of households in Britain have seen the value of their assets increase by up to £322,000 [$510,000] as a result of the Bank of England‘s attempts to use electronic money creation to lift the economy out of its deepest post-war slump. …

The Bank of England calculated that the value of shares and bonds had risen by 26% – or £600bn – as a result of the policy, equivalent to £10,000 for each household in the UK. It added, however, that 40% of the gains went to the richest 5% of households.
It’s not hard to see why this happens. One way the bank’s quantitative easing program works, in theory, by pushing up asset prices in order to support the broader economy. And, according to the Bank of England, the median British household only holds about $2,370 in financial assets. So the direct benefits largely accrue to wealthier households.

What about the United States? Much like in Britain, the distribution of financial assets are also heavily skewed. As you can see on page 26 of this Fed report (pdf), the median American family in the middle income bracket has about $19,900 in financial wealth. By contrast, the median family in the top income bracket has $423,800 in financial wealth. So any move by the Fed to push up asset prices is likely to increase wealth inequality in the short term.

There are other effects, too. As The Wall Street Journal has reported, the Fed’s efforts to bring down interest rates have mainly helped better-off Americans with good credit scores. For instance, it’s exceedingly cheap to get a mortgage right now — for a small number of people. (The folks at Zero Hedge, who are no fan of Bernanke’s stimulus efforts, have compiled a much longer list of links on how the Fed’s quantitative easing program benefits the wealthy.)
Indeed, Bernanke knew in 1988 that quantitative easing doesn’t work.  But he keeps caving in to the super-elite, and implementing it anyway.

Friday, September 7, 2012

Jobs Report Worse Than Thought

Job Growth Stalls, But Stocks Rise Anyway

WASHINGTON (Reuters) - Jobs growth slowed sharply in August, setting the stage for the Federal Reserve to pump additional money into the sluggish economy next week and dealing a blow to President Barack Obama as he seeks re-election.
Nonfarm payrolls increased only 96,000 last month, the Labor Department said on Friday, below what would normally be needed to put a dent in the jobless rate. Payrolls had grown by 141,000 jobs in July.
While the unemployment rate dropped to 8.1 percent from 8.3 percent, it was only because many Americans gave up the hunt for work. The survey of households from which the jobless rate is derived actually showed a decline in employment.
"The economy is crawling up the down escalator and today's report can only give ammunition to the activist members of the Fed board to loosen monetary policy further next week," said Patrick O'Keefe, head of economic research at J.H. Cohn in Roseland, New Jersey.
The lackluster report piled pressure on Obama ahead of the November vote in which the health of the economy looms large.
While acknowledging the tepid pace of job growth, Obama laid the blame for the labor market's woes on Congress, in particular Republicans.
"If Republicans are serious about being concerned about joblessness, we could create a million new jobs right now if Congress would pass the job plans I sent to them a year ago," Obama said at a campaign rally in Portsmouth, New Hampshire.
Republican presidential nominee Mitt Romney said Obama had done nothing during his first term in office to inspire confidence among Americans in his economic policies.
"Seeing that kind of report is obviously disheartening for the American people who need work and are having a hard time finding work," Romney told reporters in Sergeant Bluff, Iowa.
The weakness was virtually across the board, with average hourly earnings slipping and manufacturing -- the star of the recovery from the 2007-09 recession -- shedding jobs for the first time in nearly a year.
The data dampened spirits in U.S. stock markets, which were little changed in afternoon trade after posting sharp gains earlier in the week. Treasury debt prices rallied on prospects of bond purchases by the Fed next week, while the dollar dropped to a near four-month low against the euro.
Economists polled by Reuters had expected payrolls to rise 125,000 last month, but some had pushed their forecasts higher after upbeat data on Thursday.
Fed Chairman Ben Bernanke last week said the labor market's stagnation was a "grave concern," a comment that raised expectations for a further easing of monetary policy.
The economy has experienced three years of growth since the 2007-09 recession, but the expansion has been grudging and the jobless rate has held above 8 percent for 43 straight months, essentially all of Obama's term and the longest stretch since the Great Depression. Economists say jobs growth in the range of 125,000 a month would normally be needed just to hold the unemployment rate steady.
The jobless rate peaked at 10 percent in October 2009, but progress reducing it stalled this year, threatening Obama's bid for a second term. An online Reuters/Ipsos poll on Thursday gave Romney a 1-point edge on Obama, 45 percent to 44 percent.
The lack of headway putting Americans back to work also has put the question of further monetary stimulus on the table at the Fed, which meets on Wednesday and Thursday. Some economists who had thought the central bank might bide its time said the jobs data made action next week more likely than not.
The central bank has held interest rates close to zero for nearly four years and has pumped about $2.3 trillion into the economy through two bouts of bond buying, or quantitative easing, to drive borrowing costs lower and spur growth.
In addition, it has said it expects to hold rates near zero at least through late-2014, a pledge that is also in play at next week's meeting.
"We expect the Fed to extend its 'low-rates' guidance through mid-2015, and to launch a third round of quantitative easing worth $500-$600 billion," said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.
"We don't think these measures will be very effective in boosting growth, but for the Fed it's a question of trying to do what it can."
The weak tenor of the report was underscored by revisions to June and July data that showed 41,000 fewer jobs created during those months than previously reported.
In addition, the labor force participation rate, or the percentage of Americans who either have a job or are looking for one, fell to 63.5 percent in August, the lowest in 31 years.
A total of 368,000 people gave up looking for work last month, the household survey showed.
Since the beginning of the year, job growth has averaged 139,000 per month, compared with an average monthly gain of 153,000 in 2011. Last month's increase still left the economy 4.7 million jobs short of where it stood when the recession started.
"Today's numbers should check any enthusiasm that the economy was gaining momentum toward the end of the summer. Instead, the economy appears to remain stuck in the mud," said Michael Feroli, an economist at JPMorgan in New York.
Economists say fears of the so-called U.S. fiscal cliff -- the $500 billion or so in expiring tax cuts and government spending reductions set to take hold in 2013 -- and Europe's long-running debt problems have made businesses cautious about hiring in an already sluggish recovery.
Manufacturing payrolls fell 15,000, largely because of declines in automobile assembly jobs. Factory jobs were inflated in July because auto manufacturers kept plants running when they would normally shut them for retooling.
There was little improvement in construction employment, which added 1,000 jobs, even though home builders continued to break ground on new projects at a fast clip. Temporary employment, seen as a harbinger of future permanent hiring, declined for the first time since March.
Retail jobs were one of the few bright spots, rebounding after declining for two straight months. While payrolls at utilities grew 8,800, that was a snap back from a strike in July.
Government payrolls declined for a sixth straight month, dragged down by state and local governments as they continue to tighten belts to balance their budgets.
Average hourly earnings fell one cent, which could weigh on consumer spending. Earnings have risen just 1.7 percent over the past 12 months.
The average work week was steady at 34.4 hours in August.
(Additional reporting by Jason Lange in Washington and Sam Youngman in Iowa; Editing by Andrea Ricci)

Thursday, September 6, 2012

Stocks Explode to Fresh FIve-Year Highs...

...on promises by central bankers, both in the US and Europe, to monetize unlimited amounts of government debt, and the first positive weekly jobless claims report in four weeks. The chart shows the past four weeks for stocks, including the magnitude of the elation this morning (last candle). The Dow is up nearly 250 points thus far.

Something doesn't match between the stock chart above, and the various news reports below.

Mr. Market: Things Are So Bad in Europe, ECB Must and Will Act

We're back in the mode of central bank worship and "bad news is good news". Stocks are sharply higher in expectation of ECB bond buying without restraint.

Wednesday, September 5, 2012

Tuesday, September 4, 2012

US Manufacturing Contracts, Food Stamps Usage Grows

from the WSJ:
The U.S. manufacturing sector continued to contract in August, while cost pressures jumped, according to data released Tuesday by the Institute for Supply Management. The weak factory sector may push the Federal Reserve to implement more policy accommodation. The ISM's manufacturing purchasing managers' index slipped to 49.6 last month from 49.8 in July. The August reading was the lowest since July 2009 and marked the third consecutive contraction for the ISM index.

Monday, September 3, 2012

No Good News From Europe

Even Euro's Bulls Are Bears

Sunday, September 2, 2012

China Manufacturing PMI Lowest Since March 2009

Stocks have fully recovered, despite this headline of more horror:

John Mauldin: The Unexpected Consequences of Long-Term Easy Monetary Policy

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."
– Ludwig von Mises
We heard from Bernanke today with his Jackson Hole speech. Not quite the fireworks of his speech ten years ago, but it does offer us a chance to contrast his thinking with that of another Federal Reserve official who just published a paper on the Dallas Federal Reserve website. Bernanke laid out the rationalization for his policy of ever more quantitative easing. But how effective is it? And are there unintended consequences we should be aware of? Why is it that the markets seem to positively salivate over the prospect of additional QE?
Quickly, I will be doing an inaugural "Fireside Chat" with Barry Ritholtz on Tuesday, September 11 at 1 PM Eastern. This webinar will be hosted by my friends at Altegris Investments and will be available to accredited investors and financial professionals. If you have already registered with the Mauldin Circle (and are in the US), you will shortly be receiving an invitation to attend. If you have not, I invite you to go to and register today, so you can hear Barry and me discuss the latest news and, of course, touch on the election and what it means for investors. Now, let's delve into quantitative easing.


No one really expected any fireworks in Bernanke's speech, and he fully met expectations. We got the obligatory rationalization for what passes as current Fed policy. The part the markets wanted to hear is highlighted below for you.
"… As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.
"Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability."
Did that last sentence ring any bells? Let's look at his Jackson Hole speech in August of 2010 (hat tip Joan McCullough).
"We will continue to monitor economic developments closely and to evaluate whether additional monetary easing would be beneficial. In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool."
Standard-issue Fed speech. This has been his theme for the last four years, if memory serves. In every speech he gives a nod to the proposition that he and his colleagues are seriously analyzing the effects of Fed quantitative easing policies to make sure the benefits outweigh the costs. I have not heard a serious critique or exposition from Bernanke of those risks, as of yet. But we did get a victory lap from him this year, as he took credit for the economy and the stock market. Let's go back to the speech (again, my bold):
"Importantly, the effects of LSAPs [large-sized asset purchases] do not appear to be confined to longer-term Treasury yields.
"Notably, LSAPs have been found to be associated with significant declines in the yields on both corporate bonds and MBS. The first purchase program, in particular, has been linked to substantial reductions in MBS yields and retail mortgage rates.
"LSAPs also appear to have boosted stock prices, presumably both by lowering discount rates and by improving the economic outlook; it is probably not a coincidence that the sustained recovery in US equity prices began in March 2009, shortly after the FOMC's decision to greatly expand securities purchases. This effect is potentially important, because stock values affect both consumption and investment decisions."
I missed the part where Congress gave the Fed a third mandate, to target the stock market. But Bernanke not only takes credit for the stock market, he points out that the rebound in the housing market is also due to Fed policy, because it fostered lower mortgage rates. Which it did. But let's also remember that it was Fed policy that helped create the housing bubble to begin with. Which I don't remember Bernanke taking credit for, even though he was on the Fed then and up to his eyeballs in supporting that policy.
Joan McCullough, in her own irreverent style, gave us a few must-read paragraphs this afternoon:
"And then [Bernanke] has the sand to make a public comment that stocks go up when he prints money because discount rates have gone down and the economic outlook has improved on account of it? This is what makes the hot dogs run stocks up the flagpole when The Bernank saddles up? Better economic outlook? Amazing.
"Lemme go back now and give you the reality version of the Bernanke portfolio balance channel.
"He relieves investors of the lowest risk-bearing vehicles, forcing them to seek yield elsewhere and at the same time, take on increasing risk. Until, increasingly yield-starved as this 'balancing' is relentless, they arrive at the door of the stock market. And mindlessly take the plunge. Because they have no choice. They are now balls-to-the-walls exposed. Waiting for the next round of QE.
"Because Lord knows, the first two did jack. Of course, in the earliest part of his diatribe today, he does make a case as to how the lower rates worked some magic on the economy, although exactly how much is difficult to pinpoint. As usual, too, he also blames the fiscal intransigence as well as tight credit conditions at the banks for holding back the beauty of his genius from working its total magic."

Quantitative Easing as Trickle-Down Economics

Let me get this straight. If I design a tax policy that somehow might benefit "the rich," I am immediately labeled a Luddite supply-side theorist, as well as heartless, etc.
It is pretty standard for Keynesian economics professors to deride supply-side economics and what they call trickle-down economics. Cutting taxes on the rich will translate into a better economy and jobs? They scoff at such notions, as do almost all the liberal elements in politics.
Which brings us to this delicious irony. While they abhor trickle-down economic policy, they love what is in effect trickle-down monetary policy.
Bernanke explicitly targets a policy of helping the rich (those who own stocks) and then suggests that the result of making the rich richer will be increased consumption and final demand. Which will somehow trickle down to the guys and gals in the unemployment line.
The paper posted at the Dallas Fed, which we will take up in the next section, specifically notes that QE has a special benefit for "the senior management of banks in particular." That amounts to a thunderous indictment of the crony capitalism of current policy. It's hard to argue that there is much trickle down with that particular unintended consequence!
The paper also notes that "… it is also worth asking whether, to some degree, this [rising income inequality] might be another unintended consequence of ultra easy monetary policy. Not only has the share of wages (in total factor income) been declining in many countries, but the rising profit share has been increasingly driven by the financial sector [which explicitly benefits from QE]. It seems to defy common sense that at one point 40 percent of all US corporate profits (value added?) came from this single source."
Understand, I am NOT arguing that an easy monetary policy doesn't have an effect on stocks and that it will have an effect on the overall economy. There is clearly a wealth effect. It is just that almost all (not quite but almost) of the arguments that one can make for trying to boost the stock market are the same that one uses for arguing that tax cuts also increase consumption and the wealth effect.
As a short preview to next week's letter, Christina Romer and her husband and fellow UC Berkeley professor, David H. Romer, published a paper in the normally staid American Economic Review which noted that tax cuts and increases have a multiplier of about 3. (Christina Romer was Obama's chair of the Council of Economic Advisors, from the beginning of his term until [very] shortly after this paper was published.)
Most mainstream economists and liberals (or those who are both, as in the case of Krugman) make fun of the wealth and economic effects from tax cuts and ignore Romer's work, or try to show why it does not apply to eliminating the Bush tax cuts, which they oppose (and which, interestingly, the Romers' study specifically included). But then they turn around and ask for more of what is effectively the same thing in monetary policy. It will be great fun to watch the contorted positions they have to assume in trying to suggest this is not the case. Kind of like the contorted position that Clint Eastwood was referring to last night. They will use anecdotal "evidence" and allegories without actually referring to academic analysis or peer-reviewed studies. It is much easier to make an assertion than to actually demonstrate its validity in the real world. Their antics will serve to drive me nuts, however.
Note that I am not saying that either tax policy or monetary policy should be evaluated in the harsh glare of immediate economic results. Taxes have to be evaluated on more than just their effect on the economy, and monetary policy has to be judged on more than the immediate reaction of the markets.

That Which Is Seen and That Which Is Not Seen

Which brings us to the more serious part of this letter. Let's start with a review of a quote from Bastiat:
"In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.
"There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
"Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil."
- From an essay by Frédéric Bastiat in 1850, "That Which Is Seen and That Which Is Unseen"

"Ultra Easy Monetary Policy and the Law of Unintended Consequences"

William R. White is currently the chairman of the Economic Development and Review Committee at the OECD in Paris. He was previously Economic Advisor and Head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland. He is clearly no economic lightweight, nor is he an ideologue. When he writes, attention must be paid. (
And he has written a rather pointed indictment of Federal Reserve monetary policy, which has been published on the Dallas Federal Reserve website:
Basically, he looks at the unintended consequences of quantitative easing and concludes that there are limits to what central banks can do, and negative consequences if policies are too easy for too long. He notes later in the essay that:
"Stimulative monetary policies are commonly referred to as 'Keynesian'. However, it is important to note that Keynes himself was not convinced of the effectiveness of easy money in restoring real growth in the face of a Deep Slump. This is one of the principal insights of the General Theory."
I am going to quote him at length in the next few pages. I hope that it intrigues you enough that you will want to go and read the paper yourself. This is not just dry theory. If QE is maintained for too long, then those of us in the "cheap seats" will have to deal with the consequences. Let me note that there are some 126 footnotes. I would recommend at least keeping up with them, as I found the "extra" commentary to often be very enlightening. This is a well-written paper that avoids the all-too-typical verbal garbage that passes for economics writing these days.
Let's start with his introduction:
"The central banks of the advanced market economies (AME's) have embarked upon one of the greatest economic experiments of all time – ultra easy monetary policy. In the aftermath of the economic and financial crisis which began in the summer of 2007, they lowered policy rates effectively to the zero lower bound (ZLB). In addition, they took various actions which not only caused their balance sheets to swell enormously, but also increased the riskiness of the assets they chose to purchase. Their actions also had the effect of putting downward pressure on their exchange rates against the currencies of Emerging Market Economies (EME's). Since virtually all EME's tended to resist this pressure, their foreign exchange reserves rose to record levels, helping to lower long term rates in AME's as well. Moreover, domestic monetary conditions in the EMEs were eased as well. The size and global scope of these discretionary policies makes them historica lly unprecedented. Even during the Great Depression of the 1930's, policy rates and longer term rates in the most affected countries (like the US) were never reduced to such low levels.
"In the immediate aftermath of the bankruptcy of Lehman Brothers in September 2008, the exceptional measures introduced by the central banks of major AME's were rightly and successfully directed to restoring financial stability. Interbank markets in particular had dried up, and there were serious concerns about a financial implosion that could have had important implications for the real economy. Subsequently, however, as the financial system seemed to stabilize, the justification for central bank easing became more firmly rooted in the belief that such policies were required to restore aggregate demand6 after the sharp economic downturn of 2009. In part, this was a response to the prevailing orthodoxy that monetary policy in the 1930's had not been easy enough and that this error had contributed materially to the severity of the Great Depression in the United States.7
"However, it was also due to the growing reluctance to use more fiscal stimulus to support demand, given growing market concerns about the extent to which sovereign debt had built up during the economic downturn. The fact that monetary policy was increasingly seen as the 'only game in town' implied that central banks in some AME's intensified their easing even as the economic recovery seemed to strengthen through 2010 and early 2011. Subsequent fears about a further economic downturn, reopening the issue of potential financial instability, gave further impetus to 'ultra easy monetary policy'.
"From a Keynesian perspective, based essentially on a one period model of the determinants of aggregate demand, it seemed clearly appropriate to try to support the level of spending. After the recession of 2009, the economies of the AME's seemed to be operating well below potential, and inflationary pressures remained subdued. Indeed, various authors used plausible versions of the Taylor rule to assert that the real policy rate required to reestablish a full employment equilibrium (and prevent deflation) was significantly negative. Such findings were used to justify the use of non standard monetary measures when nominal policy rates hit the ZLB.
"There is, however, an alternative perspective that focuses on how such policies can also lead to unintended consequences over longer time periods. This strand of thought also goes back to the pre War period, when many business cycle theorists focused on the cumulative effects of bank‐created‐credit on the supply side of the economy. In particular, the Austrian school of thought, spearheaded by von Mises and Hayek, warned that credit driven expansions would eventually lead to a costly misallocation of real resources ('malinvestments') that would end in crisis. Based on his experience during the Japanese crisis of the 1990's, Koo (2003) pointed out that an overhang of corporate investment and corporate debt could also lead to the same result (a 'balance sheet recession').
"Researchers at the Bank for International Settlements have suggested that a much broader spectrum of credit driven 'imbalances', financial as well as real, could potentially lead to boom‐bust processes that might threaten both price stability and financial stability. This BIS way of thinking about economic and financial crises, treating them as systemic breakdowns that could be triggered anywhere in an overstretched system, also has much in common with insights provided by interdisciplinary work on complex adaptive systems. This work indicates that such systems, built up as a result of cumulative processes, can have highly unpredictable dynamics and can demonstrate significant non linearities. The insights of George Soros, reflecting decades of active market participation, are of a similar nature."
And then White anticipates his conclusion:
"One reason for believing this is that monetary stimulus, operating through traditional ('flow') channels, might now be less effective in stimulating aggregate demand than previously. Further, cumulative ('stock') effects provide negative feedback mechanisms that over time also weaken both supply and demand. It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the 'independence' of central banks, and can encourage imprudent behavior on the part of governments. None of these unintended consequences is desirable. Since monetary policy is not 'a free lunch', governments must therefore use much more vigorously the policy levers they still control to support strong, sustainable and balanced growth at the global level."
White anticipates the objection that ultra-easy monetary policies clearly had a positive effect early on.
"The force of these arguments might seem to lead to the conclusion that continuing with ultra easy monetary policy is a thoroughly bad idea. However, an effective counter argument is that such policies avert near term economic disaster and, in effect, 'buy time' to pursue other policies that could have more desirable outcomes. Among these policies might be suggested more international policy coordination and higher fixed investment (both public and private) in AME's. These policies would contribute to stronger aggregate demand at the global level. This would please Keynes. As well, explicit debt reduction, accompanied by structural reforms to redress other 'imbalances' and increase potential growth, would make remaining debts more easily serviceable. This would please Hayek. Indeed, it could be suggested that a combination of all these policies must be vigorously pursued if we are to have any hope of achieving the 'strong, sustained and ba lanced growth' desired by the G 20. We do not live in an 'either‐or' world.
"The danger remains, of course, that ultra easy monetary policy will be wrongly judged as being sufficient to achieve these ends. In that case, the 'bought time' would in fact have been wasted. In this case, the arguments presented in this paper then logically imply that monetary policy should be tightened, regardless of the current state of the economy, because the near term expected benefits of ultra easy monetary policies are outweighed by the longer term expected costs. Undoubtedly this would be very painful, but (by definition) less painful than the alternative of not doing so. John Kenneth Galbraith touched upon a similar practical conundrum some years ago when he said
"'Politics is not the art of the possible. It is choosing between the unpalatable and the disastrous'.
"This might well be where the central banks of the AME's [advanced-market economies] are now headed, absent the vigorous pursuit by governments of the alternative policies suggested above."
White then launches into a long litany of unintended and undesirable consequences of maintaining an easy monetary policy too long, some of which we can clearly see developing now. He particularly notes problems with the shadow banking system and the effects of low interest rates on insurance companies (and, I would add, pensions!).
"What are the implications of ultra easy monetary policy for governments? One technical response is that it could influence the maturity structure of government debt. With a positively sloped yield curve, governments might be tempted to rely on ever shorter financing. This would leave them open to significant refinancing risks when interest rates eventually began to rise. Indeed, if the maturity structure became short enough, higher rates to fight inflationary pressure might cause a widening of the government deficit sufficient to raise fears of fiscal dominance. In the limit, monetary tightening might then raise inflationary expectations rather than lower them."
"A more fundamental effect on governments, however, is that it fosters false confidence in the sustainability of their fiscal position… Koo, Martin Wolf of the Financial Times, and others are undoubtedly right in suggesting that a debt driven private sector collapse should normally be offset by public sector stimulus. What cannot be forgotten, however, is the suddenness with which market confidence can be lost, and the fact that the Japanese situation is highly unusual in a number of ways."
If interest rates were to rise in the US to more normal levels, the deficit would explode under current spending and tax policies, destroying whatever policy solutions are reached next year.
There is no easy way to exit from current policies, and the longer one waits the more difficult it will get. This is true in the US, Europe, and Japan. It is part and parcel of the Endgame. And this is the defining challenge of our time, and especially in the US as we approach the coming election. I will attempt to outline the key economic issues next week.

QE Rebuttal

At the end of December 2010, Philipp Bagus (he of the must watch/read 'Tragedy of the Euro') provided a clarifying and succinct rebuttal or Bernanke's belief in the extreme monetary policy path he has embarked upon. Bernanke's latest diatribe, or perhaps legacy-defining, self-aggrandizing CYA comment, reminded us that perhaps we need such clarification once again. Critically, Bagus highlights the real exit-strategy dangers and inflationary impacts of Quantitative Easing (a term he finds repulsive in its' smoke-and-mirrors-laden optics) adding that:

Money printing cannot make society richer; it does not produce more real goods. It has a redistributive effect in favor of those who receive the new money first and to the detriment of those who receive it last. The money injection in a specific part of the economy distorts production. Thus, QE does not bring ease to the economy. To the contrary, QE makes the recession longer and harsher.

Will There Be QE3, QE4, QE5...?
Philipp Bagus, December 2010, via the Ludwig von Mises Institute,
Recently, Ben Bernanke indicated that Quantitative Easing II (QE2) might be followed by QE3, etc. In an interview at the beginning of December, Bernanke was asked, "Do you anticipate a scenario in which you would commit to more than $600 billion?"
Bernanke's answer was startling. "Oh, it's certainly possible," he said. "And again, it depends on the efficacy of the program. It depends on inflation. And finally it depends on how the economy looks."
The answer is interesting because it not only indicates the possibility that the Federal Reserve (Fed) will purchase more government bonds but also implies that Bernanke thinks that inflation and QE are different concepts, because otherwise his claim would be a meaningless tautology: more inflation depends on inflation.
To make sense of Bernanke's technical talk, let us go back to the beginning of the infamous QE, to the darkest months of the financial crisis. During the boom fired by artificially low interest rates, financial institutions had financed malinvestments, especially in the housing sector. When the bubble burst and housing prices started to fall, these investments lost value rapidly. Bank losses mounted, bank equity fell, and solvency problems arose. Liquidity dried up as financial institutions started to doubt each other's solvency given the problematic loans on their books.
When credit markets dried up in September 2008, after the collapse of Lehman Brothers, loans that financed malinvestments did not serve as collateral for interbank lending anymore. The Fed stepped into the breach and accepted these bad assets as collateral for loans. In March 2009, the Fed started to buy these assets outright in what was dubbed QE1. As a consequence of this qualitative and quantitative easing, the Fed's balance sheet almost tripled within a few months.
How long would these extraordinary emergency measures be maintained? In March 2009, Ben Bernanke stated that the Fed had an exit strategy from its emergency credit policies. It could simply undo its credit policies and asset purchases, thereby reducing the size of its balance sheet to its pre-crisis level.
I have argued that such an easy exit option does not exist. The Fed's purchase of problematic assets did not solve the underlying real problems in the economy: injecting new money does not cause malinvestments to go away. By propping up financial institutions, necessary liquidations and readjustments of the structure of production are only delayed. QE1 could even cause more malinvestments and thereby aggravate the problem. The consequence could be a Japanization of the banking system, with insolvent banks held afloat by the central bank.
If the Fed would exit the emergency situation, reduce its balance sheet, and stop accepting problematic assets as collateral for loans, financial institutions would be back to the initial situation of September 2008. If housing prices do not return to their bubble level, many of the problematic assets will continue to be bad and not serve as good collateral. If valued at the market price, these assets might eat up banks' equity. If the Fed ended its emergency measures, we would effectively be back to the initial situation of frozen interbank markets and general illiquidity.
In October 2009, I concluded that the Fed could not go back to its initial balance sheet without causing the collapse of the financial system. One possible way out would be to reinflate the bubble. Rising asset prices — and especially housing prices — would make many problematic bank assets valuable again. The Fed could increase the quality of its assets by inflating the housing bubble.
In the winter of 2010 [ZH - just as now in Summer of 2012], no one is talking about reducing the Fed's balance sheet or about exit strategies anymore. On the contrary, the Fed has chosen the path of more inflation and dubbed this strategy "QE2."
QE2 has a slightly different purpose than QE1. QE1 directly supported struggling banks by buying their problematic assets. QE2 supports the government.
The inflationary policies of the Fed have been coupled with the Keynesian fiscal policies of the US government. The US government engaged in deficit spending to bail out financial institutions and automakers, disrupting a fast liquidation of malinvestments and a smooth adaption of the structure of production to consumer wants.
QE2 is a direct response to this deficit spending, which obliges the government to issue more bonds. With QE2, the Fed supports the government by buying these bonds. The Fed thereby actively helps the government in its Keynesian policies, which disrupt recovery. While QE1 supported the financial system, QE2 supports the government. Granted, this difference is not substantial given that the fates of the financial system and the government are interwoven. The banking system finances the government that in turn grants the privilege of fractional-reserve banking and implicitly gives guarantees for banks' losses.
Of course, Ben Bernanke does not say that he wants to help finance the government's deficit via money creation. The official excuse for QE2 is, yet again, the scapegoat "deflation."[2] Price inflation is too low. James Bullard, president of the St. Louis Federal Reserve Bank, states that "it's important to defend inflation from the low side as we would on the high side."
In other words, if prices rise too slowly, we must print money so that things get more expensive faster. Bernanke even denies that QE2 would be inflationary: "One myth that's out there is that what we're doing is printing money. … The money supply is not changing in any significant way."
Bernanke plays a semantic trick in this statement. Of course, the Fed does not create the bulk of its new money by literally "printing." Rather, the Fed creates money by manipulating digits in its computer. When the Fed buys a $1,000 government bond from a bank, it transfers 1,000 new dollars as a payment to the bank. It is true that the Fed does not print the money and ship it over to the bank physically. Rather, it increases the account that the bank holds at the Fed by $1,000. It is more convenient to just create the new money in a computer.
"In other words, if prices rise too slowly, we must print money so that things get more expensive faster."
However, the fact that the new money is created electronically does not mean that QE2 is not inflationary. QE2 is inflationary in several ways:
First, base money (bank reserves) increases. When the Fed buys a government bond, it creates money that it transfers to the bank selling the bond. At the end of the operation, the bank has more bank reserves and the Fed owns the government bond.

Second, the quality of money tends to decrease. The average quality of assets that the Fed holds decreases when it buys government bonds. The percentage of gold of total assets that could be used in a monetary reform decreases, while the percentage of government bonds increases. Moreover, these bonds are for a government that is ever increasing its debts.

Third, prices will be higher than they would have been otherwise. Prices would probably have fallen substantially without QE1 and QE2. The injection of new bank reserves inhibited a credit contraction and falling prices. In fact, one aim of QE2 is to bid up asset prices.

Money flows into the stock market, bidding up stock prices. In March 2009, when QE1 started, the Dow Jones was below 7,000 and rose to 10,800 until QE1 expired. When the Dow fell below 10,000 again, markets began to speculate about the possibility of QE2, and a new rally started.

While the newly created money flows to asset-price markets, consumer prices might not surge strongly. But sooner or later, these investments will flow out of asset-price markets and start to bid up consumer goods' prices.

Fourth, the exchange rate will be lower than it would have been otherwise. Market participants will value the dollar lower, given that the base-money supply increases and the dollar's quality decreases. This devaluation is another aim of QE2. It is a way to give exporters an advantage. The devaluation is not as crude an instrument as a tariff but has similar effects. It makes consumers poorer. They have to pay higher prices for imported goods.
Consequently, QE2 is, despite Bernanke's words, inflationary. In fact, it is a euphemism to call the policy QE2. The term quantitative easing conceals the true inflationary nature of the instrument. Furthermore, it sounds technical. The added number "2" makes it even more so. People who know little about economics might ignore news on QE2. Why bother to understand something so technical — let the experts deal with it. The term also has a positive connotation. Who does not want "ease"?
As Walter Block has repeatedly pointed out, we should carefully watch our language. Language is crucial to clear communication. The use of the term quantitative easing generates a smog to hide the production of new money. Words, as Block states, can be mightier than pens or swords. They guide our thoughts and writings. The invention of the term quantitative easing prevents people from thinking about the consequences of inflation. The term distorts thinking.
"The term quantitative easing conceals the true inflationary nature of the instrument."
Why not name QE for what it is? Why not name it after the effects it has?
Money printing cannot make society richer; it does not produce more real goods. It has a redistributive effect in favor of those who receive the new money first and to the detriment of those who receive it last. The money injection in a specific part of the economy distorts production. Thus, QE does not bring ease to the economy. To the contrary, QE makes the recession longer and harsher.
The injection of new money into the economy reinflates old bubbles and generates new ones. Most importantly, QE facilitates government deficit spending — additional distortions and rigidities in the economy. Malinvestments can endure. Factors of production are not shifted to places where the consumer wants them to be most urgently.
Thus, QE2 would be better called, "Quantitative Straining," "Quantitative Destruction II," or "Crisis Prolongation III."
Or we might name it after the intentions behind it: "Currency Debasement I," "Bank Bailout I," "Government Bailout II," or simply "Consumer Impoverishment." Finally, we might also name it after its essence: "Money Printing I and II." Or, if we follow Bernanke, who pointed out that most of the new money is created in a computer, we can call it "Money Creation I and II." This might be the most neutral term.
The rhetorical tricks should not distract us from the fact that QE is simple money creation. The aim of Money Creation II is to finance government spending, debasing the dollar. We should dismiss the term QE and instead call money creation what it is: inflation.

Hideous Holiday Headlines

Stock futures have dropped to near Friday's lows.