Writings of a techie wizard
Wed, 27 Nov 2013
A few weeks ago the Federal Reserve announced that it would continue "quantitative easing" at its current level. The reason, as explained in the press release just linked to (though in rather oblique language, as is the usual practice with such things), was basically that, while the economy appears to be recovering, the Fed isn't sure that it's recovering strongly enough. Which leads to the obvious next question: how much longer will this have to go on?
To see just how acute this question really is, you have to bear in mind that the reason the Fed is doing "quantitative easing" (QE) in the first place is that it has already maxed out its other tools. The Fed's target interest rate is already as low as it can go, i.e., zero, and the press release makes it clear that there are no plans to change that any time soon (in fact, the release notes that the rate will probably remain at effectively zero for some time after "quantitative easing" ends, whenever that is). Bank reserve requirements are about as low as they can possibly go without admitting openly that they are basically zero (and note that the upper limit of the "low-reserve tranche" in which only 3 percent of liabilities must be held in reserve, has been rising steadily, as shown on the table further down the page, and is scheduled to rise again in January 2014). Yet the economy continues to be sluggish.
Of course, there is no shortage of theories as to why the economy has not responded more emphatically to all this nice treatment. The standard Keynesian answer, which you can find even at The Economist these days, is that without QE the recession would have been much worse. On this theory, the Fed should certainly not be even thinking about scaling back QE (as they almost did in September); if anything, they should be thinking about expanding it. The main problem with this theory is that, if the Keynesians actually believed it, they would be advocating expanding QE, yet none of them are. True, they aren't advocating reducing the pace either; this column by Paul Krugman is a good example of the current Keynesian wisdom:
That bit about "forward guidance" just means that, instead of QE, Krugman would prefer that the Fed just cross-its-heart-and-hope-to-die-double-promise that it really, really, really won't raise interest rates, and hope that by itself is enough to get the economy to recover. You will note, of course, as I did above, that the Fed basically did exactly that in the press release; in fact they have been doing it pretty consistently for the past few years. So if it were going to work, you would expect that it already would have worked, with or without the added push of QE. Another beautiful theory spoiled by an ugly fact.
Let's try a different theory. Consider: what is the Fed actually doing when it does QE? According to the press release, it is buying "additional agency mortgage-backed securities...and longer-term Treasury securities". In plain English, the Fed is buying various securities from banks in order to drive up their price and thereby drive down the interest rates on them. The hope is that the lower interest rates will encourage people and businesses to take out more loans and thereby start spending again.
But for that to happen, the banks, who are the direct recipients of the $2.8 trillion and counting from the Fed, have to make the loans. What if they just choose to hold on to the cash instead? According to the Fed's accounting of bank reserves, that's exactly what they have been doing. As you can see from the link, at the end of October, 2013, total bank reserve balances were about $2.4 trillion. Does that number sound familiar? And what's more, only $73 billion of that is required to meet the banks' reserve requirements. According to the Fed, they can lend out all the rest, i.e., about $2.3 trillion. But they haven't. Why not?
Before answering this question, we should pause to observe how outlandish this situation is, at least on the surface. As CNBC points out, banks can earn anywhere from 4 percent to 10 percent or more on various types of loans; yet instead, they are leaving their money deposited at the Fed earning 0.25 percent. What's going on here?
CNBC's answer is simple:
In other words, on this theory, banks are actually acting rationally: they would make less than 0.25 percent, on net, if they actually loaned out that $2.3 trillion. So the situation is actually even more outlandish than it first appears; what kind of messed up economy do you have to have for banks to think that their best available rate of return is 0.25 percent?
I've never seen a Keynesian economist even ask this kind of question, but there are other kinds of economists, though you rarely see them as talking heads on the news or blogging in venues like the New York Times. For example, you could try this article from the Ludwig von Mises Institute:
First, a side note: many non-Austrian economists would object to the term "monetary pumping" being used to describe QE. For example, this article on the "Pragmatic Capitalism" site claims that QE does not actually create any new money. All it does is transfer money from one asset to another: the Fed gains an asset such as a mortgage-backed security and the seller gains a reserve balance at the Fed.
However, this analysis ignores the fact that a bank can make loans based on its reserve balance at the Fed (as long as the balance doesn't go below the "reserve limit", which as we saw above, is basically negligible right now), whereas it cannot make loans based on its holdings in mortgage-backed securities. And everyone agrees that banks making loans based on fractional reserves does create new money; so the fact that QE itself is just an "asset transfer" is a red herring: banks' ability to make loans is being boosted, and that's what counts.
Having got that out of the way, let's look at the real point: what if banks aren't making loans because, quite simply, there really is so little actual productive activity going on that there are no useful loans they can make? Of course it isn't quite right to say that there is no productive activity going on. Obviously there are a lot of people still doing productive work, because life is still going on: people still need food, clothing, and shelter, they still need cars to go places, they still want new smartphones and wide screen TVs and other gadgetry. But there is more than enough of all that stuff already being produced; nobody needs a bank loan to make more of it.
What is not happening is the creation of new forms of wealth. Bright, ambitious young people no longer want to be scientists or engineers or explorers; they want to be investment bankers and hedge fund managers. But these activities don't generate any wealth; all they do is transfer wealth from one pocket to another. Of course investment bankers and hedge fund managers will vehemently object to this, but there's an easy way to test it. Just ask the question: when you trade a stock or a bond or some other security, do you expect to make money? Of course the answer is yes, otherwise you wouldn't be making the trade. But if that's the case, you must also expect the other party to the trade to lose money.
It's worth taking a bit to unpack this. Normal transactions, involving money on one side and something tangible on the other--a good or a service--are positive sum: both parties are better off after the trade. When you buy a DVD player, the player is worth more to you than the money you pay for it, because you can't use money to play DVDs. But to the store, the money is worth more than the player, because they don't need it to play DVDs; they only have it in the first place in order to sell it. In other words, the good or service that is traded has a different value to you than it does to the store.
But when you trade stocks or bonds, that isn't the case, because the stock or bond is no use for anything by itself; its only use is as a financial instrument, entitling you to some series of cash flows in the future. Those future cash flows will be the same regardless of who owns the stock or bond, so it must be the case that, whenever the stock or bond is traded, one party to the trade is worse off. If the stock or bond is going to do well, the seller is worse off: the cash they receive is worth less than the net present value of the future cash flows. If the stock or bond is going to do poorly, the buyer is worse off: the net present value of the future cash flows is worth less than the cash they paid. One or the other must be true, as a matter of simple math, which means that, as above, one party to the trade must lose money.
Now consider what must happen for bank loans to be profitable. The bank gives the borrower present money in exchange for future money: a series of future cash flows. The bank will not make the loan unless the net present value of that series of future cash flows is greater than the amount of present money they lend. But that means the borrower, in order to be able to pay back the loan at all, must do something productive with it, i.e., something that is positive sum, something that creates enough new wealth to be able to pay back the loan from the proceeds and still come out ahead. Of course, it's quite possible for some people to take loaned money and start investment banks or hedge funds (of course, they call the lenders "clients" instead), and transfer enough wealth to themselves to pay back the money. But it's impossible for everybody to do that; and if enough people start trying to do it instead of productive activity, loans will shut down, no matter how much QE you pump into the banks.
On this Austrian view, the solution is simple: stop QE, and in fact stop all of the Fed's interventions into the economy. All they are doing is masking the true state of the economy, and therefore preventing people from adjusting to reality. True, the adjustment will be painful, but it would have been less painful if we'd done it sooner.
So whose view is right? The Austrian view has at least this much going for it: it offers an explanation for what is, on the mainstream Keynesian view, the great mystery of why the economy continues to stagnate despite all of the TLC lavished on it by the Fed. However, it looks like the TLC is going to continue, though it seems to me to be a rather bitter twist on the standard line about beatings and morale.
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