Monday, September 3, 2012

Analyzing quantitative easing

I am using this post as a vehicle to document the different views on quantitative easing and their relative merits/demerits. The conventional view point is as follows:

GDP = C + I + GS + Net exports

C= Consumption  (private sector)
I = Investment (private sector)
GS= Government Spending (public sector)
Net exports = the difference between total exports and total imports

In order to boost GDP, one should be able to increase any of the 4 factors. It is a well-known fact that households and the private sector are saturated with debt and the deleveraging process has just begun. Therefore consumption cannot be easily boosted if debt levels are elevated.  Even though interest rates remain repressed through QE, the lower interest rates cannot immediately spur further borrowing because this borrowed money cannot be easily serviced when wages are stagnant. Although the Fed's reasoning is that lower interest rates will encourage more consumer spending, it cannot sustain itself because of saturated debt levels.

Investment can be boosted by reducing effective corporate tax rates, but there should be consumption capacity for the investment to take place. When consumption capacity is low, then regardless of the tax rates -- new investments cannot happen. It is a vicious cycle.

The political appetite for government spending determines whether it can be increased. Clearly since 2011, the debate on the US political spectrum has shifted towards the debt ceiling and therefore the political appetite for increasing spending is waning.

This leaves us with net exports. Exports can be increased either by exporting more goods and services or by exporting the same goods and services but devalue the currency. Devaluing the currency has negative consequences as well. US imports are much higher than US exports, therefore the cost increase in imports (since a devalued dollar means US pays more for imports)  could overwhelm the gain in exports and net effect can still continue to be negative. There's quite a bit of non-linearity in all this discussion, so it is important to bear this in mind. Cost of imports may not immediately increase, for example because the dollar inflation is not immediately detected (dollar being the world reserve currency).

James G Rickards, a renowned financial expert explains the above as the Fed's rationale for QE2 and further QE, in his popular book Currency Wars.

There are two other alternative views which I would like to highlight. Professor Fekete writes about the risk-free bond speculation in his article There is no Business like Bond Business, Still. Here's his 2010 article on the same subject. The professor makes a valid point that the primary dealers can front-run the Fed (since the Fed announces when it is going to buy and how much before market opens) and then flip the bonds back to the Fed at a higher price and pocket risk-free profits.

This means that interest rates keep going lower and lower until this game cannot continue.As interest rates keep going lower and lower, it is harder to service the previously acquired debt because the income stream keeps reducing. It is a perverse effect since the Fed is trying to fight deflation, but actually making the pain worse. He compares the current paradigm to an economic resonance with a built-in runaway vibration that can snap the whole system(similar to Tacoma Bridge collapse of 1940). Here's an excerpt from his article titled 'Premature Obituaries (for the dollar)'.

When the energy level of the self-boosting system overwhelms centripetal forces, the system snaps like a broken chain, releasing the surplus energy most destructively. This is the substance of every crack-up boom. Like Mises, I also object to the use of the word hyperinflation, albeit for a different reason. It suggests that the phenomenon is linear and follows the laws of the Quantity Theory of Money. The more money is printed, the higher do prices go. However, we are here facing highly non-linear phenomena. Our economy is torn to pieces by runaway vibration. We are victimized by the self-destruction of the monetary system subjected to oscillating money-flows boosted by the resonance of fluctuating interest rates resonating with fluctuating prices.

The other alternative view that I want to highlight is that of a popular blogger, FOFOA who writes on two topics: a) dollar hyperinflation and b) Freegold monetary theory. In his post Inflation or Hyperinflation, he details how QE is all about managing the unstoppable flow of Treasuries.

The USG today is spending $3.6B more than it is taking in, each and every day. That's a big mess of dollars flooding out of the USG. $1.5B per day is flooding outside of our zone while $2.1B is staying right here on our front lawn. This is all flow. It is ongoing and unstoppable. And it all must be mopped up by someone. And by someone, I mean either the foreign sector, the domestic private sector or the Fed buying up US Treasuries. $3.6B per day, an unstoppable, unending broken water main gushing out dollars. Marginal flow!

Don't be fooled by the misdirection. QE, twist, whatever; it's not about interest rates or helping the economy recover. It's 100% about disguising and managing this uncontrollable, unstoppable mess. It's more like a broken sewer line than a water main now that I think about it.

Sure, the Fed needs to keep interest rates from rising. Because what happens when interest rates rise? The value of the entire $35T bond market starts to collapse and bond holders panic. The Fed doesn't want that, so don't bet on them letting interest rates rise. But as I said, I'm not worried about the stock of dollars. I'm worried about this broken sewer line we call the federal budget deficit which means no one has to sell a single bond. In fact, someone has to continuously buy $3.6B
more each and every day, including weekends and holidays.
In another post titled Moneyness, FOFOA writes:

The USG thinks (and truly believes) that the key to rejuvenating the US economy is trashing the dollar as a short cut to increasing exports (reducing the trade deficit). But what it can't see (nor anyone that focuses solely on the monetary plane for adjustment) is that the huge trade deficit the USG wants to quit is actually its own heroin fix. This is a deadly combo for the US dollar.
The key point to take away is that Budget Deficit and Trade deficit are inter-related in the sense that government spending towards goods and services increases our imports, therefore worsening the trade deficit.

To summarize, following are the stated or unstated effects of quantitative easing:

1. Lower interest rates to boost consumer borrowing and spending (Fed's take, but not true in the real world because the transmission mechanism is broken when debt levels are saturated)

2. Increase exports through cheaper dollar, which causes global inflation and boosts US GDP (Rickards's take in his book -- this is supported with some empirical data and real world evidence)

3. Risk-free bond speculation reinforces a feedback loop of lower and lower interest rates leading to capital destruction until the system cannot handle this anymore (Fekete's take -- interest rates are heading lower even though they take a wibbly wobbly path)

4. Manage US Government budget deficit and sustain the US trade deficit amidst political gridlock and unwillingness to raise taxes or cut spending (FOFOA's take -- plausible explanation)

But one aspect is quite clear. QE is a grand experiment where consequences are unknown and there are several negative effects (because of the fact that it is implemented on a complex system with non-linear effects) which are hardly discussed by the Fed.

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