These are epic times in the developed world’s attempt to deal with the implications of government and consumer over-indebtedness. A general unshakable malaise has set in due to sluggish spending and a deleveraging banking sector, and as a result, employment growth is suffering. Governments in turn are faced with diminished tax yields and deficits remain bloated. As shown in Europe, ultimately they run out of willing buyers of government debt.
Inevitably central banks are called in to treat all these related symptoms of the underlying debt disease. That momentous time has arrived for Europe as the debt symptoms have progressed to adversity in the selling of government bonds. Meanwhile, the more stressful symptom for the U.S. at this time is unemployment.
In the past weeks, the central banks of the developed world have taken the next big step, a monetary Hail Mary, to combat these symptoms. A Hail Mary is an act of desperation associated with putting all the chips on the line when your team is behind and time is running out. The ECB offered to support the bonds of those Euro countries that have lost willing private buyers and Germany — the last holdout — has accepted the offer. This will be a four-decade bond support program given the demographic-related deficits that will occur. For the baby boomer generation, their related entitlement spending has only just begun.
The Fed then made an open-ended Hail Mary of mega asset purchases that will ostensibly continue until the labor market is healed through self-sustaining growth.
This could be a long period of time given Bernanke’s claim that 2 million jobs have been created as a result of $2 trillion of QEs to date. If this estimate is correct — and there is ample evidence that it is an overestimate of monetary effectiveness — it implies that each added job comes at a cost of very close to a million dollars of monetary expansion. These are very expensive jobs.
The Fed’s estimate is imbedded in its macro model of the economy, which is based on the good old times when the Fed could be effective when not faced with the retardant effects of an over-indebted consumer wishing to deleverage and a banking system that does respond to more base money (See Eisenbeis Critique).
But for the sake of argument, let’s accept the Fed’s estimate of the employment response to base money increases to allow us to ballpark the needed size of the current QE. There are more than 12 million unemployed and 9 million labor force dropouts since the onset of the Great Recession, some of whom would return to the labor force if jobs were forthcoming. Furthermore, in the years ahead there will be new labor force entrants which number over a million per year.
To make this both easy and highly conservative, let’s assume that jobs will be created for only half of the jobless and half of the recent labor force dropouts, setting aside the future labor force entrants. That works out to about 10 million new jobs — a policy victory that the Fed would happily claim.
At the Fed’s implied rate of dollars per job created, this implies an asset purchase/monetary injection of perhaps $10 trillion on top of their original (pre-QE) balance sheet of $1 trillion and a current balance sheet of nearly $3 trillion. This would take the Fed’s balance sheet to $13 trillion — which, interestingly, is the size of the moribund commercial banking system that contributes no balance sheet expansion in response to the Fed’s base liquidity. Basically a beefed-up Fed would fill the gap of the petrified banking system, at least in term of the quantity of assets held by financial institutions. Too bad the Fed doesn’t have loan officers to make small business loans to make the effects really comparable.
This lack of commercial banking response to central bank liquidity growth is demonstrated (thanks to Gary Shilling) in the accompanying graph. M2 is approximately the sum of the balance sheets of the commercial banks and the central bank is shown relative to the central bank monetary base. It has shrunk by two-thirds as a result of the tripling of the central bank monetary base without much follow through by the commercial banking system.
Hence, to get the same monetary punch by itself, the central bank would need to expand to be an equally sized banking system as a replacement for the petrified banking system that hopes to survive by not lending.
But this is not the end of the epic monetary growth story. It didn’t take long for these QE announcements to have expectation changes that will lead to further second-round monetary expansion coming from abroad.
In response to the Fed’s actions, investors imbued with the Milton Friedman Reflex of money causing inflation are known to move wealth to countries with less exposure to what they believe is an inflationary future in the countries receiving the high doses of money. These dollars run to some alternative port that would cause the recipient country’s currency to appreciate, as occurred with QE2.
In anticipation of this, central banks around the world are stepping in with plans to preempt a loss of export competitiveness that occurs when inflows of foreign capital cause currency to appreciate. As a defensive measure, the central bank sells its currency on foreign exchange markets to offset a currency appreciation. But the same money, when deposited in its still-intact banking system, is parleyed with banking system expansion. All in all, this makes inflation more likely with money flowing from central banks worldwide.
Japan will be the first big domino to fall in this monetary knock-down process, and Brazil, Turkey, and Korea are likely to follow. The Swiss are prone to offset currency appreciation, and so is China if capital washes up on its shores. So, the ripples of mega money expansion from the U.S. and Europe in turn creates mega monetary expansion in countries that were simply minding their own business and wishing to buy some protection their currency appreciation as a byproduct of the developed world’s debt problems.
This phenomenon, last seen in the depression years of the l930s, has a few names associated with it in the history books, but the clearest tag is competitive (currency) devaluations.
So now the monetary Hail Mary is “QE Squared” or “QE to the Third Power” (or more, depending on how many follow suit. So where does that take us?
This scaling up of monetary expansion with so little in the way of positive economic impacts calls into serious question the efficacy of Keynesian economics as it is currently understood, but this will not stop academia from teaching it. Keynesianism will likely remain the gospel for some time, but hopefully it will at least be amended to include the important idea that aggregate demand generation only works if there is not a debt load to scuttle spending and a well-capitalized flexible banking system to ramp up the monetary base. These pre-conditions cannot be taken on faith.
Furthermore, this blatant policy failure scuttles the 60-year era of faith in the efficacy of not just monetary policy but also fiscal policy to smooth out the business cycle. Emphasis is shifting to supply-side issues as opposed to more demand-side fixes that, in the words of David Rosenberg, have gone to infinity without positive effects.
While the Fed intended for QE3 to aid the unemployed, little or no mention was made that it has been financing approximately 60 percent of net new government debt issuance in recent years. So, there are both stated and unstated purposes of this monetary Hail Mary. On the sly, the Fed is doing the same thing the ECB is doing, which is treating both the employment symptom as well as the government finance symptom of the debt overload disease.
While the need to treat the government finance symptom in the U.S. will be more evident in coming years, as it is in Europe today, the more immediate goal is to maintain as near to zero nominal interest rates all along the yield curve with a constrained but positive inflation rate. The net result of that magic is that the real cost of borrowing is negative — hence benefitting debtors both private and public. But this is confined only to those able to refinance into today’s negative real interest rates.
This leaves out perhaps the most important stressed consumers: those with upside-down mortgage debt relative to home values.
While this monetary Hail Mary is good news for some debtors, the flip side to investors is known as financial repression. This does significant damage not just to the “moneyed” class (in today’s class warfare terms) but to everyone with hopes for either a private defined-benefit or defined-contribution retirement plan with income generation based on microscopic yields in the fixed income market. This also includes state and muni pensions (which are seriously underfunded to boot,) as well as the Social Security Fund that to the extent it is funded is 100 percent invested in U.S. Treasuries.
So saving the unemployed and creating the ability to honor entitlements today comes at a high cost to future cash flows for retirees and institutions hoping to survive on a steady income flow. The classic Keynesian marginal investment function is not responding to the lowest interest rates ever available. Few benefits and lots of costs have been the result of this over the top monetary Hail Mary.
But given that the inhibition to run the printing press is now passé, the race to the bottom (the cheapest currency) is a race to produce more money that enters the economic system not as money in our pocket but as money chasing assets that have a chance to appreciate. That has included stocks to some extent, though that movement seems overstretched relative to floundering profit growth tied to a floundering economy.
Taking all this policy action and associated responses, the markets will put premiums on real assets, especially those producing income that have some inflation sensitivity. There are not many assets in this category. As an example, the yield on Treasury TIPs has appreciated to the point where the yields are now negative based on the fixed return component, requiring a 2.7 percent future inflation to have an equivalent positive yield compared to the fixed income equivalent.
The most desirable asset class is the long duration and real income producing variety, especially if financed with fixed rates — which augurs well for income producing real estate or infrastructure. This includes the new respect given dividend paying stocks. Gold and precious metals are also up there despite not producing income. These are the premium assets in today’s markets, especially if found in the few countries that might not move to offset currency appreciation until seriously burned in the export markets. That might be Canada, for example, given its bent for market-determined exchange rates and financial prices.
There are endless issues raised by these historic and monumental QEs. For now I will note a few of them: The Fed will most certainly lose some of its cherished independence as a result of this overreach, especially in that it has created income redistribution. That is, it has stepped on a Congressional prerogative. The only question is how much Congress will dictate future monetary policy. It depends on how inflationary it actually becomes. As a reminder, in the inflationary 1970s, Congress stepped in to restrain the Fed with the Humphrey-Hawkins Act, even under a Democratic majority and president. For better or worse, Ron Paul’s status as cult hero is growing.
Secondly and perhaps most sadly, given the Fed’s inability to stimulate the economy under the circumstances of a consumer and government debt burden and a petrified banking system that fears future losses and an over-dictatorial FDIC driven by self-defense rules. This means the Fed’s Hail Mary is destined to fail under today’s circumstances. The market will consider the Fed de-fanged even if it is not de-fanged by Congress. It will be considered the toothless tiger of Constitution Avenue.
With such a fall from grace, the intangible but important confidence factor in the Fed as a reliable rudder to the system will be lost for a long time to come. The Fed will cease to be held with reverence but rather will be considered irrelevant.
All this invites major Congressional recapture of the monetary compass, which is its Constitutional prerogative and would be the largest setback of all. For if that were to happen, Congress, not an independent Fed, would at the time of U. S. government bond market stress be in the driver’s seat to do just as the ECB is doing in Europe. The Fed’s has sadly extended its reach beyond its grasp with ill consequences ahead.
Some will say that academic lessons are sometimes learned well, but not wisely. This could well be the final ultimate test of Keynesianism or more broadly demand generating economic policy. Not only can they not be afforded, but they are also not effective in today’s circumstances, but they will still try.
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