Thursday, November 4, 2010

QE2 or the Titanic?

The big news of the moment (other than the election) is the Fed's decision to inject $ 600 billion into the economy, as a monetary stimulus to get the US out of a recession. Here is Bernanke's rationale:

Will it work? For a monetary stimulus to actually stimulate the economy, it has to change how consumers behave. Since consumers do not get any of the cash directly, the only instrument that the Fed can hope to affect is interest rates. In theory, the monetary stimulus will push down interest rates and thus unleash more borrowing by consumers and companies. I see four problems:

1. Level of interest rates: If short term rates were 5% and long term rates were 7%, I can see the potential for lower interest rates inducing more borrowing and higher consumption. But short term rates are already close to zero and long term rates are at historic lows. If people are not borrowing money at 4% (long term mortgage rates are down to that), what makes the Fed think that a 3.5% rate will induce them to do so? As for companies borrowing money, why should they when they are sitting on huge cash balances?

2. Existing leverage: The average US household already has too much debt, some of it reflecting a hang over from excessive credit card and other borrowing in the good times and a great deal of it a result of the housing boom and bust. Assuming QE2 works, is it a good idea to induce consumers to borrow more? It may create some short term growth, but are we not setting ourselves up for the next bubble bursting?
3. Inflation fears: The power of monetary stimulus rests on the credibility of the central bank. If investors trust the central bank to keep inflation in check in the long term, they will respond to the stimulus by lowering interest rates. If, on the other hand, that trust is lost, a stimulus can actually be counter productive. The pumping of money into a system that is already flush with cash and facing potential deficits down the road will raise the inflation bogeyman, which in turn will push up interest rates. I am not convinced by Bernanke's twin rejoinders: that existing inflation is very low and that the last stimulus did not create inflation. That was because the last stimulus did not work. If this one does, then what?

4. Currency devaluation: Related to inflation fears is the effect on the US dollar, which has been under selling pressure for a while. A dollar devaluation will also make imported goods more expensive in the US, and given the trade deficit, that has to feed into price increases in the future.

Having listed these concerns, I must confess I am not a macro economist (and have no desire to be part of that crew). The Fed presumably has access to "experts", who have thought through all of these issues and decided that the benefits overwhelm the costs. At least, I hope so...

I don't know about you, but I am starting to wonder about these multiple stimuli. Using the analogy of the emergency room,  those electric paddles used to shock a faltering heart back into a rhythm are a godsend for someone with cardiac arrhythmia, but I also know that they sometimes do not work. That is when the cardiac surgeon is called in for more radical remedies or worse. To stimulate the US economy, we tried QE1 and it did not work, we tried FS1 (Fiscal Stimulus 1) and it did not work either. Now we are trying QE2  and if we listen to Paul Krugman (who must be having seances with Keynes every night), we should try mega FS2 next...Perhaps, it is time to accept the reality that there is something fundamentally wrong with the economy that stimuli will not fix. And perhaps, it is time to call in the surgeons! (Let's not even think about the other alternative)

And for those of you who may be wondering about the title of this post, here is the original QE2.


David Sable said...

Looks a bit like the Titanic.

Unknown said...

A superb post!

tunck. said...

Gold hit record as FED feeds inlation or double deep fear, QE2 will give way to QE3 and beyond.

Miguel de Vargas said...

It will work, to what degree I do not know.

The enactment of QE1 was due to the lack of liquidity in the banking system. Financial Institutions were not willing to lend to one another and this was present in the LIBOR rate immediately after the collapse of Lehman brothers. The real interest (nominal rate minus inflation) rate skyrocketed--the fed was slow to lower the Fed Funds rate. FS1 was not timely or targeted and very small. It was planned to take effect over two and a half years, a failure before it got off the ground. QE2 is a different beast--see below.

Long-term interest rates will be lower with QE2. The risk-free rate will be lower thereby lowering the discount used in doing valuations--increasing the value of stocks and bonds.

With the increased Wealth Effect--people will feel wealthier as their portfolios have increased in value. Wealthier people constitute a higher portion of consumer spending in our economy.

For people who are current on their mortgages/debts and can refinance, they will eventually be able to do so. The savings of said refinancing will go into savings and consumption (depending on the Marginal Propensity to Consume of the individual), thus increasing GDP components C & I.

Inflation has been below the optimal 2%. What I would like to know is, since much of the valuation of stocks is contingent on future value, to what extent are recent stock market gain been attributed to a lower discount rate vs. top-line nominal revenue growth due to expected inflation?

We need the inflation boogeyman—the Congress is unwilling to act seriously, hence why the Fed waited until after the election. If the Congress will not find away to pay for this crisis, the Fed will pay for it through inflation. The real value of debt will shrink with inflation, thus helping consumers repair their balance sheets faster. As for the banks, four or five percent inflation would be the equivalent of a tax on excess reserves, thus creating an incentive to lend it out to the creditworthy.

The $600 billion bond purchases will allow banks to exit from any holdings they may have in long-term government bonds. LT Gov't bond have been out performing the market as of the last two years. This is important as banks can escape from capital losses in bonds when the fed begins to raise interest rates --many, many, months if not years away.

The Fed in essence announced a strong incentive to hold risky assets as opposed to "safe" (ignoring interest rate & inflation risk) treasury assets.

Rafael M Vargas, a former student of yours in undergrad Fall 2008.

Aswath Damodaran said...

You are building a castle on a sliver of land. Let's start with the first piece, that risk free rates will be lower. The treasury bond rate is already at 2.5%. How much lower can it get and how would a lower rate be compatible with your other argument that the Fed wants to feed some inflation into the system. If this is, in fact, the plan, it is a disaster waiting to happen.

Aseem Madan said...

QE1/QE2/FS1 - did not work, what will then? We all know the issues but nobody has the solution and has an investor how do we make money on these events ( I am more interested in this part)...

There was a excellent article on WSJ on QE2 Q&A , very similar argument to what Prof. has mentioned in his blog.

JoelW said...

1. The whole point of increasing inflation is to make the real interest rate even lower. Since they can't actually make the interest rate lower, then they are trying to make people spend and invest by decreasing the long-run value of saving.

2. Increasing inflation lowers the real value of household debt, which is another good thing. The point isn't to induce consumers to borrow more, it's to induce corporations to spend the stockpiles of cash they haven't been investing because there is no demand. We will reduce the real value of consumer debt, so then they can buy new goods, and start a virtuous cycle.

3. Deflation is the worry, not inflation. There are no inflation fears right now, there are lack of inflation fears. I keep reading about fears of inflation without any proof of the matter from the market. We need inflation because companies aren't spending the money they have.

4. Currency devaluation is also good! It makes our exports cheaper, meaning people in other countries will buy more of them, meaning more Americans will be hired to make the goods. It will help balance our trade deficit by increasing exports and decreasing imports.

The market clearly agreed with that thinking as it had a great day yesterday in the wake of QE2. If anything, we need a commitment to more inflation, not less.

Aswath Damodaran said...

Inflation lowers the real rate only if nominal interest rates don't change... You need a very large supply of irrational and stupid bond buyers for this to happen.

Nishit Vadhavkar said...

Perfectly summed up. We are heading for the Perfect Storm in the US. All what is needed now is just any event for the world to lose confidence in the USD.
Zimbabwe did I hear anyone say?

Gaurav Mehta said...
This comment has been removed by the author.
Gaurav Mehta said...

All i think this is doing is creating inflationary pressures in Asian Economies...for the short term asset prices including equities are going through the roof...If money could stimulate consumer behavior the last set of QE would have done that...I don't really think a republican win or a QE2 can create growth/jobs. The only way out would be the UK/City Bank effect... both trying to stabilize their balance sheets ( reduce budget deficit, right size the Company). Unless the US decides to swollow the pill .....which would mean pain now gain later, US is looking for a Japan decade.

Overall it seems, on the longer term UK would be a better place to invest if they are going to follow what they have been proposing!

However i do fee the Republican having a greater say... the QE2 might not really happen in the true sense and if that happens... there could be a correction in global equities...

tunck. said...

"Inflation lowers the real rate only if nominal interest rates don't change..."

US economy went through stagflation during 1970s. Stagflation means first
high unemployment, high inflation then, high interest rates and recession.

US economy has recession and high unemployment and, we are waiting to see high inflation in 2011 or 2012, then we are heading to 1970s again.

donlsan04 said...

As the short-term interest rate cannot go down below 0, I think Bernanke’s attempt is to make the real interest rate negative by making people believe that there will be a reasonable amount of inflation ahead. By doing so, it will provide an inducement for people to spend. In turn, this will end the vicious cycle in this deleveraging world led by lack of aggregate demand and high unemployment rate.
Right now, the nominal short-term rate has hit 0, so it cannot go down any further. Then I believe the static nominal interest rate problem that you have raised is solved.
While I clearly don’t like the way how we ended up here, at this point, I think we have to agree with Bernanke’s approach. His biggest fear comes from observing how Japan ended up as a weak engine; he is trying to avoid the lost decade Japan has experienced, and this seems to be the only way to get out of this current mess.

Aswath Damodaran said...

If people believe that expected inflation in the future will be high, nominal interest rates will also be high. The only way you can pull this off is by pushing up inflation in the short term while convincing investors that inflation will be held under control in the long term. I am not sure that any central bank can pull off this trick.

Accounting Tutor said...

Please dont assume the the Fed has the "experts". Write to them and challenge their thinking.

I through the economic team had some heavy weights when they introduced the cash for clunkers program. Read this article called ‘Clunkers,’ a classic government folly' to see how it was a disaster

Guru said...

Fed (Ben) is seeking to undo the consequences of sins unabashedly committed sequentially over the period of last three decades.

While Fed embarked on the easier task of advancing the onset of pleasure by postponing pain during the last couple of decades, it refuses to undergo pain now that the time has come....and fondly wishing that pain can be postponed for eternity.

It destined on Lord Shiva to consume the voluminous poison generated from the ocean by the venomous serpent, to rid the world of the otherwise impending pain that was looming large on the entire populace.

Its high time that we go back to the Gold standard. Let large casualties fall by the the long neutralize the effects of economic and fiscal Himalayan blunders committed in the past by the lords of the central bank.

daninreallife said...

Do you think that possibly they are doing this in part to help out municipal markets? I
can't help but think California, as an example, really needs rates to be low to avoid major
issues (more than they already have). By keeping rates low maybe they are keeping
big states/cities with major budget issues out of the fire. How much trouble would
California, New York City etc be in if their borrowing costs started to rise? Might it
trigger a PIIGS-type crisis with states in the US?
Any thoughts?

Aswath Damodaran said...

I understand your concern about state and local government bonds, but I don't see how the Fed easing can remove the fundamental reasons why these entities are in trouble. They have committed to making payments (in the form of union pensions and health care obligations) that they do not have the revenues to cover. I guess that one way the Fed can bail them out is by pushing up inflation to 10, 15 or 20%, making the present value of their obligations lower. Is that a cost we are willing to pay as an economy?

Unknown said...

The Fed presumably has access to "experts", who have thought through all of these issues and decided that the benefits overwhelm the costs.

Pfft. Bloody economists. Riddle me this: if the Fed had so many experts, then how comes the US is in such a mess?

I don't know about you, but I am starting to wonder about these multiple stimuli.

Not me. I'm not starting to wonder. I knew it would all be a disaster. Why is it that economists so completely fail to learn from history? How can they be so short-sighted?

Nothing is for free. If you're going to pump money into the system, then that money has to come from somewhere. The industry you pump your money into is likely to have overcapacity - 'cause otherwise, why did it need a bailout (OK, banks don't fit into this particular template). Then, of course, you're still left with the money you had to borrow to pay for the bailout.

I thought von Mises already sorted this out decades ago - so why is there any confusion on behalf of politicians and economists?

In the end, I think the wisest words ever uttered by a human being about economics was uttered by Thatcher: you have to treat the economy like a household budget.
There. That's everything anyone needs to know about economics. Time for gold.

Unknown said...

Urgh. When I said "time for gold", I actually meant "time for GOLF". Yes, that's right, economists should be playing more golf. Seriously. they'll cause less damage that way.

That'll teach me for firing off a message without carefully considering what it is I wrote. Um, on second thoughts, it probably wont.

Aswath Damodaran said...

I am just as skeptical about experts and especially economic experts as you and I do think golf would be a better idea than gold... At least, it would be more relaxing.

Krasen Yotov said...

Prof. Damodaran, you are absolutely right. There are some major fundamental problems that no monetary or fiscal stimuli can solve. The economy needs to undergo structural changes. Yes, there is excess capacity but for what - housing construction?! But I guess Paul Krugman or Joseph Stiglitz will never realize that. They will keep on pushing for FS2 because they have assumed they are right by default.

Ming Tung said...

Dear Prof.,
I posted a silly article on this subject, and would love to hear your critique if you have time and find it worthy...

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