It is even worse in Europe with a double-dip recession. Most strikingly, unemployment data support the common popular feeling that we have not yet moved out of the Crisis (understood as an unusually long episode of economic growth slower than the average national long term trend). Why is it so?

One may identify four main answers :

  • The «Bernanke conventional » response: in 2008 US macroeconomic policy – ie the Fed reaction to the Lehman failure + the US Treasury TARP program - saved the world from a major systemic collapse (remember: for a period of twelve months the economy moved downwards at a rate even faster than during the Great Depression first year). It is true that five years of Quantitative Easing policies have not succeeded in engineering a strong and stable recovery, but there is no ground to claim that it is a failure. Let's have more of the same, and it will finish by paying off... Indeed, recent economic data suggest the economy is getting stronger and that time may come soon when authorities will be able to begin moving away from the use of unconventional monetary tools and get back to more traditional monetary policy. In a word: no worry, we are anyway heading in the righ direction.
  • The « Keynesian » critique (Krugman, Stiglitz) : the economy is still suffering from a large aggregate demand deficit that has not been compensated for by too conservative fiscal policies while usual monetary policy tools are no more operative with interest rates at zero bound (liquidity trap). Quantitative easing policies go the right way but economic policy would be more efficient if central banks were allowed to directly finance public deficits (directly buying Treasury bonds, without repayment... of course !) rather than relying on the private banks reserve transformation mechanism for expanding monetary supply. It is imperative to put an end to all public austerity programs and increase public investment and redistribution in order to quick start faster economic growth and definitely rule out the threat of any new deflationary accident
  • The « New Monetarists' » explanation (Scott Sumner, David Beckworth) : contrary to common belief and despite multiple QE operations, post recession monetary policy has been over restrictive, thus putting a check on recovery). For years, Ben Bernanke went on stating : « we shall not do it again ! » (committing the same basic monetary mistake as during the Thirties). But he did it. The reason has something to do with the topic of his doctoral thesis. While he shares Milton Friedman monetary explanation for the origins of the Great Depression, his personal teaching interest led him to focus more on dangers deriving from the systemic chain effects of strategic bank failures rather the per se role of overall money supply. According to the « new monetarists », QE policy should be continued so as to steer up higher inflation expectations. Ironically, they join their arch ennemies the Keynesians ! But they think the Federal Reserve should abandon its inflation target and move to a nominal GDP targeting system relying not on direct and discretionary management by the central bank but on market forces through an innovative and complex mechanism of index futures targeting (Sumner).
  • The « QE Skeptics » analysis - i.e . the idea (we shall now focus on) that present macroeconomic policy (zero interest policy + Quantitative Easing) defeats its own goals by multiple effects that play against economic recovery. A burgeoning list of authors and publications or blogs.

What is wrong with QE ? The skeptics arguments may be listed under five headings.

1 - A bureaucratic credit allocation scheme.

Most people mistakenly believe that Quantitative Easing is just another name for an open licence given to the central bank to use (and abuse) the « printing press ». Reality is different. If Milton Friedman had been in command, his response would most likely have come in the form of a general, untargeted massive liquidity injection through regular open market operations. Under Bernanke, Fed interventions went on a very different path.

According to Professor Jeffey Hummel (1), what has been set up is a complex and sophisticated multichannel bailing out system whose specificities have been little publicized. Basically, its concern is not regulation of money supply using market instruments, but directly channelling liquidity to key financial intermediaries whose failure, as decided by the Fed bureaucracy, would create massive disruptions in the intermediation chain (« too big to fail »).

To that purpose, the Fed resorted to an array of ad hoc specific support programs aiming at different categories of financial products and intermediaries. During the bail out phase of the first period, most of the Fed's lending activity to banks and financial establishments was sterilized by compensating sales of Federal securities so that these operations took place without adding much to base money (if nothing at all as was the case at the end of 2008 – i.e. at the most critical time). The most obvious feature of the following phase was an unprecedented expansion of the monetary base that doubled in a matter of a few months, along with a huge increase of the central bank balance sheet. Nearly all of this base money increase took place through a massive increase of banks balances held at the central bank. This response supposedly represented a massive injection of liquidity to the benefit of the economy, but most of it remained unused as the Fed policy of very low short term interest rates induced banks to keep huge accounts of well remunerated « excess reserved ». Consequently, everything worked as if the Federal Reserve in effect created money but immediately borrowed it back from banks by paying them interest, while banks financed their implicit loan to the central bank by reducing loans to business and the public.

As a result, rather than injecting new money in the economy QE policy amounted mainly to a shuffling of assets from the private sector to the Fed and a transfer of responsability for allocating loans from market processes to central bank planing. Without advertising it, as Professor Hummel claims, Bernanke changed the basic nature of his establishment, adding to the central bank traditional function of simply manipulating the money supply the function of centrally allocating credit. The Fed thus has morphed into «a central planning agency» (Selgin) with consequences on economic efficiency and growth dynamics that are unescapably negative.

2 - The Fed « Carry-Trade » bubble.

A major feature of QEs is a pre announced commitment by the central bank to maintain its near zero interest rate policy over a long undetermined (or predetermined) period of time. Few people remember that the first time the Fed resorted to such a device antedates Bernanke's appointment. It dates back to the summer of 2003 when the Fed under Greenspan chairmanship officially committed itself to keeping interest rates low for a « considerable period », while announcing that from then on it would periodically tell markets what it plans to do under a reasonable range of forecast.

These promises radically changed the set of incentives that determines the working of the US financial system. It made it more profitable for operators to speculate by borrowing as short term as possible (overnight) and investing in longer duration safe securities, using leverage to compensate for their lower returns, rather than acting as brokers whose job is to transfer money from cash rich companies with few profitable investment opportunities to businesses with no money but bright investment ideas. Institutions that used to shun balance sheet risk (such as pension funds) reversed course and began to engage in « carry trade » activities, borrowing short term to invest in securitization. The system became a sort of gigantic « carry trade » bubble game fueled by the Fed new strategy. But, to the monetary authorities, such developments were no cause for alarm since they delivered precisely what they were looking for: low interest rates even at the longer range so as to win their fight against what was (then mistakenly) considered as a pressing threat of deflation. (During that period, monetary authorities mistakenly interpreted a softening of US prices as signaling an impending threat of « bad » demand-led deflation while it was the consequence of an unexpected new surge of « good » productivity gains).

As explained by Diego Espinoza (2), by changing its communications strategy the Fed had in effect enabled a long chain of events and reactions that led to generalized overleveraging and ultimately ended in the great banking panic of 2008.

However this is not the end of the story. By promising to hold rates close to zero and engaging in QE it appears that the post recession Fed did learn little from the unintended and unfortunate consequences of its past policy. It has been implicitly acting as if it wanted to enable again a burgeoning « carry trade » activity. But in a new environment where, as a consequence of the financial collapse, the great factory for providing a growing and wide supply of arbitrage instruments (such as securitized products, CDOs, etc) had been dismantled. The consequence has been a growing scarcity of safe assets (used as collateral) that are necessary for bringing the interbank market back to life and resurrecting an active bank loan activity benefiting all industries, particularly small and medium size businesses.

QE also contributed to this scarcity in another direct way : when ailing institutions are bailed out by reselling to the Fed billions of dollars of Treasury securities that end up on the central bank balance sheet, these no-risk assets are definitely withdrawn from the collateral market. Such a scarcity holds back growth recovery by increasing the price of collateral and credit costs to the economy.

3 - Basle III and the role of regulation.

Basically the function of Quantitative Easing is to make up for the huge destruction of private money supply that resulted when trillions of dollars of collateral assets exchanged on the banking and shadow banking markets disappeared almost over night.

Over the last twenty years, there has been a major change in the western monetary institutional framework. « Base money » (i.e. money directly issued by central banks) accounts now for no more that a tiny fraction of « money supply » (defined as the whole stock of market assets that share about the same transferability and mobility characteristics as what we usually consider as « money »). In 2007, just before the first Wall Street crash, base money accounted only for 6,5 % of money supply at large (M4). This means that in modern economies the supply of money is now mainly private and is a product of market forces. More than 90 % of additions to the money stock are supplied via a double « multiplier » mechanism : the traditional banking multiplier that works on deposits, but also the new shadow banking multiplier (about x4) that results from « repo » hypothecation practices.

While most people assume that with zero interest rate policy and massive bail out assets purchases central bank « printing presses » are back working full speed, such a large ratio between base money and money at large explains why actual post-recession monetary policy remained unexpectedly and deceptively far tighter than commonly assumed. It is just a matter of mere arithmetics. The Fed may double its yearly supply of new base money – which may look big -, yet these additions will only have a small and slow incremental effect on the growth of the overall stock of money. Even after four years of QEs, US state money still accounts for little more than 16 % of the stock of money.

Moreover monetary tightness is compounded by the fact that, at the same time, under the guise of making the banking and financial system more secure, central bank authorities are busy at implementing new bureaucratic regulations (Basle III). The consequence is to slow down the recovery process of private money creation. After such a macro shock, deleveraging is the normal course of action for banks and financial institutions eager to restore a safer balance sheet. However, this post-recession deleveraging process has been exacerbated by a politically motivated frenzied campaign by some western government leaders, supported by central bankers, to enforce new compulsory tigther capital ratios (Hanke). Deleveraging is a good and necessary thing, but nobody is in a position to determine its optimal level and speed. One-size-fits-all has never been good economic policy. It is a choice that is best left to market spontaneous feed-back mechanisms. When private money accounts for almost 90% of money stock such a regulation forced deleveraging may easily translate into a massive negative multiplier effect that  nullifies central bank efforts to accelerate overall money growth through incremental base money accretions. According to Professor Steve Hanke, this is what happened and explains a continuing deflationary effect on the economy. The central bank lost effective control of money supply.

4 - A vicious circle.

More fundamentally, basic microeconomic theory teaches that, by saying that the short-term rate will remain near zero for several years in the future, « forward guidance » policy not only keeps the long-term rate low but also prevents it from rising and locks it below its equilibrium level, thus effectively putting an interest rate ceiling on the longer-term markets. Recent empirical research (Swanson & Williams) confirms that during periods of forward guidance the long term interest does not adjust to events that shift supply or demand as it does in normal times.

In effect, near zero rate policy acts very much like a price ceiling in a housing rental market where landlords react by reducing the supply of rental apartments (Ronald McKinnon, John Taylor). While borrowers benefit from it, lenders supply less credit at the lower rate. The decline in credit availability creates a lasting environment of « credit crunch ». Money keeps flowing to large corporate businesses that are « too big to fail » and benefit from direct financial support, while small businesses fall victims of insidious credit rationing. However, in a deadly vicious circle, the harmful effects of these interventions then justify futher retreat from market mechanisms and greater reliance on direct administrative allocative tools such as those developed by the Fed under Bernanke.

Finally, as documented by Jim Dorn from the CATO Institute, five years after the crash, the same causes (near zero rate policy and its « carry trade » effect) bring again the same consequences : distorting risk perceptions, causing bubles (stocks, government bonds, commodities), malinvestment, market signals discoordination, etc.. but no real growth.

5 - The Exit issue

Why such a deceptive recovery ? We now have the explanation. A major central bank management failure was the root cause of the Big Crash and the Great Recession that followed. Another (and largely similar) central bank failure is failing the Recovery.

Where does this lead us to ? The answer ties up with the heating up debate about the exit issue from present QE policies. The very same policy that led to the big bubble and crash, and then failed the recovery is also making exit from QE very risky and difficult. The reason comes from the new incentive structure generated by the Fed « forward guidance » policy. These incentives are heavily sensitive to any change in the expected future interest rates path. If that path unexpectedly departs from its preannounced course, it will immediately wreak a financial havoc by modifying the terms on which individual investment decisions in the global economy were made. It may rapidly quick start another full fledged financial crisis and deflationary bust by inducing a reversal of previous investment strategies that ends up in a mess of discoordinated reactions. This is precisely the type of alert that occurred recently following declarations of Fed members about QE tapering and quickly led them to retreat. (See the recent reversal of capital flows on world currency markets : India, Brazil, Indonesia...)

Theoretically it is possible for central bankers to manage such a sensitive transition and to prevent uncontroled interest rates hikes. But it would imply an incredible fine tuning capacity and communicating ability that may be easy to assume in abstract policy models such as those developed by BIS experts, but much more difficult to apply in the real world of incomplete and uncertain information. Given the past ten years experience and the Fed's record of repeated policy failures, can we still trust these men and naively bank on their skills to manage such tricky situations ? One may seriously doubt it.

Consequently, even if QE strategy were to be a success – i.e. magically succeeding in reviving consumers and investors « animal spirits », as Keynesians would put it - a quiet and peaceful transition from QE unconventional policies back to economic and monetary normality looks most unlikely. Two outcomes are evenly possible: first, a new systemic financial bust with another banking panic that may lead to economic collapse (the dreaded deflation « Charibdis » scenario) ; or, second, a rush into run away inflation (the hyperinflation « Scylla »).

The only thing we know is that, as confirmed by a recent academic study (Frederic Mishkin et al), hyperinflation probability is closely related with the US government ability to urgently enforce a severe fiscal consolidation policy over coming years (not in ten years...). Here again it is just a matter of mere arithmetics.

Is it politically likely? I let everyone take his bet. Fiscal policy choices will decide on which side of the cliff the economy will fall.

Conclusion 

How much confidence can we still place in people who keep accumulating such mistakes? Are they just regretful random accidents or do they reveal more systematic fundamental flaws (as it becomes clearly apparent when reading non conventional accounts of the Fed's history : Selgin, Driscoll, Horwitz, Krozner) ? I think that, more than ever before, time is ripe for questioning the action and raison d'être of central banking and, beyond the central bank itself, the monetary regime that legitimates its existence (i.e  the regime of fiat money based on a fractional reserve banking system lacking market based feed-back mechanisms).

Learning about the true story of recent central bank failures offers a favorable opportunity for resurrecting an active debate about the future of central banking and the possibility of alternate monetary regimes. It also brings about a great opportunity for popularizing the more radical « Austrian» critique of macroeconomics (« it is just a scientific illusion »), macroeconomic policy (« it can only hamper the adjustment process and transfer of ressources necessary for a modern economy to keep growing  and generating employment») and central banking (« the true root cause of booms and busts »).

Failed recovery in Europe.

The above lines focus on the american Fed experience. But there is no reason to believe things are fundamentally different in Europe, though the ECB is using somewhat different means for securing market liquidity and helping ailing banks or financial institutions. For example, the ECB does not carry outright purchases but lend liquidity against holding assets collateral. Growing liquidity supply is achieved by lowering collateral minimum requirements which allows banks to monetize a growing quantity of their own country sovereign debt. This system is more flexible since central bank loans have to be repaid, even if other monetary loans are immediately provided. Such a feature should make exit easier and less problematic. But things might become very different when the task of responding to governments calls for financial help and securing liquidity over the medium term will be taken over by the new European System Financial Mechanism which is likely to operate more like american institutions as described above. Such a change would make it easier for statist and keynesian lobbies to reach their goal of extended « financial repression » and centralized ressource allocation along lines similar to what Bernanke is indeed silently achieving in the US.

Europe shows worse recovery records than the United States. This is undoubtedly a consequence of the sovereign debt crisis striking part of Eurozone countries. Many explanations have been proposed to account for the present european predicament. Most of them are not really convincing. Europeans are simply paying today the bill for a major institutional failure that lies at the core of the Euro system and dates back to the very beginnings of its design but nobody is yet ready to acknowledge : the absence, among the rules managing how the euro money system works, of any spontaneous feed-back mechanism allowing swift adjustments to productivity growth differentials in member countries. The common currency founding fathers mistakenly relied on a procedural political solution (which did not work). It never came to their mind that market based mechnanisms inspired by what keeps the large continental US money market together (Werner Sinn) could offer a better solution.

Henri LEPAGE


NOTES

(1) - voir Jeffrey Rogers Hummel : "Ben Bernanke versus Milton Friedman: The Federal Reserve's Emergence as the US Economy Central Planner", dans Boom and Bust Banking: the causes and cures of the great recession, édité par David Beckworth, The Independant Institute 2012.

(2) - voir Diego Espinoza: "The chain reaction: How the Fed Assumetric Policy in 2003 led to a Panic in 2008", dans Boom and Bust Banking, 2012

Cette note a été rédigée début août 2013 en vue d'une présentation à la réunion "Lusanne 2013 Liberty Conference" organisée par Christian Michel et l'ISIL (International Society for Individual Liberty), avec l'active coopération du Mouvement pour la liberté (association de jeunes libéraux suisses).