End of QE? – I don’t buy it

A new meme is spreading in financial markets: the Fed is about to turn off the monetary spigot. US Printmaster General Ben Bernanke announced that he might start reducing the monthly debt monetization program, called ‘quantitative easing’ (QE), as early as the autumn of 2013, and maybe stop it entirely by the middle of next year. He reassured markets that the Fed would keep the key policy rate (the Fed Funds rate) at near zero all the way into 2015. Still, the end of QE is seen as the beginning of the end of super-easy policy and potentially the first towards normalization, as if anybody still had any idea of what ‘normal’ was.

Fearing that the flow of nourishing mother milk from the Fed could dry up, a resolutely unweaned Wall Street threw a hissy fit and the dummy out of the pram.

So far, so good. There is only one problem: it won’t happen.

Now I am the first to declare that the Fed SHOULD abolish QE, and not only in the autumn of this year or the summer of next, but right now. Pronto. Why? Because a policy of QE and zero interest rates is complete madness. It distorts markets, sabotages the liquidation of imbalances, prohibits the correct pricing of risk, and encourages renewed debt accumulation. It numbs the market’s healing powers – by enabling more ‘pretend and extend’ in the financial industry – and it adds new imbalances to the old ones that it also helps to maintain.

This policy may have prevented – for now – debt deflation, but maybe debt deflation is what is needed.

QE is nothing but heavy-handed market intervention. It is destructive. It doesn’t solve the underlying problems. It creates new ones.

Larry Summers’ getaway car

However, none of these objections even register at the Fed. The Fed has a completely different perspective: this policy was a roaring success and as it has worked so well it can now be faded out. Soon there will be no need for it. Larry Summers’ dreadful phrase captures that thinking best: the economy will soon have achieved ‘escape velocity’.

Most analogies are somewhat poor but this one is particularly inept. Ironically, though, the reference to mechanics captures beautifully the logic of Keynesians and other interventionists: the economy is like a physical object moving through space and is occasionally in need of a little push to get moving again at an appropriate speed. Policy provides the push.

Bernanke doesn’t use these terms but his thinking is similar. He explained QE to the American public in 2010 by announcing that his job was to occasionally manipulate interest rates and asset prices to encourage lending, borrowing, spending, shopping, and other healthy economic activities, and that once his machinations had stimulated enough of those activities, the economy would again enter a virtuous cycle (his words) of self-sustained growth. Escape velocity has been restored.

I think this is nonsense – however appealing it may sound to many laypersons. The economy is not an object that needs a push, or a machine that needs to be jump-started, or a lazy mule that needs a gentle slap on its behind to get going again (of course, you should never hurt an animal!). The economy is a complex process of coordination, an elaborate system that allows an extensive and diverse group of actors with different and frequently conflicting goals and interests to co-operate with one another peacefully toward the best possible realization of their own material aims. A crisis is a failure of that coordination process. It is a cluster of errors. The only explanation for the occurrence of such a cluster of errors is a systematic distortion of the market’s coordinating properties, such as occurs when monetary expansion distorts interest rates and other relative prices, and leads to imbalances that unhinge the economy.

The economy went into recession because of massive financial deformations. Easy money had led to excessive indebtedness, a housing bubble and dangerous levels of leverage. The problems were such distortions, not lack of momentum. The real question is not whether the GDP statistics exhibit the right velocity but if the underlying dislocations – which, to the chagrin of the econometricians, cannot be easily ascertained from the macro-data – have now dissolved.

No Escape

The Fed believes it has healed an economy that was sick from easy money with more easy money. The patient is feeling better and can soon be released from intensive care. In my view, the patient is still sick and now suffers from a dangerous addiction to boot. The ‘feeling-better’ bit maybe, just maybe, a lingering drug high from Dr. Bernanke’s generous medication. Withdrawal symptoms may surface soon. If they do, Dr. Bernanke will simply open the medicine cupboard again. Don’t forget, only a few weeks ago the man appeared on TV and tried to talk up the Russell 3000 stock index.

I do not doubt that, if measured by overall GDP, the US economy is presently doing better. I would be foolish to take on the Fed on this point. The Fed has a staff of 200-plus economists, most of them, I assume, from America’s finest universities, which doesn’t mean they are good economists but at any rate they are probably good statisticians. If they say there are signs of life in the economy, that’s good enough for me.

Where I disagree is on the narrative. The deformations are largely still there. How can they not, given the enormous policy effort to suppress the very market forces that would – in a free market – have exposed and liquidated these deformations? They are still visible, among other indicators, in high degrees of indebtedness. And they matter. That is why I am mistrustful of the Fed’s projections. Their theories compel them to believe in virtuous cycles and ‘escape velocity’ and to disregard imbalances and distortions. Any sustained removal of super-easy money will allow these deformations to resurface and immediately cloud the near term cyclical outlook. According to my worldview, this should be allowed to happen as it is part of the essential healing process. But it runs counter to the Fed’s worldview and the Fed’s view of its own mission.

The one institution that lacks ‘escape velocity’ is the Fed. It will remain hostage to the financial monsters it created and the dangerous misconception of its own grandeur.

This article was previously published at DetlevSchlichter.com.

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4 replies on “End of QE? – I don’t buy it”
  1. says: Paul Marks

    If B.B. tried to “unwind Q.E.” (i.e. sell that stuff that the Federal Reserve bought with money it created from thin air) the bond market would collapse, and so would the stock market and the property market.

    The same is true in Britain – if the Bank of England really changed course, the bond market would collapse, as would the stock market and the property market.

    The above does not mean that the policy of propping up these markets with monetary policy should continue – on the contrary D.S. is quite correct it should stop (and stop at once).

    But there would indeed be terrible agony if did stop – the economy has become a junkie dependent on the poison of monetary policy.

    But if the poison is not stopped (and the agony of its ending not faced) then the economy will die.

  2. says: George Thompson

    (This comment was originally posted at http://detlevschlichter.com/2013/06/end-of-qe-i-dont-buy-it/)

    Mr. Schlichter, of course you are right. As the sell-offs on the 19th and 20th show, when the DJIA declined a whopping USD 559.91 and about 3.66% of its 6/18 value was cashed out of the market to be redirected to other causes thereby escalating the visible signs of inflation, investors proved they are playing with easy money without the inherent risk that in a sane age justified the profits-to-be-made. The entire improvement in the economy is nothing but a lie. Even the increase in consumer spending proves the lie since low interest rates have disincentivized investment and money that just sits there depreciates leaving spending it the only option by default. The ‘panic’ those two days can be thought of as a warning shot across the front window of the cabin of the whirlybird wizard’s helicopter. He can’t help but notice what he wants to see – ending stimulus will topple the economic Potemkin village he has labored lo these many years to build in order to fool all the people all the time. He may tinker a bit with the amount of his monthly bond purchase – but that’s it.

    I’d rather read the clear thinking of one sane voice than 200 paid political hacks any day – which is all those ‘economists’ are anyhow. How many scientists backed the Pope when he threatened Galileo with excommunication for witnessing to God’s Truth? As the results of the last two American Presidential contests clearly prove, even tens of millions of people can be fooled at election time. As you are fond of writing: “This will end badly.” Hope I have enough Bourbon and Scotch to see me through the troubles ahead.

  3. says: Peter

    The nub of this lies in the perception of the “boom” phase of the cycle.

    Politicians and court economists see nothing wrong with this phase of the cycle. Unemployment is low, the roads are swarming with vans carrying stuff bought on credit around and new building projects are going up everywhere. Tax revenues are high – so government budgets can grow.

    What they don’t appreciate is that this boom phase is unsustainable and is causing massive malinvestment across the economy.

    Thus, when the inevitable bust sets in, they mistake the market’s healing process for some kind of disease and desperately try to restore boom conditions.

    So what happens? Ultra cheap money and a poisonous jungle of “schemes” designed to prop up tottering zombie firms.

    But all this process does is preserve the malinvestments (while creating new distortions of its own). And as soon as these measures end the market will resume its attempt to correct – which politicians do not recognise for what it is.

    This is why, as you say Detlev, that physical analogies like “escape velocity” are so wide of the mark. The whole model that this kind of thinking is based on is completely flawed.

    Of course QE etc never will voluntarily be withdrawn. Because all they have done is to suspend the correction process – which will restart with redoubled vigour if they were ever to be taken away.

    When Bernanke talks of ending QE, he is really like an alcoholic telling his friends he can stop “any time I like”. Yeah right…

  4. says: waramess

    Preserving the bad investments surely does more than keep the bubble inflated, it crowds out small start ups in particular, in favour of low and non performing companies. This will slowly destroy the future economy

    The result is an economy of low and
    non-performing companies, huge government debts to service and, eventually repay and, a declining private sector with all that implies for employment.

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