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Is The Fed Killing the Recovery?

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April 25, 2014 – Comments (1)

Board: Special Ops: Strategy Room

Author: aleax

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I think there's even a rational argument to be made there but he seemed unwilling & unable to present any sort of cogent case for it.

Actually I've seen two different, rational arguments against QE specifically (definitely not against ZIRP!).

One was presented by David Malpass in a guest editorial on the WSJ and it relies on a "crowding out" effect -- it's rational, I just think it's wrong, based on several empirical data points about availability of credit in plenty of specific credit markets (summarized as: credit is quite reasonably available in most cases). Malpass points at how the economy has been doing quite decently since the taper actually began, but while this does hint at the likelihood that QE wasn't helping, it does not indicate the how or the why of it.

The other argument has been around far longer -- essentially since the very start of QE's first round, in fact -- and best articulated, in my opinion, by Ken Fisher. Essentially, Ken points out how a steep yield curve (a large spread of long-term debt compared to short-term debt) always helps the economy overall, historically, because lenders are very motivated to lend broadly in such conditions (as their profits depend exactly on borrowing short-term and lending long-term); vice versa, a flatter yield curve purports bad times, and at the extreme an inverted one spells disaster.

So, ZIRP is good, because, by anchoring short-term yields very low, it helps steepen the curve. But QE deliberately aims to flatten the curve...! So by design it sabotages the economy rather than helping it.

The taper has seen a nice steepening of the curve, so that's a very direct mechanism whereby it's helping.

I eventually allowed this second argument to convince me as I kept observing facts on the ground, and they matched it much better than the pro-QE ones. Indeed, the Fed itself has done numerous studies showing that the bond-buying part of QE was at best neutral, more likely a (small) negative for the economy (the smaller MBS-buying did help the housing market recover a bit, at least temporarily; how significant or not that was is more debatable).

So what were the pro-QE arguments that originally persuaded me, and why are they wrong? Summarizing, the model behind QE was that lenders would have been quite happy to lend (so the yield curve was plenty steep enough), but would-be-borrowers were discouraged by high borrowing costs. Why wrong? Because the real reason for scarce demand for credit (compared to the credit on offer) was many borrowers' urge to de-leverage -- painful for the economy (and the root cause of the recovery being painfully slow), but inevitable and actually healthy in the middle- and long-term.

QE couldn't stop the tide of de-leveraging in the private sector -- it may have fueled it by prompting a wave of refinancing (I'm not thinking about residential mortgages in particular, although there sure was a lot of refinancing there, but mostly about the corporate bond markets, where issuers retired a lot of existing, higher-rate debt by floating new, lower-rate issues) that's not technically de-leveraging (demand for credit remains constant when an issuer refinances, as opposed to when the issuer de-leverages, when demand for credit diminishes), but has similar effects in many ways (more solid balance sheets for issuers, long-term hurt to lenders' profitability albeit after a transient wave of fees for the refinancing operations themselves).

Differently from Bernanke-haters, I don't condemn him (or the Fed in general) for the QE experiment: it was a bold new experiment in a climate that desperately called for action, any action -- nobody could know in advance which arguments would work out in practice (although I tip my hat to Ken Fisher's finely-tuned investing nose for smelling it right just from the start!) -- so, a noble, though misguided, try.

But it's high time to proclaim victory and go home:-).

What's worrisome is that there's a lot of talk about the ECB considering some QE of its own, specifically the worst, bond-buying variety. As a European citizen (although I doubt I'll be a permanent resident over there ever again -- that's where the vast majority of my relatives live!), I sure hope they reconsider any temptation in the matter...!-) 

1 Comments – Post Your Own

#1) On April 25, 2014 at 3:37 PM, Goofyhoofy (< 20) wrote:

You might want to consider that the EU, having not engaged in the QE that the Fed has done, is a basket case full of economies, most with double dip recessions, some in full depression, nearly all (except Germany, which spent billions in corporate/industry support by a different name) on the verge of deflation.

Contrast that with the US, which economy is recovering, albeit slowly, is not threatened with deflation, and where even the worst hit areas are coming back.

This was a full blown financial panic, a bank run, not some typical recession, and nearly all of the prescription by "knowledgable" economists have been wrong. Recoveries from bank panics are never quick and never easy. Re-flating the banking sector, while odious, has been the right thing to do. (The whole thing should have been nationalized, the bums thrown out, then privatized again, but that is too much to hope for.)  

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