Forever blowing bubbles

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My opinion piece in the AFR today on a third round of quantitative easing (QE3) is below.  It discusses the pros and cons of quantitative easing in the US.  The main point is that the biggest danger of quantitative easing is not that it will cause consumer or producer price inflation — that is its purpose; the danger is that it will inflate a third asset price bubble (after the dot-com bubble and the housing bubble), the bursting of which would be highly damaging, perhaps even catastrophic.  A large third round of quantitative easing may be necessary (I favour it) but we shouldn’t underestimate how risky it is.  

Get ready for Quantitative Easing Mark 3 — a third round of the Fed bypassing the banking system and injecting credit directly into the US economy.  In the last two weeks both the past growth and future growth estimates of the US economy have been revised downwards.  The Commerce Department estimates of growth in the last three years were recently revised sharply downwards (by 0.4% per year), and now the future growth forecasts of influential analysts have been moved down, sending global stock markets tumbling.

Backwards or forwards, Ben Bernanke, the Governor of the US Federal Reserve Board, is looking at lower growth than he was two weeks ago.  Moreover, he now knows that another Federal Government fiscal stimulus package is politically impossible (unless the wheels really come off).  There is an significant danger of the US descending into a deflationary spiral, in which lower aggregate demand in the economy causes lower prices for goods and services, which causes the firing of workers, which in turn leads back to lower aggregate demand.

Facing this elevated danger of deflation we know that Ben Bernanke will want to crank up the printing press – he has told us so in the most ardent terms.  In his famous Bernanke Doctrine speech of 2002 he declared that there is no mystery about what causes deflation — it is a steep fall in aggregate demand.  Further, that the solution to deflation is for the Federal Government to print money until deflation is reversed.  Later, at the 90th birthday party of the great monetary economist Milton Friedman, Bernanke literally promised Friedman that the Fed would never repeat its crucial mistake of the Great Depression when the Fed allowed the US money supply to shrink as deflation set in.

Bernanke will face resistance to more quantitative easing, especially from the Republican members of Congress who were the most insistent on large cuts to Government spending before raising the debt limit.  But Congress does not control monetary policy.  Bernanke must report to Congress, but the Fed is wholly independent of outside interference in decision-making.  It has as much freedom in setting monetary policy as Australia’s Reserve Bank does.

Three years into quantitative easing, it is easy to forget what an extreme, unnatural and risky policy it is.  When monetary policy is working properly the Fed acts through the banking system.  If the Fed wants to stimulate economic activity then it decreases interest rates.  This brings forward in time the consumption and investment plans of households and firms because interest rates are the exchange rate between the present and the future.

Ordinarily, to decrease interest rates the Fed pumps liquidity into the commercial banking system and that new liquidity is converted by banks into credit in the form of loans that finance the increased demand for consumption and investment.  It all works beautifully.  The banking system may stand between the Fed and the real economy, but nonetheless, the Fed can raise and lower the greater lever of monetary policy and see the flames of the economy rise and fall in response.

But normal monetary policy is not working in the US today   Interest rates are already at zero and when the Fed pumps liquidity into the badly broken American banking system it is not converted into credit, but instead it just wells up in the accounts of the banks at the Fed.

Hence the extreme actions of QE1 and QE2 in which the Fed created new money to buy the bonds of Fannie Mae and Freddie Mac, the giant housing finance agencies in the US.  This is the bypassing of the banking system to inject credit directly into the US mortgage market.  It is the analogue of abandoning cautious medical treatment and injecting adrenalin directly into the heart of a moribund patient (if you have seen Pulp Fiction then you have the image).  It is unprecedented and before the GFC hardly anyone thought that it would ever happen in the US.

Apart from being radical, quantitative easing is fraught with danger.  Too much money chasing too few goods will eventually ignite consumer and producer price inflation.  Of course, if deflation is your ailment then moderate inflation is your cure.  Moderate inflation would speed the deleveraging of household and government balance sheets, devalue the currency, stem the fall of housing prices and allow real wages to fall where they need to.  But even moderate inflation must be squeezed out eventually and that will take a recession down the track of 1982 proportions.  Of course, there is the danger that the induced inflation is not moderate.

However, the great danger of quantitative easing is not consumer or producer price inflation; the danger is asset price inflation.  Quantitative easing could ignite another asset price bubble, the bursting of which could devestate an already weakened world economy.

The reason is as follows.  All liquidity has to be held on someone’s balance sheet: on the balance sheets of either households, firms; or financial intermediaries.  Investors won’t hold low yielding liquidity unless the yields on longer term assets, such as stocks, bonds or real estate become less attractive.  That is, the new liquidity is a hot potato in the system until long-term assets become overpriced and hence less attractive relative to liquidity.  The markets understand this idea and refer to it in the expression ‘the Bernanke put’.  Witness how the mere mention of the possibility of QE3 by the Fed ended the stock market’s fall earlier in August.

Opponents of QE3 also understand this link between liquidity injections and asset prices.  They argue that it is the collapsing of asset price bubbles in first the dot-com and then the US property bubble that caused the GFC.  They believe that QE3 may ignite another asset price bubble, the collapsing of which would be catastrophic.

Quantitative easing may be seriously dangerous and unhealthy but with fiscal stimulus off the table, and growth prospects sharply down, Ben Bernanke may have no alternative.  QE3 is likely to be in the trillions, which will drive asset prices up, but that asset price increase will be unstable.

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