Posts tagged ‘QE’

We Are In the Best of Hands: Janet Yellen Edition

The Arizona Republic today reviews a speech given by Yellen in January, 2007 in Phoenix:

It was January 2007 when Yellen, then head of the Federal Reserve Bank of San Francisco, spoke here about financial literacy before transitioning into comments about the economy — comments that now look remarkably unperceptive.

Back then, months before the real-estate and banking crisis took down the economy, Yellen expressed concern that inflation was uncomfortably high while job gains were coming too swiftly.

“If labor markets are as tight as the unemployment rate suggests, then there may be reason for concern about building inflationary pressures,” she said according to my Jan. 18, 2007, article.

Subsequent events showed that inflation was the last thing we had to worry about, while the lack of jobs has emerged as a central drag on the economy. Back then, U.S. unemployment was around 4.5 percent. But after the recession took hold, it more than doubled, peaking at 10 percent in late 2009. At 7.3 percent currently, it remains well above where it should be this far into an economic recovery.

In contrast, core consumer inflation (which excludes food and energy costs) of 1.8 percent today has hardly budged from the 2.2 percent rate that had Yellen all worked up back then.

In another comment during her Phoenix talk that now looks wildly off-base, Yellen, who later was named vice chair of the Fed’s board of governors, said recession risks had receded despite lingering weakness in housing. She cited the Valley as a place where home-price appreciation had come down from unsustainably high rates of increase.

The Great Recession, as we all now know in hindsight, began later that year, triggered by a home-price slide of epic proportions.

I don't want to beat her up too bad for missing the bubble burst, since most everyone did.  They also all missed the last bubble burst, and the one before that, etc.

This is what makes me crazy:  not that these folks were wrong, even consistently brutally wrong, but that they display absolutely no modesty in their actions given that they were so wrong.  They propose policy steps, such as seemingly eternal QE, that are astoundingly risky unless one assumes that they have a very, very good grasp on exactly where the economy is going.  Which they clearly never have had in the past.  If they acted like they had been wrong most of the time, then I would have little to criticize.  But to be consistently wrong and then make huge risky bets as if you have reliable predictive powers is hubris of the worst sort.

Most Unsurprising Headline of the Year

Via the AZ Republic:

The pay gap between the richest 1 percent and the rest of America widened to a record last year.

...

Last year, the incomes of the top 1 percent rose 19.6 percent compared with a 1 percent increase for the remaining 99 percent.

...

But since the recession officially ended in June 2009, the top 1 percent have enjoyed the benefits of rising corporate profits and stock prices: 95 percent of the income gains reported since 2009 have gone to the top 1 percent.

That compares with a 45 percent share for the top 1 percent in the economic expansion of the 1990s and a 65 percent share from the expansion that followed the 2001 recession.

The Federal Reserve is pumping over a half trillion dollars of printed money into inflating a bubble in financial assets (stocks, bonds, real estate, etc).  It should be zero surprise that the rich, who disproportionately get their income and wealth from such financial assets, should benefit the most.   QE is the greatest bit of cronyism the government has yet to invent.

(yes, I understand that there are many reasons for this one-year result, including tax changes that encouraged income to be moved forward into last year and the fact it was a recovery off of a low base.  Never-the-less, despite decades of Progressive derision for "trickle down" economics, this Administration has pursue the theory that creating an asset bubble that makes the rich much richer will in the long term help the economy via the "wealth effect.")

Forgetting the Fed -- Why a Recovery May Actually Increase Public Debt

Note:  I am not an expert on the Fed or the operation of the money supply.  Let me know if I am missing something fundamental below

Kevin Drum dredges up this chart from somewhere to supposedly demonstrate that only a little bit of spending cuts are needed to achieve fiscal stability.

Likely the numbers in this chart are a total crock - spending cuts over 10 years are never as large as the government forecasts and tax increases, particularly on the rich, seldom yield as much revenue as expected.

But leave those concerns aside.  What about the Fed?  The debt as a percent of GDP shown for 2012 in this chart is around 72%.  Though it is not labelled as such, this means that this chart is showing public, rather than total, government debt.  The difference is the amount of debt held by federal agencies.  Of late, this amount has been increasing rapidly as the Fed buys Federal debt with printed money.  Currently the total debt as a percent of GDP is something like 101%.

The Left likes to use the public debt number, both because it is lower and because it has been rising more slowly than total debt (due to the unprecedented growth of the Fed's balance sheet the last several years).  But if one insists on making 10-year forecasts of public debt rather than total debt, then one must also forecast Fed actions as part of the mix.

Specifically, the Fed almost certainly will have to start selling some of the debt on its books to the public when the economy starts to recover.  That, at least, is the theory as I understand it: when interest rates can't be lowered further, the Fed can apply further stimulus via quantitative easing, the expansion of the money supply achieved by buying US debt with printed money.  But the flip side of that theory is that when the economy starts to heat up, that debt has to be sold again, sopping up the excess money supply to avoid inflation.  In effect, this will increase the public debt relative to the total debt.

It is pretty clear that the authors of this chart have not assumed any selling of debt from the Fed balance sheet.  The Fed holds about $2 trillion in assets more than it held before the financial crisis, so that selling these into a recovery would increase the public debt as a percent of GDP by 12 points.  In fact, I don't know how they get the red line dropping like it does unless they assume the current QE goes on forever, ie that the FED continues to sop up a half trillion dollars or so of debt every year and takes it out of public hands.

This is incredibly unrealistic.  While a recovery will likely be the one thing that tends to slow the rise of total debt, it may well force the Fed to dump a lot of its balance sheet (and certainly end QE), leading to a rise in public debt.

Here is my prediction:  This is the last year that the Left will insist that public debt is the right number to look at (as opposed to total debt).  With a reversal in QE, as well as the reversal in Social Security cash flow, public debt will soon be rising faster than total debt, and the Left will begin to assure us that total debt rather than public debt is the right number to look at.

Risks of QE

So far, I have mainly been concerned about inflationary risks from quantitative easing, which is effectively a fancy term for substituting printed money for government debt (I know there are folks out there that swear up and down that QE does not involve printing (electronically of course) money, but it simply has to.  Operation Twist, the more recent Fed action, is different, and does not involve printing money but essentially involves the Fed taking on longer-term debt in exchange for putting more shorter term debt on the market.

Scott Minder in the Financial Times highlights another potential problem:

In 2008, just before the first of two rounds of quantitative easing, the Federal Reserve had $41bn in capital and roughly $872bn in liabilities, resulting in a debt to equity ratio of roughly 21-to-one. The Federal Reserve’s portfolio had $480bn in Treasury securities with an asset duration of about 2.5 years. Therefore, a 100 basis point increase in interest rates would have caused the value of its portfolio to fall by 2.5 per cent, or $12bn. A loss of that magnitude would have been severe but not devastating.

By 2011, the Fed’s portfolio consisted of more than $2.6tn in Treasury and agency securities, mortgage bonds and other fixed income assets, and its debt-to-equity ratio had dramatically increased to 51-to-one. Under Operation Twist, the Fed swapped its short-term securities holdings for longer-term ones, thereby extending the duration of its portfolio to more than eight years. Now, a 100 basis point increase in interest rates would cause the market value of the Federal Reserve’s assets to fall by about 8 per cent, or $200bn, leaving it insolvent, with a capital deficit of about $150bn. Hypothetically, a 5 per cent rise in interest rates could cause a trillion dollar decline in the value of the Federal Reserve’s assets.

As the economy continues to expand, the Federal Reserve will eventually seek to normalise monetary policy, resulting in higher interest rates. In this scenario, the central bank could find that the market value of its portfolio has declined to the point where it no longer has enough sellable assets to adequately reduce the money supply and maintain the purchasing power of the dollar. Given US dependence on foreign capital flows, if the stability of the dollar is drawn into question, the ability of the US to finance its deficits may falter. The Federal Reserve could then find itself the buyer of last resort for Treasury securities. In doing so, the government would become hostage to its printing press, and a currency crisis or runaway inflation could take hold.

George Dorgan observes, on the pages of Zero Hedge, that European countries are taking even large balance sheet risks.  The most surprising is the Swiss.

A Terrible Chart

OK, to go along with the bad study in the last chart, I will offer up a terrible chart.  From Kevin Drum:

Drum uses this chart to hammer home the point that the current deficit is Bush's, rather than Obama's fault.  I have absolutely no problem with blaming Bush for all variety of stupid spending and handing him a share of the blame for the Federal debt.   Even using this bad chart (more in a moment), I think Obama gets a lot of the blame, though.  The highlighted bars don't really substantially move the debt until 2009 and after, on Obama's watch.   His complete lack of any effort to take on the rising debt, to pare back past spending programs (or wars, or whatever) has been unparalleled.  In fact, I think it is his absolute indifference to deficit spending and the debt levels that saddles him with a lot of the blame.

Anyway, back to the chart.  Notice that these are just a few of the many components of Federal spending, all of which are increasing in this period.  Picking out which ones "caused the debt" is not a neutral procedure.  Money is fungible.  One could just as easily substitute rising Medicare and Social Security costs (or education funding or transportation funding or government employee salaries) for any of the bars above and be just as correct.  Even if one wanted to just look at Bush actions, one would reasonably need to include the debt associated with the costs of Medicare part D, something left off this chart presumably because Drum supports that particular spending.    All this chart does is demonstrate the biases or preferences of the author, showing us which categories of spending the author most opposes (or which the author feels Obama can't be blamed for, like the down economy).

By the way, the chart's construction actually worse than this, because the chart is only "public debt" rather than total debt (for example debt bought in QE is no longer public debt).  If one looks at public debt, the total number should have crossed 100% some time in the last year, rather than the 70% or so in the chart.   So there are a lot of other things, presumably that the author likes, that are also causing total debt to rise.  But these are hidden, because presumably the Fed only buys debt created by the good spending, and the public buys all the debt created by the bad spending.

Finally, my suspicion is that some of these numbers are just plain wrong.  The chart implies Fannie, Freddie, and Tarp are only going to cause a total of 1% of GDP in debt, or about $160 billion.  That is WAY below the loss numbers that Fannie and Freddie have already acknowledged, with more to come.

A Thought on the Trade Deficit

Most of the time when folks lament about the US's trade deficit, I just yawn.  That is because to a large extent the trade deficit is simply an artifact of an arbitrary accounting definition.  Basically, we define a certain fairly arbitrary subset of total commerce and commercial activity between two countries, and then throw tantrums when that arbitrary account is unbalanced.  At the end of the day, the payments loop has to close - the dollars come back to the US somehow.  Historically, most money from such trade deficits have come back to the US as foreign investments in US assets (think, for the example, Japanese investments in the late 80's in US real estate and high profile companies).

It is amazing that we would complain about such a situation.  First, we should be thrilled that foreigners choose to invest in our productive assets rather than just our manufactured goods.  Second, think about it this way -- if we export a product, we get the foreign money but the product goes overseas.  When foreigners invest in our fixed assets, we get the money and the assets remain here.  It is the outsized political influence of shareholders and workers in a few export-oriented industries  rather than economic rationality that keeps the US Congress so fixated on the "trade deficit."

The one issue I have with the trade deficit is it is in large part tied closely to the budget deficits run by the Feds.   Think about it this way -- let's take the definition of the balance of trade and keep it intact, adding just one single additional export product to the calculation:  US Government debt securities.   Certainly these are products we export, and there is nothing wrong with thinking about them as an alternative way for foreigners to spend dollars vs. buying US exports  (just as we all face the choice of investing for savings or buying consumer goods with our own incremental income).

Last year the US trade deficit was between $400 and $500 billion per year.  In 2009 the US government deficit was something like $1.4 trillion.  Assuming they issued debt securities to fund this deficit (ignore QE for now) and assuming foreigner bought 40-50% of these bods, then we exported as much as $700 billion in US government bonds to foreign buyers.  Now, suddenly, when we consider this one additional export product in the mix, we are running a trade surplus.  This is why currencies like the yuan are not necessarily as undervalued as people (including President Obama) may assume -- the issuance of government bonds creates a huge demand for the dollar, and keeps the value high.  If exporters are truly pissed off about the high value of the dollar vs. the yuan, they should not complain to the Chinese, they should complain to Obama and the US Congress for competing with them in foreign markets.  Though we tend to go through phases where we forget it, saving is a competitive product to consumer goods.

Update: Scott Grannis via Carpe Diem

"The Chinese sell us mountains of cheap goods, then turn around and invest most of the proceeds (equivalent to our trade deficit with China) in U.S. Treasury securities. We get the goods, and we get to keep the money. Then we devalue the dollar, and they lose on their investment. Why we would want them to stop doing this is beyond me, though if I were a Chinese citizen, I would be furious with my government for directing such massive quantities of my country's export earnings to Treasuries.

Quantitative Easing: Wacky Progressive Economics or Financial Annealing?

This post is based on playing around with some analogies to try to understand quantitative easing in my own mind.  I can't decide if this approach is helpful or just wanking.  I fear it is the latter, but if we banned all banned all intellectual wanking in blogs,  my feed reader would be virtually empty.

I haven't really written much about the Fed's latest round of quantitative easing, dubbed QE2.  Basically they plan to print some significant fraction (I see different numbers in different articles) of a trillion dollars and use the newly created money to buy government bonds  (they don't actually print the money but create it out of thin air in the memory banks of computers).  As I understand it, the theory is that this will boost the price (and thus reduce yields) on the government bonds on the balance sheets of private banks.  This will in turn have two effects:  improve (at least on paper) the balance sheets of banks, hopefully making it more likely to lend; and it will reduce the yield on the bonds on their balance sheets, hopefully making private loans look like a better investment in comparison.

I am not an economist, and so won't get embroiled in issues I don't understand, but it strikes me that even if one accepts the theory of QE, it will be difficult to have any measurable impact as long as Congress  and the administration keeps generating new debt at astounding rates.

But what is really happening here is that the dollar is being devalued.  This is one of the semantic quirks that make me laugh -- when Argentina or Zimbabwe do this, its called devaluation.  When a western nation does it, it is called quantitative easing.  Because, uh, we are much smarter or something.   But I have to believe that a lot of progressives have hitched their wagon to QE2 out of the hope for some inflation (wow, the revenge of William Jennings Bryant).   Because inflation and dollar devaluation would nominally achieve some of the goals they are hoping for, including:

  • making Chinese imports more expensive, creating a wealth transfer from consumers to a few politically powerful exporters
  • re-inflating the housing bubble while devaluing long-term fixed rate mortgages, creating a wealth transfer from creditors to debtors
  • continuing the wealth transfer from average workers (who typically don't have COLA's) to government and union workers (who typically do have COLA's)
  • acts as wealth transfer from individuals to government since it creates an effective income tax rate increase, as key income levels in the tax tables, particularly where AMT kicks in, are not indexed for inflation

It is impossible to argue that devaluing a currency is a path to wealth generation.  It can't be, though progressives, as always, are willing to tolerate a total reduction of wealth as the price for the type of re-distributions discussed above.

But excepting the re-distribution arguments, it strikes me that the only possible argument for this devaluation is that the economy is somehow trapped in a local minima from which the escape energy is too high.  This would make QE a bit like annealing in a metal, where metal that is heated up and cooled too fast can be hard and brittle.  The only way to get it to be ductile is to re-heat it and then allow it to cool slower.

This is kind of a pretty comparison, but in large part it is probably BS.  The economy is way, way, way more complex and multi-variate than crystallization in a metal.  Even if we were trapped in a local minima, which by the way it is pretty much impossible to determine, we don't know what kind of energy should be applied to the system to move it out.  In fact, if we wanted to use this analogy, it would make far more sense to me to remove barriers to entrepreneurship and wealth creation which likely form a large part of the energy barrier that keeps us in such a local minima.  In fact, the annealing analogy would likely point one in the direction of decalcifying markets and increasing labor mobility rather than massive government interventionism.  It is much easier for me to argue that the missing energy is entrepreneurship rather than liquidity.  Apparently, the German finance minister agrees with me:

The American growth model, on the other hand, is in a deep crisis. The United States lived on borrowed money for too long, inflating its financial sector unnecessarily and neglecting its small and mid-sized industrial companies. "¦I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don't recognize the economic argument behind this measure. "¦The Fed's decisions bring more uncertainty to the global economy. "¦It's inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money.

Update: Chinese bond rating agency downgrades US treasuries

The United States has lost its double-A credit rating with Dagong Global Credit Rating Co., Ltd., the first domestic rating agency in China, due to its new round of quantitative easing policy. Dagong Global on Tuesday downgraded the local and foreign currency long-term sovereign credit rating of the US by one level to A+ from previous AA with "negative" outlook.