The Ongoing Folly of Quantitative Easing

With the US economic rebound still slow relative to past post-recession recoveries, the majority opinion within the Fed (as evidenced once again by this week's minutes) is that further expansion of its balance sheet will boost lending on the way to increased output and employment in an economy that is falling short.

Despite a dollar that continues to test new lows versus gold and a broad range of foreign currencies, the Fed presently fears deflation. By one argument, monetary ease will increase currency in circulation, and the inflationary effect will induce consumers to buy goods in advance of looming price increases.

While some might laud the Fed's efforts to aid an economy that is presently performing sub-optimally, its Treasury purchases have potentially destructive investment implications and will prove superfluous at best. The individuals who comprise the US economy would be better served if the Fed were to float the money-market rate that it sets, and then let the economy heal itself free of further intervention.

Monetary ease. Economic commentators across the ideological spectrum have been impressed, alarmed, or both, by the substantial increase in the Fed's balance sheet that began in 2008. In January of 2008 it stood at $739 billion, but as of late October, it had expanded dramatically to $2.3 trillion.

Empirically, the Fed's mass purchase of assets from money-center banks was largely superfluous when it came to increasing the amount of money in circulation. While circulation amounted to $829 billion as 2008 dawned, it had only increased to $961 billion as of October despite assets on the Fed's books having jumped 300%.

Whether commentators approve or disapprove of this expansion, there was then and is today a broadly held view that the Fed's actions were and continue to be inflationary. It's an overused, and perhaps misunderstood concept, but the Fed's expansion of its asset base spoke to the "printing of money" that according to some would end in tears.

Thanks to reduced economic growth, demand for the money and credit necessary to lubricate production and trade has increased more slowly over the last few years. And with money demand weak, the Fed's attempts at monetary ease have not produced the dramatic increase in money in circulation that so many economists expected.

A second look at currency in circulation versus the size of the Fed's balance sheet tells the same tale. From December of 2002 to December of 2007, when the economy was growing at a stronger pace, 90% of the Fed's balance sheet was in circulation against 3% held at the Fed itself.

Fast forward to October. Despite the Fed's strong efforts to increase bank liquidity, the vast majority of dollars exchanged for interest-bearing assets have returned to the Fed where they earn a nominal level of interest paid by the central bank. As of October 20th, only 41% of the Fed's balance sheet represented currency in circulation, while 42% is at the Fed gathering interest.

The low demand for money today mirrors what occurred in the early 1930s. Contrary to popular belief on the left and right which suggests money was tight during the Great Depression, the exact opposite scenario prevailed.

Indeed, as William Greider observed about the '30s in Secrets of the Temple, "banks found themselves floating in an excess of reserves - a pool of surplus lending capacity - because they could find no customers who wanted to borrow."  It sounds like today. 

None of this should surprise H.C. Wainwright clients. Indeed, as David Ranson has frequently pointed out, the Fed cannot push into circulation money that otherwise isn't desired by productive economic actors.

The saying that you can lead a horse to water, but not force it to drink, perhaps applies here. Staffed by individuals who naively believe that money creation itself is a source of economic energy, the Fed has overloaded financial institutions with dollars that are now back at the central bank.

To put it simply, the Fed has put the cart before the proverbial horse. Money supply, or money in circulation, isn't the driver of economic activity as much as economic activity is the driver of demand for money and credit. Production increases money in circulation, not the other way around as so many assume.

In short, the Fed's actions have been superfluous at best. As economic individuals, we trade products for products. The sole purposes of money in the process are to facilitate exchange and serve as a measuring stick so that investors can place value on capital goods and labor.

If superfluous, where's the harm? While the Fed's balance-sheet expansions haven't led to any major increase in the amount of dollars circulated, the evidence suggests that its actions could have been economically harmful. Though it would be difficult to place a value on the damage, and nearly impossible to distinguish between cause and effect, classical theory says that the Fed's actions must be hurting the U.S. economy.

To see why, we must at least briefly recall the role of housing in the economy. Though it's widely assumed that housing is an economic input, Adam Smith and other classical economic thinkers taught us that housing is merely a cost.

When an individual purchases a home, far from stimulating productivity, the purchaser instead simply transfers wealth to another individual. More to the point, an investment in property cannot help cure cancer, lead to the creation of efficiency-enhancing software or any capital good that makes us more productive, nor will it open foreign markets.

A house is just a house, and not a gateway to other investment opportunities. When capital flows in the direction of property, on the margin, the productive parts of the economy suffer a capital deficit. And since the Fed's balance-sheet expansions boost the demand for mortgage-backed securities, the central bank is explicitly subsidizing increased capital flows in the direction of consumption at the expense of wealth-enhancing production.

Quantitative easing. Turning back to the Fed's plans to purchase $600 billion in longer-dated Treasury securities during existing and future rounds of quantitative easing, this too will be economically problematic. Indeed, in telegraphing its future actions, the Fed is telling investors in government debt that their purchases will be subsidized by the central bank.

Governments have no resources other than those they extract from the private sector, and so long as it's known that Treasury investments will be bolstered by the Fed's own purchases, owners of Treasuries will have greater incentive (notwithstanding the recent rise in Treasury yields) to fund government rather than more productive private sector pursuits. In a world of limited capital, the Fed's attempts at ease will on their face subsidize the growth of government.

Of course it's important to remember how the Fed has arrived at its latest policies in favor of buying up longer-dated Treasuries. Having taken the Fed funds rate down to zero, our central bank has moved on to the seemingly exotic notion of "quantitative easing."

But there lies the problem. The Fed shouldn't be setting the short rate for money, or any cash rate for that matter, and it's arguable that its decision to reduce the funds rate to zero has exacerbated our present economic situation.

Rates of interest are - other than the dollar - arguably the most important prices in the world for matching supply of, and demand for, credit if left alone. The Fed's actions in this very real sense are blurring these incredibly important price signals.

Ultimately, all of the Fed's actions are treating symptoms rather than causes. Indeed, it was irresponsible lending that helped cause the financial crisis of not long ago. Higher, market-driven rates of interest would have been curative by virtue of creating incentives for savers to replenish capital, while being rewarded with higher rates of interest paid on capital invested.

Unwilling to let the economy heal itself through rewards for the prudent, the Fed is essentially doubling down on a decade in which faulty lending to property and nosebleed spending in Washington led to some highly trying times for the financial markets. If it didn't work the first time, it is the height of naivete for the Fed to subsidize the same mistakes once again.

Ultimately economic policy needs to move beyond what is seen, and gravitate to what is less visible. Fed activity has given us nominally low interest rates, but unseen is what the economy has lost through penalties placed on the very savers whose replenishment of the capital stock at higher rates of interest would have helped fund a more natural, market-driven recovery.

Deflation isn't necessarily bad. Fed Chairman Bernanke feels that another benefit from quantitative easing is increased inflation. Fearful of deflation despite a dollar that continues to test new lows, Bernanke's view is that if the prices of consumer goods decline, consumers will lie in wait before making purchases, and a bad economic outlook will grow worse.

On its face, Bernanke's thinking is unfortunate. Indeed, the last thing governments should ever need to do is to stimulate consumer demand. As humans all, we're wired to consume, and surely we produce to do just that.

Even better for an economy that's still sagging, everything we have today - from computers to cars to life-extending pharmaceuticals - is the result of thrift: the willingness of some to delay consumption in favor of investment. More saving at present would be dynamite for expanding capital on the way to innovation and job creation.

But assuming a further decline in the cost of consumer goods, far from something that would retard consumption, falling prices are widespread in developed-world economies. From long-distance calling, to mobile phones, to flat-screen televisions, declining prices are the norm for much of what we buy.

And far from depressing output, falling prices merely expand the range of goods available to us. As the cost of consumer products declines, we demand formerly out-of-reach goods thereby raising their prices. Absent monetary error, the price level doesn't change; rather price declines in some products are matched by price increases in others.

Fed actions meant to drive up consumer prices serve to starve tomorrow's visionaries and innovators of capital. Simply put, if prices aren't allowed to decline, the ability of consumers to save will similarly be hamstrung on the way to reduced investment in the industries of the future.

Conclusion. As evidenced by the unimpressive increase in circulated money, the Fed's ability to push money into an economy that doesn't want it is highly overrated. While the Fed's actions are largely ineffective, quantitative easing will be economically harmful, essentially subsidizing increased capital flows into housing and government.

Rather than continue its further interventions telegraphed in yesterday's minutes, the Fed would do well to acknowledge that far from something to stave off through monetary machinations, recessions can be a corrective mechanism. They tend to starve activities that waste capital and redirect limited funds to undercapitalized areas that will author any recovery.

It's only when governmental bodies restrain an economy's natural, recuperative abilities that short downturns turn into painful and prolonged depressions. At present the Fed is trying to shield us from economic hardship; but far from helping us, its actions merely ensure that the recession's negative effects will remain with us even longer.