Monetarists Don't Seem To Get Monetizing
The American Enterprise Institute's James Pethokoukis recently wrote a post ostensibly in defense of the Federal Reserve's QE programs. If not a full argument in favor, at the very least Mr. Pethokoukis is arguing that current Fed policy has been at least consistent with the historical norm. According to the chart presented, despite ongoing QE the Fed has been purchasing less of total US official marketable debt securities than it was during most of the 2000's (that featured no mistakable "monetization"). The implication seems to be that since we are not in uncharted territory there is no need to fret or worry about the potential for monetization, or even the level of monetary intrusion.
The argument presented in favor of the QEs is that they are designed to reach monetary goals largely unrelated to the fiscal optics of monetization, and thus are likely only a temporary expansion of the central bank balance sheet. That they also fall into this presented historical margin serves to quantify the "normalcy" of these decidedly extra-normal affairs.
The evidence offered to define that compliance in the AEI post is, however, inarguably flawed in its basic premise. Mr. Pethokoukis is using the very instrument in question as the scaling variable to judge that context. Using total US official marketable debt in the denominator of his calculation amounts to a calculated sleight of hand, a misdirection that misses the key issue (I make no claim as to intent here).
We cannot measure whether QE is in fact aligned with recent experience using this metric because both the numerator (Fed balance sheet) and denominator (US debt) are themselves in extraordinary circumstances. There is no external measurement given by which we can relatively measure the degree to which both are out of alignment. In other words, by the logic contained in the post, as the second Obama administration embarks upon structural trillion dollar deficits the rest of the decade and assuming the Fed purchases between 15% and 18% of the new debt issued, it would conform to the historical data as presented. If the total new debt over that period amounted to $10 trillion, and the Fed balance sheet expanded by $1.5 trillion (or even close to $2 trillion), it would appear to be totally in line with monetary means of the past three decades.
Is that monetization? In the context of the Fed balance sheet measured against GDP (not a perfect external parameter, but far better than the level of total US debt) it is certainly out of the ordinary and inconsistent with the historical context. But that in itself is not the decisive factor either, in my opinion.
As I wrote recently, total US debt was about $10 trillion at the close of FY 2008. During that fiscal year the US government paid about $450 billion in interest (amounting to an average interest cost of about 4.5%). US debt at the end of FY 2012 was 64% greater, at $16.4 trillion, yet total interest paid out during FY 2012 was under $360 billion. The monetary interferences, to achieve "temporary" monetary goals, of QE's and ZIRP have allowed the federal government to rapidly expand debt and maintain trillion dollar deficits without any interest constraint whatsoever.
The idea of monetization itself relates to that very process - the elimination of constraints on fiscal matters through money. We can argue the mechanism or semantics of the word monetization, but the net effect is exactly the same. I don't care if we call it monetization or subsidization, in practice there is no difference. There is no distinction between a central bank that exchanges printed currency for government debt securities or a central bank that uses modern financial tools of purchasing largely on-the-run treasury securities indirectly from primary dealers. The former is the traditional notion of monetization, the latter simply accomplishes the same through the use of derivative financial leverage.
By buying on-the-runs from primary dealers, the Fed is influencing the yield curve (those "temporary" monetary goals) with the least amount of direct balance sheet expansion since influencing federal debt auction prices allows the Fed to set the marginal interest rate across the whole of the marketable spectrum without having to actually purchase massive quantities of debt. Indeed, in another sleight of hand, the idea of "marketable" debt is entirely misplaced since liquid debt markets, even for treasuries, are largely non-existent when securities go off-the-run.
The size of the actual tradable, liquid market is immensely smaller relative to the proportion of the entire debt inventory, therefore the Fed can engage an expansion an order of magnitude less and accomplish a much larger interest rate impact - that is leverage (we see this in many futures markets where derivative futures prices actually drive cash market prices without much actual cash committed in futures due to the leverage factor). Because the Fed is using this kind of leverage in the on-the-run space, and not just buying up huge chunks of existing debt, it can avoid the appearance of monetization (particularly by engaging the legal distinction of indirect purchases through the primary dealers) while leveraging its actions into accomplishing the exact same net effect.
Intent is immaterial to the larger discussion. We may give the Fed the benefit of the doubt that it in no way seeks to allow fiscal profligacy through its focus on monetary economics, but that proclaimed innocence does not matter if profligacy is itself a direct but unintentional consequence.
As it relates to duration, "temporary" has now run to a full four years and will likely be in place at least two more. In that "temporary" space of four years, the US federal government has grown its debt by 64% with nary an interest rate threat to the already imbalanced budget. There is no going back on that debt expansion either, no matter what the anticipated duration of monetarism remains. The Pandora's Box of federal debt has been opened directly through monetary means. The Obama administration has been literally afforded the opportunity to grow the size of government relative to the economy (or any external measure, including historical context). Government expansion, once unleashed, will work fully and unflinchingly toward remaining permanent - its proponents have made that amazingly clear.
Whatever the intentions of scope, scale and duration, the current Federal Reserve policy is disabling the very financial market mechanisms by which big government is constrained from getting bigger. Those scoffed and mocked bond vigilantes have been either co-opted into the monetary schemes themselves (the profitable skimming of bond flipping between auction and expectations of pricing in a QE regime) or simply replaced altogether by the Fed. There are dire consequences, monetary and real, of this bypass of true market-based limitations; trying to make this appear as the normal course of monetary business is indeed misguided.
Just from an economic standpoint, the growing domination of the federal budget is itself an impediment to returning to a growth economy. The more the federal government imposes itself into the economic sphere (much like the imposition of the central bank) the less true markets are able to function as means toward productive and sustainable economic growth. Again, it matters absolutely not whether the Fed intends to finance that domination or for how long, all that matters is that it has become a possibility through interference in the interest rate mechanism.
In that respect, the fact that QEs support the growth of government at the expense of the real economy only creates a positive feedback loop that belies the temporary intentions of monetarists. The more the government is given room to expand, the more it will diminish the growth prospects of the real economy (through both real means and through realistic expectations of tax increases), the more the Fed will "feel" the need to impose additional temporary monetary goals and in so doing give the federal government even more financial subsidy. And so on. Was that not the history of 2010-2012, between QE 2 and QE 3 & 4?
This reflexive impulse to defend the Federal Reserve's unmatched, historic measures from those at least cosmetically committed to free enterprise and capitalism is disheartening and discomfiting. QEs can only expand the amount of potential "money" into the real economy. They cannot create capital, the one element most missing under the thumb of unending monetarism. The fact that such monetarism and money finds its way to circulate into the real economy through the federal government's permanent expansion (whether it is government workers, SNAP, SS disability, etc.) actually detracts from the expansion of capital. It suffocates entrepreneurialism through the extended reach of government and the monetary system that increasingly flows only to the biggest corporations. The combination here results in a system where only size matters, where merit or productivity are not even factored. Monetary-driven liquidity preferences have very real consequences.
In short, the economic system is impoverished by a dearth of capital expansion as the "money" created flows in the worst possible manner - directly contrary to what a healthy recovery and economy actually needs. It does not really matter if we call it monetized debt or subsidized debt, or something entirely different. The historic and immense size of the interventions on both ends of the spectrum need to be viewed in the primary context of distortion - the combination of monetarism and statism absolutely matters here, far more than any fears of potential inflation.
The net result of distortion is a system that is malignant with the wrong incentives and "values", the wrong channels of flow and unsurprisingly continued dysfunction. It should be far more concerning that the central bank's goals and those of the expansionary federal government have now closely aligned without any monetary or financial check on either (political checks of the two party system have been lost as both parties now defend one or the other, or both). That is the worst of all worlds, economics and politics.