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Alternative working title: How QE2 went wrong.
In order to understand what’s really at stake at Jackson Hole on Thursday we need first to understand how the Fed’s thinking has evolved post 2008.
And there’s an excellent presentation from Professor Lew Spellman, from the McCombs School of Business at the University of Texas at Austin that neatly sums up what’s been going on. Because the whole thing lasts about an hour, however, we’ll try to summarise. And we should point out that Spellman’s credentials are pretty impressive. As well as being an acomplished finance academic, he also owns patents that led to the development of the Treasury TIPs securities. He does seem to know what he’s talking about.
So firstly, he says, it’s important to realise we are in a debt deflation crisis (one of Ben Bernanke’s specalist subjects). Second, that there’s always been a major difference in the Fed’s thinking when it comes to QE1 and QE2.
QE1 was ultimately a defensive move designed to put a floor on a major output collapse. QE2 was, however, was always designed as an offensive manoeuvre.
Under QE1, the Fed expanded its balance sheet by taking in Treasuries, as well as a whole bunch of “other” assets, including a major slice of non-performing mortgage debt.
The balance sheet expansion allowed the Fed to achieve one of two critical support functions to the banking industry. It provided banks with much needed liquidity via an expansion of base money.
Measures like Tarp, meanwhile, helped to recapitalise the banks. And both capitalisation and liquidity were essential to keep banks in the business of lending — and with that the floor on the crisis stable.
The problem was, that despite the recapitalisation and liquidity, banks were still not lending due to a general lack of creditworthy customers. No matter how hard the Fed tried to get the money into the spending stream via the banks, it quickly realised it couldn’t.
By 2010, the Fed became aware the US could be approaching a deflationary trap — where top line revenue for companies and individuals begins to decline, meaning the ability to pay off debt declines, extending the recession indefinitely. The weight of past debt simply keeps getting heavier.
Negative inflation thus had to be avoided at all costs.
But with traditional monetary clearly not working any more, how was the Fed to prevent the floor instituted by QE1 and Tarp from caving in?
At Jackson Hole, says Spellman, the Fed decided to do something quite extraordinary. Something they’d never done before — they put their hope in the shadow banking system to get the money into the spending stream instead of the banks.
After all, the reasoning was, inflation is a goods market phenomenon.
Rather than putting the money out to banks to loan, they would put it out to public capital markets in a bid to try to create an asset bubble. This they hoped would a) create a wealth effect and b) raise the price of public securities and reduce the rate for borrowers. In this way some business firms would be able raise capital cheaply enough in the public capital markets to cause them to pass on the money into the wider economy through energy and infrastructure spending.
A major economics 101 fail
But here’s where the story gets funny. Initially QE2 did exactly what it was intended to do. It inflated equities. Private institutions from which the Fed had purchased Treasuries began to put their money directly into the equity market. Stocks went up. Hurrah!
But there were also some unintended and potentially more serious consequences. Firstly, many institutions had no intention of getting riskier. They wanted to allocate the cash exactly the same way they had always done — in safety. Though, idealy, in better-yielding ‘safety’ securities.
According to Spellman, that saw QE2 money flow out in many curious ways. Among them, back into shadow banks and hedge funds, via overnight collateralised repo loans (unsecured lending is dead remember). The hedgies would use these loans to invest in high yielding instruments like junk bonds, emerging market securities (usually corporate) and even distressed peripheral debt. The “prudent” institutions were happy to do this, because it was only ever on a very short-term duration and they received a better return.
On top of all this, one of the most important factors in determining how money flowed was connected to a major monetary misunderstanding due to the way economics has been taught around the world for fifty-plus years.
Due to the quantity of money theory and the overuse of the term “money printing” in economics 101 coursebooks, Spellman says QE2 became synomyous with “money printing”, a fact which radically changed inflation expectations. This suited the Fed fine, since inflation expectations are important in a debt deflation. But arguably, the inflation expectations overshot entirely. (Spellman interestingly blames Bill Gross for fueling much of the inflation hysteria.)
When “prudent” investors, due to an inflationary view, decided to allocate QE2 cash into commodities and other emerging markets, further unintended consequences began to appear.
Unintended consequences
The first unintended consequence was the degree to which inflation was exported out of the United States and into emerging markets and commodities.
The second was the volatility this passed over into the foreign exchange markets — currency wars, capital control fears, and hot money inflows fears being the primary results.
The third was the degree to which all of the above posed a quandry for emerging market countries, torn between allowing currency appreciation and lower exports or domestic asset bubbles, which ultimately ran even more serious risks.
The fourth was the double-tiering of the US economy. Whatever policy route emerging countries took, Americans ultimately ended up paying more for imports whilst prices of domestically produced goods continued to fall.
Debt debacle effect
And that’s about where we were at when the debt debacle kicked off and QE2 finished. Which, as yet, has not been covered by Professor Spellman.
But FT Alphaville’s own interpretation is that this possibly changed everything. Above all it’s probably injected a short sharp shock of realisation into the market that high inflation expectations in an over-leveraged economy are highly unrealistic. The search for safety has now taken new and radical proportions, so much so that negative real inflation rates are once again the key concern of the Fed. But you can read more about that here. And here.
What are the options left now that QE3 is clearly not a viable option? We’ll discuss those in a follow-up post. But we ultimately we see debt deflation being prominently on Ben Bernanke’s mind at Jackson Hole more than anything else.
Related links: Introducing the 2011 deposit crisis "“ FT Alphaville Shadow banking "“ from Giffen goods to Triffin troubles - FT Alphaville The Fed's secret QE equivalent "“ FT Alphaville A Return to the Grand Tetons: Perspective on the Economic Obstacles Ahead - The Spellman Report
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