The Case for Unwinding QE

  • Ben Bernanke, former Chairman of the Federal Reserve, says in his new book that it took “moral courage” to embark on the path of quantitative easing. I suppose that history will be the judge of that statement. What is clear, seven years later, is that the Fed’s failure to reverse QE does not represent an act of courage, but rather a lack of courage.
  • Quantitative easing (“QE”) is, without doubt, the most controversial of all monetary policy programs conducted by the Federal Reserve in its one hundred year history. This week we will consider the benefits and the costs associated with reversing such an unprecedented and aggressive program of monetary base expansion.
  • While the near-term costs of reducing the monetary base may seem to outweigh the benefits, there is a terrible risk associated with the path of inaction. If the Federal Reserve fails to act, then the Fed risks losing not only its credibility, but any significant control over economic outcomes.
  • In many ways, the decision by the Fed to reduce the monetary base is similar to the decision that many of us might face when we think about returning to the gym after a period of long absence. It may be tough to get back on the treadmill after weeks of inactivity, but most of us understand that the benefits are worth it. Moreover, the long-term risks of not any taking action are, quite frankly, unacceptable.
  • Reversing quantitative easing is a good step for the long-term health of the economy. Capitalism, just like the human body, works best when it is constantly being tested. When the capital markets are working efficiently, good ideas thrive, while bad ideas are quickly discarded. By removing the trillions of excess capital that have flooded the global markets, both debt and equity markets can once again begin to send the right price signals to investors and entrepreneurs.
  • However, getting back into a regular exercise routine is tough. Similarly, removing a couple of trillion dollars from global financial markets is not going to be easy. There will be inevitable negative consequences in both the financial economy (a fall in the value of most financial assets) and the real economy (recession and higher unemployment), consequences that will make it politically difficult for the Fed to persist.
  • Nevertheless, while reversing quantitative easing will be no walk in the park for the global economy, the alternative is much worse. If the Fed fails to reduce the monetary base, then high levels of inflation will return. In a world overburdened with both private and public sector debt, a return of high inflation would have terrible consequences on the ability of the West to maintain current levels of leverage and, consequently, the global economy.

What is Courage?

Courage is the mental or moral strength to act in the face of fear and difficulty. Last week, Ben Bernanke claimed that it took “moral courage” to embark upon the path of quantitative easing. While it may have taken a certain intellectual “conviction” to commence quantitative easing, it is not clear that it took great “courage” to embark upon a program that the markets, and the public more generally, welcomed with open arms.

In contrast, reversing quantitative easing and reducing the bloated balance sheet of the Federal Reserve will require an act of great courage.

Let’s be clear on this point. In late 2008/early 2009, when the financial markets were in turmoil, the public-at-large, Wall Street and most politicians demanded that the Fed take dramatic action. With the Fed funds rate sitting already sitting at an extraordinarily low level (the fed funds rate was 1% at the time the depths of the crisis hit), the Fed had backed itself into a corner. It had little choice but to attempt something new.

Consequently, it didn’t take an act of “courage” to do something new and drastic in early 2009. However, this isn’t to say that it wasn’t the right thing to do: the first round of quantitative easing (QE1) represented a novel approach to crisis management and, at least in my personal opinion, it was an appropriate response in the circumstances at that time. Arguably, the most important mandate of the Fed, a role that is far more important than aggregate demand management, is “crisis control”. In early 2009, the Bernanke team did what had to be done. But it could hardly be described as an act of great courage.

Courage, in the political sense, is having the intellectual and moral strength to do the right thing in the face of tremendous opposition. It didn’t take great political courage to embark upon the path of QE, but it will take great political courage to substantially reverse QE.

In order to understand why there will be great opposition to any reversal of QE, we need to think about the impact that QE has had on both the markets and the economy. The best way to do this is to put the trillions of dollars created by QE into context.

Benefits and Costs of Unwinding QE

A few months ago I wrote a post titled “2015: A Happy New Year for Markets?” which attempted to highlight the incredible scale of the Fed’s quantitative easing program. The $4 trillion that has been created and “invested” in the global markets by the Federal Reserve over the last six-year period is an astonishing sum.

It is hard for most people to put this amount of money into context, but here is one example. If we assume that every car in America was bought with cash (no loans, no leases), then the American public would have to give up all new purchases of cars for six years in order to save and invest the same amount of money that the Federal Reserve has created and invested in the markets. You can see the math behind this in the original post mentioned above.

With this example in mind, it isn’t hard to see how the Fed’s actions have created a massive distortion in capital markets. In the normal course of business, the $4 trillion created by the Fed and invested in fixed income securities would need to be saved by American consumers, a process that would have created a severe economic recession. As the Federal Reserve bought government bonds (and limited amounts of other fixed income securities), this lowered the expected rate of return across all investment classes (government bonds, corporate bonds, listed equities, private equity, etc.), pushing yields to record lows and equities to record highs.

As you might imagine, just an incoming tide will lift all boats, so an outgoing tide will lower all boats. The problem is that there are a lot of people sitting in boats that are going to hit the rocks as the tide goes out. And this brings us to our first key point: it is going to be very difficult politically for the Federal Reserve to reverse quantitative easing.

By lowering expected rates of return across all assets, the Federal Reserve has induced a boom in global financial markets and a recovery, albeit sluggish, in the global economy, particularly in those sectors leveraged to cheap money (the shale oil industry is a great example of this).

However, not only does this process work in reverse, but it will probably follow a more volatile path. As the Federal Reserve sells the bonds on its balance sheet, someone has to buy them. At the margin, this means that someone has to sell corporate debt and equities to buy government bonds. If lots of people try to do this at the same time, then it is very easy for prices of these securities to adjust rapidly in order for equilibrium to be restored.

Aside from the very real potential of a market crash, reversing quantitative easing will have a short-term negative effect on the real economy (jobs etc.). As the cost of capital rises across the economy, new business projects will stall and many businesses that have survived on cheap debt and equity funding (shale oil, early-stage biotech, etc.) will suddenly find themselves with few backers.

Clearly, this doesn’t sound like a great scenario. So why should the Fed reverse quantitative easing?

First, let’s consider the benefits of reversing QE and then we can consider the long-term costs associated with a failure to reverse.

The key benefit from reversing QE is simple, but surprisingly difficult for most people to grasp. The long-term health of any society depends upon the efficient allocation of its scarce resources. Quantitative easing distorts the markets and removing this distortion is a good thing for our society.

While this point should be obvious to an educated person, there are many in the political classes who don’t seem to understand this important principle.

In a small tribal economy, the survival of everyone in that tribe depends upon the efficient use of the scarce resources. If people waste time gathering food that won’t store or making tools that the community doesn’t need, then this will imperil the ability of that small community to get through the tough times.

While the dynamics of a modern industrialized economy are much more complex, the principle is the same. Our society has limited resources and for our society to grow and prosper it must allocate all these resources to the right economic activities. This process begins in the capital markets: the markets for equity and debt securities need to send the right signals in order for everyone in our society to make sensible decisions about consumption, saving and investment.

A reversal of QE will remove much of the “froth” that currently exists in global capital markets, thereby enabling these markets to do their job more effectively.

This may sound like a bad deal: an economic recession and a fall in asset values all for the sake of “efficient capital markets”. Why should we as a society choose this path short-term pain?

The answer is simple: long-term gain.

We can use the analogy of returning to a regular exercise routing after a long absence. For most of us, running on the treadmill isn’t a lot of fun. “Rewarding” perhaps, but not “fun”. So why do we do it? The answer is that we trade off short-term pain for long-term gain. By physically stressing our bodies today, we prepare them for the challenges they face in the years ahead.

We can say the same for our society. By getting back on the treadmill of free market capitalism (and let’s face it, it is a treadmill and the experience is often not that “fun”), we prepare ourselves for the challenges that our society will face in the future. If we start making the right decisions today, then we don’t have reverse poor decisions in the future. Furthermore, the longer we put off making the right choices, the harder it will be when we have to.

Avoiding the Unthinkable

So far we have considered the benefits and costs of unwinding QE. But what happens if the Fed chooses not to unwind QE? Is there a happy ending?

The short answer is “no”.

But before we get into a discussion of economic theory, let’s return to our simple analogy and think about what happens when we keep avoiding regular exercise and a healthy lifestyle.

In the short-term, it doesn’t make much difference whether you get back the gym or not. You may start to notice that you are a little out of breath walking up the stairs at work or maybe the belt needs to be let out one notch.

However, in the long-term, it makes a very noticeable difference. More importantly, the “long-term” can suddenly and very painfully catch up with us (diabetes, heart attack, etc.)

Failure to return to a regular exercise routine probably won’t lead to disaster overnight, but it dramatically increases the risk of a whole series of outcomes that are “unthinkable”.

Similarly, central bank intervention will not lead to disaster overnight: thoughtful and temporary intervention by the central bank in capital markets will often make sense, particularly in a time of crisis. But if markets become addicted to central bank intervention, then it dramatically increases the risk of a whole series of “unthinkable” economic outcomes.

The best of these bad outcomes is a return of high inflation.

Many economies can sustain relatively high rates of inflation (5%-15% per annum) without a dramatic collapse in real economic activity or investment. In some ways, this type of inflation is the type 2 diabetes of economic life: you can live with it, but it isn’t great.

However, inflation can create very poor economic outcomes if coupled with other pre-existing economic conditions (just as diabetes can create very poor health outcomes if coupled with other pre-existing medical conditions). Most notably, economies that have become increasingly addicted to very low nominal interest rates and credit expansion are very vulnerable to even a modest increase in the rate of inflation.

So, why will inflation return if the Fed fails to reverse quantitative easing?

There are two ways to answer this question: there is a simple answer and a more complex answer.

The simple answer is that, in the long run, the quantity theory of money works. Over long periods of time, an increase in the monetary base that is in excess of an increase in real output, will lead to a corresponding increase in the price level.

This shouldn’t be a controversial point. The long-term empirical relationship between the “base money/real output” ratio and the price level has been extensively documented and discussed. While economists have developed many different theories regarding inflation (cost push, demand pull, output gap, inflation expectations, etc.), the only theory that has clear empirical support for explaining the long-term evolution of prices is the quantity theory of money.

Recently, many commentators seem to have become comfortable either ignoring quantity theory or dismissing it outright. It is very easy to fall into this trap because quantity theory does not hold in the short-term. For example, in the United States, the massive increase in the monetary base has not resulted in any inflation (at least not yet!).

Unfortunately, most commentators don’t understand the role of expectations in determining the value of money and, consequently, the price level.

The view of The Money Enigma is that the value money depends primarily upon expectations of the long-term (20-30 year) path of the “real output/base money” ratio.

Despite the massive increase in the monetary base, the markets still believe that QE is a temporary phenomenon. In other words, the markets expect that the Federal Reserve will reduce the monetary base over the next few years. Moreover, markets remain optimistic about long-term economic growth in the US, despite the threat of this reduction in the monetary base.

However, if the markets begin to doubt the Fed’s commitment to reducing the monetary base, or if the markets become more pessimistic about long-term growth in the US, then the value of the US Dollar could decline sharply and the price level could rise rapidly.

Why does the value of money depend upon distant future expectations regarding the size of the monetary base relative to real output? Those readers who are interested in the answer to this question should read “Money as the Equity of Society”.

In short, the view of The Money Enigma is that money is a proportional claim on the future output of society. Just as common stock is a proportional claim on the future cash flows of a business, so money is a special-form equity instrument that represents a proportional claim on the future cash flows of society.

We can use this concept to create a valuation model for money. The absolute market value of money (the market value of money as measured in terms of a standard unit for the measure of market value) depends upon the discounted future benefits that the marginal unit of money is expected to bring. The valuation model for money highlighted below suggests that the market value of money is positively correlated with long-term expectations of real output and negatively correlated with long-term expectations of base money.

Value of Money and Long Term Expectations

In simple terms, the value of a fiat currency depends upon the expected long-term prosperity of the society that issues it. Currently, the markets are very optimistic regarding the long-term prospects of the United States. But if the Fed blinks and that faith is tested, then the value of money could decline quickly, leading to a return of inflation.

On a final note, there is one more compelling reason for the Fed to unwind quantitative easing: the magician always needs to keep something up their sleeve.

If the US economy was to plunge into recession today, what could the Fed do? Increase the monetary base by a further $4 trillion? At some point, the markets will realize that the Fed is out of bullets (or at least one’s that work). At this point, the value of money will collapse, inflation will return and the Fed will lose any control over economic outcomes. This is the “unthinkable” and a scenario that none us want to experience.

In summary, The Fed needs to act now. It’s time to get back on the treadmill. If we don’t choose to do it now, we will only be forced to do it later.