Pragmatic Capitalism

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There’s still a lot of confusion over QE and its actual economic impact despite some pretty clear-cut evidence about what the policy does.  A brief recap might help.

Just to be clear – QE in the USA does not work by “funding” the spending of the US government.  I know this is a rather unorthodox perspective, but the government does not have trouble funding itself since it can theoretically print the money it spends. But we have to be clear about the risk here – the government doesn’t “run out of money”. But it could cause a currency or inflation crisis. In a low inflation environment there is no need to assume that the government cannot “finance” its spending. Therefore, the fact that the Fed is buying bonds should not be viewed as a funding operation because the demand for bonds would be strong regardless of the Fed’s intervention (because inflation is low).  It is instead a form of standard monetary operations similar to what the Fed does with the overnight interest rate at the short end of the curve.

The keys to understanding QE is in the following points:

  • Because the USA is sovereign in the US Dollar, the government is always able to procure funds.  In a low inflation environment the demand for bonds will be high regardless of the Fed’s intervention. Therefore, the idea that QE is monetization is a myth.  Rather, QE serves as an interest rate operation that serves to lower long-term rates in a manner very similar to the way monetary policy works at the short-end of the curve.   See this article for more.
  • QE in Europe can actually “work” because it is essentially a form of fiscal policy that actually helps to fund the countries in Europe (or at least help them avoid losing funding).  This would be like the Federal Reserve buying municipal bonds from states in distress who can’t find Federal funding (this would essentially be a form of fiscal policy and would be “money printing”).
  • QE in the form of buying back government debt is not “money printing” or “monetizing the debt”.  It is a swap or a change in the composition of private sector financial assets.  No net new financial assets are being added.  The private sector gets reserves, the Fed takes the bonds.  The net loss is in the difference in interest income.  But the private sector is not left with “more money”.
  • Banks never lend reserves so more reserves don’t mean more lending.  Loans create deposits.  The money multiplier is a myth.  This is why QE1 and QE2 did not cause a surge in loans or inflation.
  • The wealth effect in equities is a myth.  The flaw in QE is that it reduces the number of specific securities so it can force investors out of one asset and into another.  This can drive up prices, but does not necessarily drive up the fundamentals.  It’s not unlike a stock buyback and its immediate effects which drive up price, but have no impact on the underlying corporation.
  • The portfolio rebalancing effect of QE can cause substantial disequilibrium in the economy.  We saw this in QE2 when I repeatedly predicted that QE was causing an imbalance in bond and commodity prices.  And when the air came out of that 2010 nearly turned into a nightmare….

If you still have questions on QE I would consult this more detailed primer.

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