I’ve had a lot of criticism for QE over the years and its transmission mechanism so I thought I’d offer the opinions of a rather well known economist as a counter to my criticisms. Paul Krugman is one of the few economists who has gotten a lot right over the course of the last 10 years. We don’t entirely agree on the mechanics of the monetary system (just another case of heterodox and neoclassical butting heads on specifics), but many of the big picture themes are in agreement. In this case, we both agree more fiscal is the optimal policy in this environment.
Anyhow, the reason he thinks QE can work here is because it could begin to impact the housing market substantially. In 2011 he originally said:
“Now, what you learned back then was that the transmission mechanism worked largely through housing. Why? Because long-lived investments are very sensitive to interest rates, short-lived investments not so much. If a company is thinking about equipping its employees with smartphones that will be antiques in three years, the interest rate isn’t going to have much bearing on its decision; and a lot of business investment is like that, if not quite that extreme. But houses last a long time and don’t become obsolete (the same is true to some extent for business structures, but in a more limited form). So Fed policy, by moving interest rates, normally exerts its effect mainly through housing.”
In a post over the weekend he added:
“This [housing recovery] means that we actually can hope that the Fed’s new policy will boost housing as well as operating through other channels, and therefore that it can act more like conventional monetary policy in fostering recovery.”
I’m skeptical of this idea. Yes, monetary policy usually works through changing interest rates, but the evidence that QE has substantially altered rates is fairly weak. Again, the Fed is not setting rates here. It is setting quantity and letting price float. That’s why we saw mortgage rates actually rise in most durations last week (yes, real rates declined, but we’ll judge the sustainability and effect of that in the months and quarters to come – during QE2 real personal consumption expenditures declined YoY, for instance, despite the improvement in real rates). Had the Fed come out and said “30 Year Treasury bonds are now 0.5%” you would have seen the curve crater last week and the cost of a mortgage would have substantially declined. Instead, by letting price float they’ve left the cost of mortgages in the hands of the market with the hope that inflation expectations will translate into higher spending – something that hasn’t materialized substantially through QE1, QE2 and Operation Twist.
So, if higher inflation expectations don’t translate into higher spending and incomes then how are higher mortgage rates supposed to help housing recover? They won’t. So the transmission mechanism here still seems broken. And that’s assuming you ignore the fact that we remain in an environment where demand for credit remains incredibly low….
More importantly though, Dr. Krugman says monetary policy is sub-optimal here which I completely agree with:
“That said, I’m still skeptical about whether monetary policy alone can come close to doing enough — a skepticism shared by Ben Bernanke:
So looking at all the different channels of effect, we think it does have impact on the economy, it will have impact on the labor market but as again, the way I would describe it is a meaningful effect, a significant effect but not a panacea, not a solution for the whole issue.
We still need fiscal policy. But it’s good to see the Fed doing more.”
So that’s Krugman, Woodford, Beckworth and myself all agreeing that more fiscal is a good idea even though we all come from different perspectives. So, Congress – anybody home????
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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