I’ve cited Hoisington in the past due to their knowledge of how our monetary system actually functions (a rarity on Wall Street unfortunately). Unlike most commentators, who believe QE is inherently inflationary “money printing” Hoisington actually understands this fairly simple procedure that Ben Bernanke has convinced us is some sort of cure-all:
“The monetary base, bank reserves plus currency, does not fulfill these functions and hence does not constitute money. To paraphrase Friedman and Schwartz, the base, which is also known as highpowered money (currency in the hands of the public and assets of banks held in the form of vault cash or deposits at Federal Reserve Banks) cannot meet these criteria. The nonbank public – nonfinancial corporations, state and local governments and households – cannot use deposits at the Federal Reserve Bank to effectuate transactions. Moreover, currency is not sufficiently broad to be considered a temporary abode of purchasing power. For Friedman, high-powered money can be properly regarded asassets of some individuals and liabilities of none.
So, let us be clear on this subject. In 2008, when the fed purchased all manner of securities, to the tune of about $1.2 trillion, the fed was not “printing money”. Bank deposits at the fed exploded to the upside, the monetary base rose from $800 billion to $2.1 trillion, yet no money was “printed”. Deposits did not rise, loans were not made, income was not lifted, and output did not surge. The fed could further “quantative ease” and purchase another $1 trillion in securities and lift the monetary base by a similar amount yet money would still not be “printed”.
That’s an important paragraph. Go back and read it again. QE does not involve the creation of net new financial assets. It does not boost lending, it does not boost output, it does not boost incomes. Yet, Ben & Co. appear to have convinced a significant portion of the population otherwise. I know I’ve hammered on this topic for the last few weeks, but I continue to read about “money printing” and all the other inflationary impacts of QE from market commentators who simply do not understand what QE actually is and how it actually works. Since this is THE single most important market factor currently it’s important that investors not be herded up to the trough of the Federal Reserve where Mr. Bernanke feeds them half truths and misguided policy responses.
In their most recent letter (which I highly recommend reading in its entirety) Lacy Hunt and Van Hoisington describe why QE is likely to fail:
Another Failed Attempt–QE2
“The flaccid nature of this business recovery should serve notice that economic conditions are far more precarious than generally understood. Federal Reserve forecasts were obviously flawed and have now been significantly lowered since they placed great emphasis on the presumed stimulative power of massive deficit spending and numerous aggressive monetary actions. The Fed is contemplating another round of quantitative easing (QE2) because the weakness of the economy has surprised them. They are feeling the political pressure to act, even though the problems facing the economy are not related to monetary policies.
The Fed’s position seems to be that more of the same economic policies are needed, even though they have failed to produce the advertised results. As microeconomist Steven Levitt (author of Freakonomics) documented, conventional wisdom is generally flawed since it fails to ask the right question about economic problems. We view the Fed’s econometric model as the personification of conventional wisdom.
For instance, as a result of QE1 the banks are holding close to $1 trillion of excess reserves. The important question is why are banks unwilling to put these essentially zero earning reserves to work. Either the banks: 1) are not in a position to put additional capital at risk because their balance sheets are shaky; 2) are continuing to experience large write-downs on commercial and residential mortgages, as well as on a wide variety of other loans; or 3) customers may not have the balance sheet capacity or the need to take on additional debt. They could also see no expansionary prospects, or fear an uncertain regulatory future. In other words, no viable outlets exist for banks to loan funds.
A parallel situation exists in the corporate sector. Non-bank corporations are sitting on huge cash reserves. In the past two quarters liquid assets amounted to 7% of total assets, the highest level since 1963 (Chart 2). This cash reflects a lack of compelling uses for the funds, as well as the need to hedge against risks, including those of dealing with potential vulnerable counter-parties. The fact that substantial bank and corporate funds remain idle is a strong signal that U.S. economic problems exist outside the monetary sphere.”
This is superb analysis. What we can see here is that QE1 essentially did nothing for the real economy. Well, that’s not entirely true. It altered bank balance sheets and helped unclog credit channels and that was an important confidence builder and a necessary move to get the economy functioning smoothly again. For this, I applaud Mr. Bernanke. However, in terms of generating sustained economic recovery QE1 can be seen as an utter failure. After all, we wouldn’t be discussing QE2 if it had succeeded the first time around. Hoisington continues by succinctly summarizing why QE2 will ultimately fail:
“The problem with the U.S. economy is fourfold: 1) The economy is grossly overleveraged, with many asset prices falling; 2) fiscal policy is counter-productive and debilitating to economic growth as government expenditure multipliers are near zero; 3) proposed tax increases are already curtailing economic activity and tax multipliers approach -3%; and 4) increased bureaucracy with many new and yet unwritten regulations from the Dodd-Frank bill, along with health care regulations, make business planning nearly impossible.
With existing excess liquidity in banks and companies, and the above-mentioned key economic problems, it should be clear that QE2 and the purchases of additional assets by the Fed will, like previous purchases in QE1, serve only to bloat excess reserves without advancing income, spending, or jobs. From this point in the cycle, for QE2 to generate expansion, money growth and therefore debt levels would have to rise.
According to economist Hyman Minsky, there are three phases of credit extension: hedge finance, speculative finance, and Ponzi finance. In view of the extremely leveraged conditions, additional credit would be almost exclusively of the Ponzi finance variety – loans with no reasonable prospect of repayment. Indeed, Ponzi finance appears to typify the bulk of the loans being made by the Federal Housing Authority to unqualified home buyers, replicating the practices underwritten by FNMA and Freddie Mac during the heyday of the sub-prime lending extravaganza whose consequences linger. But, for the purpose of argument let’s assume that with additional excess reserves the banks lend to other potential Ponzi-like borrowers. This could lead to an increase in the money supply, but the net result may still not stimulate faster growth in GDP because velocity would fall, as it did from 1997 to 2007 (Chart 3).”
The Velocity Impediment
“For a rise in excess reserves to boost GDP, two conditions must be met. First, the money multiplier must become stable. Second, the velocity of money must not decline. The second condition is not likely in view of the theory and history of velocity. Velocity is primarily determined by the following: 1) financial innovation; 2) leverage, provided that the debt is for worthwhile projects and the borrowing is not of the Ponzi finance variety; and 3) numerous volatile short-term considerations.
Since 1900, M2 velocity has averaged 1.67, and has demonstrated distinct mean reverting tendencies (Chart 3). Velocity has been declining irregularly since Ponzi finance took over in the late 1990s. For leverage to lead to an expansion of velocity the loans must meet the requirement of hedge finance, i.e., where there is a reasonable expectation that the borrower can repay both principal and interest.
Fundamentally, the secular prospects for velocity have not improved even though velocity recovered by 2.1% in the past four quarters. This marginal uptick in velocity reflected an assist in federal spending along with the unparalleled recovery in inventory investment discussed previously. Without the gain in these two GDP components, velocity was unchanged over the past four quarters (Table 1).”
That’s not all though. Hoisington actually believes the program could ultimately be detrimental to the economy:
“The Fed’s adoption of QE2 may lead to severe unintended consequences. There are two possibilities: 1) QE2 does manage to temporarily improve GDP via continued overleveraging of the economy with non-repayable loans, 2) QE2 goes into the history’s dustbin of failed projects, along with QE1, cash for clunkers, tax credits for first time home buyers, and other numerous failed attempts to boost the economy with rebate checks.
For QE2 to work, a renewed borrowing and lending cycle must take place, resulting in a further leveraging of the already highly overleveraged U.S. economy. Such additional leverage would not be beneficial since increasing indebtedness from these levels ultimately leads to economic deterioration, systemic risk, and in the normative case, deflation, as documented by Rinehart and Rogoff in their book, This Time Is Different. Therefore, at best QE2 can be nothing more than a short-term panacea exacerbating the serious structural problems already facing the United States.
Thus, we believe that QE2 is an ill advised program that offers little prospect of boosting economic activity. If the program achieves success, any gains in economic activity will be for a very limited period of time with major risks that any short-term gain will be swamped by incalculably high costs in the future. These unknown, questionable experiments in monetary policy are being made to correct problems that are clearly of a non-monetary nature.”
QE – just another wasteful government program….
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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