Before QE2 began, I was one of a handful of people who said it would do nothing for the economy and could in fact cause a margin squeeze as cost push inflation generated lower real GDP. This was exactly what happened and for a brief moment, the mainstream media appeared to accept this reality, but they have more recently reverted back to believing the standard myths that surround the policy of quantitative easing. Clearly, the misunderstandings continue and they continue even at the very highest levels. Even Goldman Sachs appears to believe QE could fix the economy if it’s just tried harder (never mind that they were fantastically wrong about QE2 as the program added exactly no growth compared to their 0.5% estimate)…..
One of the few firms who has maintained a fairly sound understanding of the program’s effects is Hoisington Management. In their latest economic outlook Hoisington elaborates on the recent effects of monetary policy:
“Although many measures of economic performance worsened during QE2, the Fed might argue that the recent M2 acceleration may eventually contribute to an improvement in economic growth as deposit growth fuels income expansion. In our opinion, such an optimistic assessment is not warranted.
In the past three months, M2 increased at a rapid annualized pace of more than 20%, and the annual increase in M2 is about 10%, well above the post 1900 average annual increase of 6.6%. This rise in M2, however, appears to reflect a massive balance sheet shift of assets, not a net creation of new assets. Theoretically, if funds are switched from non-M2 assets into M2 assets, M2 velocity would decline and bank loans plus commercial paper would be stable.
This is exactly what has been happening. After peaking at 1.69 in the second quarter of 2010, M2 velocity declined for four consecutive quarters, and we estimate that a major contraction in velocity to 1.59 is likely for the third quarter (Chart 3). Also supporting this idea of asset shifting, bank loans plus commercial paper in September totaled $7.845 trillion, down from $7.906 trillion in June 2010.
In an environment where short-term interest rates are close to zero, commercial paper has become an increasingly unattractive investment since the low interest rates do not cover the risk premium. As commercial paper has rolled off, issuers have been forced to meet funding requirements from bank loans. However, there are other balance sheet changes taking place along with the shift away from commercial paper. With the credit rating of major European banks sliding, companies operating globally may have moved euro-based deposits into dollar-based ones. Supporting this hypothesis, the dollar strengthened during this surge in M2. Economic stresses and uncertainty are responsible for the increased level of M2, not QE2. The real impact of QE2 was that inflation was boosted and real economic growth stunted.”
It amazes me that QE3 is still a viable policy option despite the clear cut evidence that it did nothing to help the economy. If it’s such a panacea then why are we even bothering with this discussion in the midst of a downturn in growth? Nonetheless, momentum builds for the QE3. I hope you enjoy my mundane QE posts. There’s a good chance I will have to regurgitate and vomit up a lot of my past work…..Bad myths are hard to kill…..
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.