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Wednesday, June 26, 2013

The Failure of Quantative Easing

by Michael Roberts

Just a couple of months ago, mainstream economic analysts were lauding the record high stock market prices as an indicator that the global capitalist economy was well on the way to recovery, thanks to the efforts of central bankers like Ben Bernanke at the US Federal Reserve in applying ‘unconventional’ monetary policy called quantitative easing (QE) to boost liquidity and keep interest rates near zero.  In various posts, I have queried both the likelihood that the stock market boom would continue and that QE had been effective in restoring economic growth (see my post, http://thenextrecession.wordpress.com/2013/03/30/its-still-a-bear-market/).

Well, in the last month stock markets have turned.  In just 23 working days, the FTSE 100 lost 846 points, collapsing from 6,875 on 22 May to 6,029.10 23 June.  And bond markets have also tanked, with the yield on US 10-year Treasuries rising from 2.2% last week to 2.61%, a massive 0.41 percentage points rise in just four working days.  This reversal has been mirrored across the globe.  Chinese stocks sank to a four-year low, pulling most other Asian markets lower.  In Brazil, the price of 30-year dollar bonds is down by 26% since the start of last month.   The rise in UK 10-year gilts has now reversed the entire drop since the start of QE2 in October 2011.  The previous euphoria has given way to a degree of pessimism.
CS Risk Appetite Index

Some leading mainstream economists are perplexed.  Tyler Cowan, a leading neo-classical economists pointed out that Keynesian guru, Paul Krugman had said in 2011 that:  ” Like Bernanke, I don’t believe that the flow of Fed purchases has been an important factor holding bond rates down, and hence don’t believe that they will jump when the purchases end.”  Cowan goes on:  “I was of the same opinion.  It no longer seems this is true.  We’ve had a significant runup in rates fro mere talk about slowing down Fed purchases.”

It all turned pear-shaped last week after Ben Bernanke stated that QE was now over – or to be more accurate that the buying up of US government debt by the Fed through the ‘printing of money’ was to be gradually reduced (‘tapering’, it is called) by as early as September and ended completely next year.  The reaction of the financial markets confirms that the stock market boom since the trough of the Great Recession in mid-2009 has been driven, not by a sustained recovery in the main capitalist economies, but by the sharp rise in profits (at least in the US) while wages have been held down; and the blowing up of a new credit bubble by central banks (the Fed, the BoE and more recently, the Bank of Japan). 

With the threat that the credit taps are to be turned down, financial markets melted.

The Keynesians are panicking.  For them, the Great Recession was caused by a ‘lack of effective demand’ and made worse by the policy of ‘austerity’ adopted by most governments.  So they argue that cutting off the liquidity tap when governments are continuing to apply ‘fiscal austerity’ will just push the main capitalist economies back into recession.  As Gavyn Davies, former chief economist at Goldman Sachs, advisor to the previous New Labour government in the UK and now a columnist for the FT put it:  “There are two risks with the Fed’s exit plan. The first, raised by Paul Krugman and other Keynesian economists, is that it sends a premature signal to the world economy that the central banks will tighten before the private sector recovery has achieved escape velocity. This has happened before: the Fed made this error in 1937-8 and the Bank of Japan in 2006. … The US recovery might peter out, taking the global economy down with it.  The second danger, in sharp contrast, is that the Fed has left it too late to bring market exposures under control, in which case the unwinding might take bond yields and credit spreads much higher than economic fundamentals seem to justify. In the famous phrase of Warren Buffett, the legendary investor, we only discover who is swimming naked when the tide goes out. Higher bond yields would spell danger for the financial system – and would mean rising mortgage rates at a time when the US housing market is only just starting to recover.”  So we are either going back into recession or heading for another financial bust.  Better to keep QE going, then.

In contrast, the Austerians argue that Bernanke has left it too late to ‘normalise’ monetary policy and may find that the credit bubble has got out of hand and now that he intends very gradually to ‘exit’ his QE measures, he will cause another slump anyway.  For them, the Great Recession was caused by ‘too much’ credit that had to be reined in.  In its latest annual report (BIS annual report 2013), the central bankers association, the Bank for International Settlements (BIS) argues that quantitative easing and ultra-low rates have failed to restore economic growth and instead have stoked up new levels of debt that could eventually plunge the world economy into a new financial crisis.  The BIS points out that the debt of households, non-financial corporations and governments has increased as a share of GDP in most large advanced and emerging countries since the crisis. In a sample of 18 countries – including the US, UK, China, India, Japan and the big Eurozone nations – this debt surged by $33 trillion between 2007 and 2012, up 20% of GDP.  Central banks now own a chunk of this new debt, equivalent to about 25% in advanced economies and 40% in emerging economies – from $10.4 trillion in 2007 to $20.5 trillion now.   If the value of these assets start to plunge as they have done this month, the central banks and governments will start to make significant losses.

The Keynesians are really angry at the BIS.  Krugman called those at the BIS “Dead-enders in Dark Suits”.  Krugman railed: “The Bank for International Settlements is the central bankers’ central bank; accordingly, it tends to exhibit the prejudices of the tribe in especially concentrated form. In particular, it has been relentless in making the case for higher interest rates, on the grounds that … well, the logic keeps changing. For a while it was warning about inflation and commodity prices; when the inflation failed to materialize and commodity prices slumped again, it simply changed the argument to one against bubbles, plus the quite amazing argument that central bankers must not keep rates low because that would take the fiscal pressure off governments. Who, exactly, elected these people to run the world?”

Krugman attacks the BIS idea that large private and public sector debt will inhibit economic recovery in a capitalist economy.  He argues that the evidence for this has been trashed after the scandal of the Reinhart and Rogoff study apparently proving that high debt restricts growth as having been exposed as full of errors and misleading analysis.  Actually, it is not quite as cut and dried as Krugman and other Keynesians make out (see my post Revising the two RRs, http://thenextrecession.wordpress.com/2013/04/17/revising-the-two-rrs/).  And contrary to what Krugman says, the BIS report is well aware of the RR controversy and thus cites other reports to back its case, if somewhat disingenuously.  But Krugman’s main argument is the one that he has promoted for some time: that more debt is not a problem when a capitalist economy is in a slump engendered by a ‘liquidity trap’.  And anyway, the debt has risen because austerity has cut economic growth.  What is needed is more QE, not less until the economy recovers through  increased demand from consumers and businesses.

Our own British Keynesian guru, Simon Wren-Lewis, in his blog takes a similar line on the BIS, (The intellectual bankruptcy of the austerians).  “It is both amusing and tragic to watch the advocates of fiscal austerity try and deal with the fact that the thin intellectual foundations for their approach have crumbled away, while at the same time the empirical evidence of their folly accumulates. … The BIS says reducing government debt is good for long term growth. But because there are long run benefits to reducing government debt, must it be the case that the sooner we start the better? No. Exercise is good for you, but you don’t start when you are down with the flu”.

The Keynesians are right that QE has not caused inflation in economies that are on their knees.  But the Austerians are right that QE has not enabled the major economies to recover either.  Instead all QE has done is support a stock market boom and stimulate yet another credit bubble that now looks likely to burst if the drug of QE is withdrawn.  The Keynesians answer that by saying that QE is not enough and what the economy needs alongside easy money is more fiscal spending, financed preferably by more borrowing.  The Austerians say that such borrowing is also a hostage to fortune and it will hold back recovery.  The Marxists would say that the Keynesians are wrong if they think QE and fiscal spending will restore sustained economic growth if there is not a recovery in profitability.  And the Austerians are wrong if they think cutting government spending, particularly government investment is going to help.  Relying on the free market has been a hopeless failure too.
(see my posts, http://thenextrecession.wordpress.com/2012/06/13/keynes-the-profits-equation-and-the-marxist-multiplier/ and http://thenextrecession.wordpress.com/2013/01/13/multiplying-multipliers/ and http://thenextrecession.wordpress.com/2012/09/30/can-austerity-work/).

The reality is that, although the business sectors in many major capitalist economies are flush with cash, investment is not taking place, while consumers are saving or paying down debt rather than spending in the shops.   What is clear from the last month is that QE has failed.  As I have argued before, you can take horses to the water fount but you cannot make them drink (see my post, http://thenextrecession.wordpress.com/2013/03/04/you-cant-make-a-horse-drink-2/).

QE is based on the idea that if you throw money at banks they will lend. But banks only lend if the risk versus return profile is in their favour. At the moment, banks don’t want to lend, because their balance sheets are a mess.  QE is based on the idea that if you make borrowing ridiculously cheap for corporates (i.e. throw money at them) they will invest. But corporates only borrow to invest if the risk versus return profile is in their favour. At the moment they don’t want to invest, because the economic outlook is very uncertain and profitable investment opportunities look few. Instead, large companies prefer to speculate in the stock market or pay out dividends while borrowing is so cheap.  Small and medium-size businesses are much more dependent on bank lending, but they are living in a financial desert.

This is the problem with the plan of Japan’s government to introduce a massive QE programme of buying government and corporate debt with the aim of driving up inflation and getting the economy going
(see my posts, http://thenextrecession.wordpress.com/2013/04/05/kurodas-triple-whammy/
and http://thenextrecession.wordpress.com/2013/06/11/abenomics-a-keynesian-neoliberal/).

Ironically, those economists who support QE and easy money argue that it will not engender inflation as the BIS and the Austerians fear.  But if that is right, then Japan’s ‘Abenomics’ wont work!  As one economist put it: “Not one QE programme has ever generated significant inflation. Not one. In fact no central bank in history has ever succeeded in deliberately creating inflation. It’s magical thinking.  When banks aren’t lending and corporates aren’t borrowing to invest, QE does not affect the wider economy in any very helpful way: its effects if anything are contractionary, because of the hit to aggregate demand for some groups caused by the depression of interest rates on savings.”

Mainstream Keynesian, Brad de Long concluded: “that Bernanke’s monetary policy has failed to raise inflation demonstrates that Bernanke’s policies have failed.“  Yet de Long clings to the hope that this won’t be the case for Abenomics:  “I tend to say that they have failed because they were tried only half-heartedly, and confusedly. And if Abenomics succeeds, I will regard that as strongly confirmed.”

Some hope.

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