QE ∞

The Keynesians and Monetarists who have so berated the Federal Reserve and demanded more asset purchases and a nominal GDP target to get GDP level up to the long-term growth trend have essentially got their wish.

This is a radical departure:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.  In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

I tweeted this earlier in favour of the idea that the Fed would adopt open-ended asset purchases:

Those who didn’t anticipate the possibility of open-ended asset purchases should have looked much more closely at Bernanke’s words at Jackson Hole:

If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of large scale asset purchases may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.

Essentially, this is nominal GDP level targeting. The reason why Bernanke has framed it in terms of lowering unemployment is that his mandate relates to price stability and unemployment, not nominal GDP level. But as Bernanke himself noted in his academic days:

Estimates based on data from more recent years give about a 2% decrease in output for every 1% increase in unemployment.

To those who accept Okun’s Law, raising nominal GDP level and lowering unemployment are effectively the same thing. Bernanke seems to believe unemployment will fall in a (roughly) linear fashion as asset purchases increase. By itself, this is a problematic assumption as the past is not an ideal guide to the future.

Yet more importantly the data shows no real job recovery in the post-2008 quantitatively-eased world. This is the prime-age employment-population ratio:

And even if unemployment falls without triggering large-scale inflation as per the Fed’s design, this is no cure for the significant long-term challenges that America faces.

As I wrote back in November 2011, when nominal GDP targeting was just appearing on the horizon America faces far greater challenges than can be solved with a monetary injection. Financial fragility, moral hazard, energy dependency, resource dependency, deindustrialisation, excessive private debt, crumbling infrastructure, fiscal uncertainty, and a world-policeman complex. The underlying problems are not ones that Bernanke really has power to address.

And how long before rising food prices cause more riots and revolutions? After, all handing over more firepower to speculators tends to result in increased speculation.

Meanwhile, US creditors and dollar-holders (particularly China) would seem from past comments to be deeply unhappy with this decision.

President Hu Jintao:

The monetary policy of the United States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level.

The dollars they accrued will lose purchasing power to every new dollar printed and handed over to the American banks in exchange for mortgage backed securities. The Chinese perspective on this will be that Bernanke is essentially engaging in theft. On the other hand, they should have considered this likelihood before they went about accruing a humungous pile of fiat dollars that can be duplicated at a press of a button. No, matter; China won’t get burnt like this again.

As PBOC official Zhang Jianhua noted:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

Chances of future trade and currency wars between the United States and China seem to be rising as fast as Chinese gold accruals.

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Inflationeering

As BusinessWeek asked way back in 2005 before the bubble burst:

Wondering why inflation figures are so tame when real estate prices are soaring? There is a simple explanation: the Consumer Price Index factors in rising rents, not rising home prices.

Are we really getting a true reading on inflation when home price appreciation isn’t added into the mix? I think not.

I find the idea that house price appreciation and depreciation is not factored into inflation figures stunning. For most people it’s their single biggest lifetime expenditure, and for many today mortgage payments are their single biggest monthly expenditure. And rental prices (which are substituted for house prices) are a bad proxy. While house prices have fallen far from their mid-00s peak, rents have continued to increase:

Statisticians in Britain are looking to plug the hole. From the BBC:

A new measure of inflation is being proposed by the Office for National Statistics (ONS).

It wants to create a version of the Consumer Prices Index that includes housing costs, to be called CPIH.

The ONS wants to counteract criticisms that the main weakness of the CPI is that it does not reflect many costs of being a house owner, which make up 10% of people’s average spending.

While a welcome development (and probably even more welcome on the other side of the Atlantic) it doesn’t make up for the fact that the explosive price increases during the boom years were never included. And it isn’t just real estate — equities was another market that massively inflated without being counted in official inflation statistics. It would have been simple at the time to calculate the effective inflation rate with these components included. A wiser economist than Greenspan might have at least paid attention to such information and tightened monetary policy to prevent the incipient bubbles from overheating.

Of course, with inflation statistics calculated in the way they are (price changes to an overall basket of retail goods) there will always be a fight over what to include and what not to include.

A better approach is to include everything. Murray Rothbard defined inflation simply as any increase to the money supply; if the money is printed, it is inflation. This is a very interesting idea, because it can reflect things like bubble reinflation that are often obscured in official data. The Fed has tripled the monetary base since 2008, but this increase in the monetary base has been offset against the various effects of the 2008 crash, which triggered huge price falls in housing and equities which were only stanched when the money printing started.

Critics of the Austrian approach might say that it does not take into account how money is used, but simply how much money there is. An alternative approach which takes into account all economic activity is nominal GDP targeting, whereby monetary policy either tightens or loosens to achieve a nominal GDP target. If the nominal target is 1%, and GDP is growing at 7%, monetary policy will tighten toward 1% nominal growth. If GDP is growing at a negative rate (say -2%), then the Fed will print and buy assets ’til nominal GDP is growing at 1%. While most of the proponents of this approach today tend to be disgruntled Keynesians like Charles Evans who advocate a consistent growth rate of around 5% (which right now would of course necessitate the Fed to print big and buy a lot of assets, probably starting with equities and REITs), a lower nominal GDP target — of say, 1% or 2% — would certainly be a better approach to the Fed’s supposed price stability mandate than the frankly absurd and disturbing status quo of using CPI, which will always be bent and distorted by what is included or not included. And for the last 40 years monetary policy would have been much, much tighter even if the Fed had been pursuing the widely-cited 5% nominal GDP target.

I don’t think CPI can be fixed. It is just too easy to mismeasure inflation that way. Do statisticians really have the expertise to determine which inflations to count and which to ignore? No; I don’t think they do. Statisticians will try, and by including things like house prices it is certainly an improvement. But if we want to be realistic, we must use a measure that reflects the entire economy.

Krugman’s Inflation Target

The Keynesian blogosphere is up in arms at Ben Bernanke’s response to Krugman’s view that he should pursue a higher inflation target as a debt erasure mechanism.

According to Chairman Bernanke:

We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four, five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.

Krugman responded:

This is not at all the tone of Bernanke’s Japan analysis; remember, Japan had nowhere near as high unemployment as we do, and his analysis back then was not simply focused on ending deflation.

Disappointing stuff.

The basic Keynesian logic is as follows:

The economy is performing far below its potential, due to an ongoing slump in aggregate demand caused by a contraction of confidence. Simply, there is plenty of money, but far too many people are risk averse and thus are not spending (and thus creating economic activity) but instead just holding onto their money. The Fed should ease some more, so as to create inflation that turns holding cash into a risk, and so encourage investment and consumption. What’s more, residual debt overhang is a burden on the economy, and additional inflation would decrease the relative value of  debts, giving some relief to debtors.

Matthew O’Brien presented this chart to make the case that output is far below its potential:


I am deeply sceptical that GDP is a sufficient measure of output, and I am even more sceptical that the algorithmic jiggerypokery involved in calculating what the Federal Reserve calls “Potential Nominal GDP” has anything whatever to do with the economy’s real potential output. But I will accept that — based on the heightened unemployment, as well as industrial output being roughly where it was ten years ago — that potential output is far below where it could be, and that the total debt overhang at above 300% of GDP is excessive.

The presupposition I really have a problem with, though, is the notion that this is a problem with hoarding:

Simply, the United States is a consumption-driven economy. And that isn’t so much of a fact as it is a problem. More and more money is going toward consumption, and less and less is going toward investment in companies, in ideas and in businesses. Exemplifying this, less and less money — even in spite of the Fed’s “pro-risk” policies (QE, QE2, ZIRP, etc) is going into domestic equities:

The fundamental problem at the heart of this is that the Fed is trying to encourage risk taking by making it difficult to allow small-scale market participants from amassing the capital necessary to take risk. That’s why we’re seeing domestic equity outflows. And so the only people with the apparatus to invest and create jobs are large institutions, banks and corporations, which they are patently not doing.

Would more easing convince them to do that? Probably not. If you’re a multinational corporation with access to foreign markets where input costs are significantly cheaper, why would you invest in the expensive, over-regulated American market other than to offload the products you’ve manufactured abroad?

As Zero Hedge noted:

In the period 2009-2011, America’s largest multinational companies: those who benefit the most from the public sector increasing its debt/GDP to the most since WWII, or just over 100% and rapidly rising, and thus those who should return the favor by hiring American workers, have instead hired three times as many foreigners as they have hired US workers.

So will (even deeper) negative real rates cause money to start flowing? Probably — but probably mostly abroad — so probably without the benefits of domestic investment and job creation.

Then there is the notion that inflation will effect debt erasure. This chart tends to suggest that at least for government debt it may not make much difference:

There’s no real correlation between government debt erasure and high inflation.

Paul Donovan of UBS explains:

The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them. In the real world, of course, governments roll over their debt on a very frequent basis.

Consumer debt may also not experience significant erasure.

From Naked Capitalism:

Inflation only reduces debt overhang in a significant way for households who are fortunate enough to see their nominal wages rise along with the general rise in prices. In today’s economy, workers are frequently not so fortunate.

The deeper reality though, is that even if my concerns are unfounded and Krugman is correct, and that a higher inflation target would achieve precisely what Krugman desires, I don’t think it would solve the broader problems in the economy.

As I wrote in November:

The problem is that most of the problems inherent in America and the West are non-monetary. For a start, America is dependent on oil, much of which is imported — oil necessary for agriculture, industry, transport, etc, and America is therefore highly vulnerable to oil shocks and oil price fluctuations. Second, America destroys huge chunks of its productive capital policing the world, and engaging in war and “liberal interventionism”. Third, America ships even more capital overseas, into the dollar hoards of Arab oil-mongers, and Chinese manufacturers who supply America with a heck of a lot. Fourth, as Krugman and DeLong would readily admit, American infrastructure, education, and basic research has been weakened by decades of under-investment (in my view, the capital lost to military adventurism, etc, has had a lot to do with this).

In light of these real world problems, at best all that monetary policy can do is kick the can, in the hope of giving society and governments more time to address the underlying challenges of the 21st Century. When a central bank pumps, metrics (e.g. GDP and unemployment) can recover, but with the huge underlying challenges like the ones we face, a transitory money-printing-driven spike will in no way be enough to address the structural and systemic problems, which most likely will soon rear their ugly heads again, triggering yet more monetary and financial woe.

On the other hand, it would be interesting to see Bernanke go the whole hog and adopt a fully-blown Krugmanite monetary policy, just to see Krugman’s ideas get blown out of the water by the cold, dark hand of falsification.

Of course, there was an opportunity to achieve debt erasure in 2008, when the world faced a default cascade and a credit collapse. Had economists and planners let the system liquidate, a huge portion of bad debt and bad companies and systems would have been erased, and — after a period of pain — we might well be well into a new phase of organic self-sustaining growth. But we live in a different world; where zombie systems, companies and their assets are preserved by government bailouts and interference, and very serious people like Paul Krugman earnestly push dubious solutions to problems that their very interventionist worldview created.

Did Cameron Just Kill the Euro?

I find it hard these days to praise any establishment political figure. Too often their actions are devoid of principle, too often their words are hollow, and too often their demeanour smacks of a rank ignorance on matters of economics and liberty.

And undoubtedly, Cameron’s austerity policies are not sound. As I have noted in the past, the time for austerity at the treasury is the boom, not the slump.

But today David Cameron seems to have bucked that trend.

From the BBC:

David Cameron has refused to join an EU financial crisis accord after 10 hours of negotiations in Brussels.

Mr Cameron said it was not in Britain’s interest “so I didn’t sign up to it”.

But France’s President Sarkozy said his “unacceptable” demands for exemptions over financial services blocked the chance of a full treaty.

Britain and Hungary look set to stay outside the accord, with Sweden and the Czech Republic having to consult their parliaments on it.

A full accord of all 27 EU members “wasn’t possible, given the position of our British friends,” President Sarkozy said.

There is an obvious fact here: scrabbling to reach an agreement in the interests of political and economic stability — which is exactly the path Japan has taken for the past 20 years, and America for the past 3 — allows broken systems to continue to be broken. All this achieves is more time to address the underlying issues, which as we are discovering is something that does not happen, because markets and policy makers fool themselves into believing that the problems have been “solved”, and that there is “recovery”.

Cameron’s intransigence could well be the spark that Europe — and perhaps even the globe — needs to degenerate to the point where the necessary action — specifically, some kind of debt jubilee — can occur.

QE Infinity

A lot of hot air has shot about the internet about nominal GDP targeting, the brainchild of Scott Sumner.

Some (including the usual suspect) have said that it’s Bernanke’s next big bazooka in the (ahem) “war on economic instability“.

What the growing recognition for nominal GDP targeting reflects is a wider awakening to something I have been talking about for a long time: Irving Fisher’s theory of debt deflation. When monetary circulation drops, prices tend to drop and nominal debts tend to become much harder to repay. Therefore, the nominal value of those debts rises: workers and businesses have to produce more to pay down debts. Inevitably, this leads to more defaults. This can lead to what I (and a few others) have termed a “default cascade” — one set of large defaults leads to deflation, leading more defaults, and eventually resulting in systemic failure.

Nominal GDP targeting gives the Federal Reserve the scope to buy assets until they hit a nominal GDP target, ensuring that no such debt deflation will occur. It is — in my opinion — the most powerful monetary tool yet-imagined for reinflating burst bubbles.

As Scott Sumner puts it:

Now why is Nominal GDP so important? That’s the total dollar value of income in the economy. And if you think about it, most debts are contracted in nominal terms. So in a sense, the economy’s dollar income is a good metric for measuring people’s ability to repay these previously contracted nominal debts.

QE was — in terms of reinflating bubbles — a blunt weapon. It shot off an arbitrary amount of newly-printed/digitally-created money, with the explicit target of lowering net interest rates (and the implicit bonus of combating debt deflation). Nominal GDP targeting flips this on its head.

The problem is that this focus on monetary means will not solve the larger systemic economic problems that America and the Western world face.

As I wrote yesterday:

The problem is that most of the problems inherent in America and the West are non-monetary. For a start, America is dependent on oil, much of which is imported — oil necessary for agriculture, industry, transport, etc, and America is therefore highly vulnerable to oil shocks and oil price fluctuations. Second, America destroys huge chunks of its productive capital policing the world, and engaging in war and “liberal interventionism”. Third, America ships even more capital overseas, into the dollar hoards of Arab oil-mongers, and Chinese manufacturers who supply America with a heck of a lot. Fourth, as Krugman and DeLong would readily admit, American infrastructure, education, and basic research has been weakened by decades of under-investment (in my view, the capital lost to military adventurism, etc, has had a lot to do with this).

In light of these real world problems, at best all that monetary policy can do is kick the can, in the hope of giving society and governments more time to address the underlying challenges of the 21st Century. When a central bank pumps, metrics (e.g. GDP and unemployment) can recover, under normal circumstances that is great. But with underlying challenges like the ones we face, a transitory money-printing-driven spike is often not enough to address the structural problems, and these problems soon cause more monetary and financial woe.

What I can say about nominal GDP targeting is that it is probably the best monetary tool for buying more time. But that is completely and totally useless if America fails to address the real problems in the mean time, and assumes that the energy, military and social problems (e.g. zombification) that are the real cause of long-term economic woe will just disappear.

A larger problem is that this “solution” will probably do more (by duplicating their dollar holdings) to annoy America’s creditors, including China and Russia, who have significant scope to cause America real economic problems through a trade war.