Credit Suisse was out with an interesting piece of research earlier this week describing the merits of quantitative easing. As we previously detailed, QE is ineffective in times of a balance sheet recession, however, CS notes 5 different ways that QE can work (according to them). Let’s take a look at each:
“QE works via five routes:
(1) It pushes up asset prices (holders of government bonds or other bonds have cash and are forced to make an asset allocation decision in an environment where real bond yields are artificially low). Indeed, Charlie Bean, Bank of England Deputy Governor, highlighted that this was the key rationale behind the MPC’s QE in 2009.”
This is an arguable point. In a deflation investors will drive bond prices higher regardless. This, in theory, will make equities more attractive, however, a case study in Japan debunks this thinking as equity prices continued to decline regardless of the move lower in yields. I have argued that QE has inherent deflationary tendencies as we remove an interest bearing asset from the private sector and replace it with cash which could actually put downward pressure on prices as a whole.
“(2) The rise in asset prices has a wealth effect on the consumer and corporates (it becomes more expensive for corporates to buy, so they build!);”
This goes back to the old cash on the sidelines argument. Companies don’t build just for the sake of building. They build when there is demand for some particular goods and/or services. John Hussman has debunked this more than a few times in recent weeks. The problems in the US economy remain demand side problems. Companies will not build just for the sake of building something.
(3) Lower real bond yields/ credit spreads help to improve housing affordability;
There is almost no evidence showing that lower interest rates will spur the housing market in this environment. Japan is Exhibit A, however, we’re seeing similar evidence here in the US. Since interest rates peaked in 2007 the real estate market has plummeted. Despite a full 2% decline in mortgage rates existing home sales have fallen 27% while housing prices have fallen 30%. I would argue that interest rates are a small factor in the current housing outlook (see my full outlook for important details).
“(4) Low bond yields give governments more discretion on fiscal policy and might encourage a looser fiscal policy (as otherwise they might be forced into premature tightening by high and rising bond yields)-it is worth noting that in the last 3 weeks the US have de facto eased fiscal policy slightly as a result of lower bond yields (we saw $32bn of further unemployment benefit being renewed and more recently $26bn of help to states/local governments);”
The argument that low interest rates are an effective government refinancing is simply not true. As the sovereign issuer of currency the US government can always fund its interest payments on bonds. Government spending is not a function of bond markets. In fact, it is the opposite. The bond market is a monetary tool that the Fed uses to control the overnight rate which is done by controlling excess reserves in the banking system. The US government did not spend more because borrowing rates declined. The government spent more because it decided that there were idle resources worthy of expenditures (the effectiveness of said spending is highly debatable and for another discussion, however, for this discussion I believe CS has the cause and effect entirely wrong). Low interest rates do not make spending more affordable just like high interest rates did not restrain Ronald Reagan from running high deficits in the 80′s.
“(5) Weaker currency. A weaker dollar in effect will export US monetary policy (if the Yen were to for example strengthen dramatically further, then the BoJ would probably resort to more aggressive QE).”
First off, the BoJ realized many years ago that QE was an exercise in futility (they have said so themselves). Second, there is no reason why QE should result in a weaker currency as the Fed is not creating net new financial assets via this policy. The currency argument is an extension of the inflationist misconception regarding QE and as we saw in Japan, is simply not true.
Credit Suisse is one step ahead of me, however, and says Japan is not an applicable example:
“In Japan’s case, we believe QE did not work because it was very late (it happened four years after deflation started) and also not sufficiently bold. Our Japan economist, Hiromichi Shirakawa, believes that buying JGBs did little to affect price expectations and that the BoJ needed to buy risk assets such as property-related securities, bad loans or equities. We have always thought that the end game to the current situation was an extended period of low real bond yields. If real bond yields in the US are zero, then fiscal tightening of 4% of GDP is required to stabilise government debt to GDP (assuming a normal economic recovery). If real rates are 3%, then fiscal tightening of 7% of GDP is required.”
I believe CS misses the whole point here. In times of a balance sheet recession the problems exist on the demand side, not the supply side. Adding more apples to the shelves does not change consumer behavior. QE did not work in Japan because the private sector was deeply indebted and there was no demand for debt. Therefore, adding reserves to the banking system did not influence private sector demand for debt.
As I have maintained (and the BoJ concluded several years ago) quantitative easing (and monetary policy in general) is highly ineffective at a time when the private sector is paying down debts. In my opinion, QE remains the most overhyped non-event in recent history.
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