Thursday, July 25, 2013

All That Is Solid Melts in the Air: The End of the Quantitative Easing (QE) Policy in the United States



In early 2010 when Bernanke came out to announce QE2, our main concern was the future impacts on inflation, assuming that QE meant an increase in base money due to an increase in M1. However, we were all wrong. Bernanke and the US Fed did not implement the so-called ‘traditional’ QE, the one we have observed in U.K. or Japan. In both countries, QE works through the purchase of long term bonds and the sale of money supply in its mostly liquid form – what we call M1. 

In contrast, the United States Central Bank decided to take the risk free route. The US QE (except for Q1, that lasts from October 2008 – through mid 2009) basically is a tool to shift expectations without producing, by its own actions, any real effects. This means that on the one hand the Fed purchases (QE2 and QE3) securities (with amounts and durations previously announced) and on the other hand it takes that extra M1 out of circulation by paying commercial banks interest rates on excess reserves. In turn, the extra amount of money going into the system is withdrawn because banks would rather lend at 0.25% to the Fed than lend to the public at a similar rate with the chance of not being paid back.

But then readers will ask: so why is the Fed doing such policy? In our view, this is the safest policy one can ever implement. The ‘classic’ quantitative easing policy carries lots of negative impacts. It may produce growth but at a cost of greater future inflation in the future. Besides, if the Central Bank keeps the securities up to maturity it means it is monetizing the debt. And, unless the system is under a depression with deflation, deficit monetization is highly inflationary.

To his credit, Bernanke is by far the most knowledgeable scholar on previous QE experiences. However, the ongoing US QE has never been implemented elsewhere before. The point we are trying to make is that the Fed is trying with the ‘unconventional QE’ to influence expectations. In other words, the growth registered in the US since 2009, the decrease in unemployment, the improvement in industrial production and the greater consumption has been highly influenced by the Fed’s policy. This means that when such policy indeed comes to an end it is possible that we observe a reversal of the ongoing recover. A policy that is solely based on expectations is not capable to produce long lasting real effects. The end is near, however, not because of unemployment (that is resilient and almost not influenced by expectations) but mostly due to core inflation that has already reached 2%. As Bernanke recently explained the 2% is a threshold, not a trigger. So, they may bear high inflation and low growth when ‘unconventional QE’ comes to an end.

A very powerful lesson from Economics is one that says: “there is no such a thing as a free lunch”. Maybe it is attributed to Friedman but the fact is that all economic decisions involve a trade-off. In the ‘unconventional QE’ policy there is no trade off. It is a win-win situation. This is so because the US QE has been able to produce growth without leading to too much inflation. It is also true that the US is the only country, on earth, that even with the greatest financial crisis of the 21st century has been able to display positive growth rates since 2010. It remains to be seen if such performance will sustainable without producing inflation or high unemployment. 

We should not dare to challenge economic theory. Trade-offs will continue to exist till the end of times. Hence, some type of trade off will occur in the US economy. The Fed could have chosen to bear the costs (hence the trade-off) in the early days when QE was first introduced, like Japan and UK. But it chose to postpone. Hence, what we may observe in a very near future is an increase in inflation, a decrease in growth with unemployment unable to achieve levels lower than the current ones (around 7%). In brief, the US QE is what Marx & Engels and later Marshall Berman coined ‘all that is solid melts in the air’ in an allusion about the contradictions of capitalism and the fact that it had lost its ways.