Quantitative Easing: Misunderstood by Popular Demand
Here's a video. You've probably seen it already.
I tripped across it some time ago and dismissed it as, well, wrong. When you base your criticisms on elements that are factually inaccurate, you fail. It's as simple as that. Sadly, last night I caught up a bit with my podcast list and heard kmo chatting with Jim Kunstler about the current failings our economy is suffering, and heard once again that video, now spliced as audio into the middle of the podcast. I think Mr. Kunstler understands far better than most why that video is factually inaccurate, but he chose not to address the inconsistencies and instead shared a hearty chuckle.
But understanding the video's failings proves key, for me, to understanding our economy's failings well enough to even attempt thinking about ways to improve things for the future. First and foremost, the video equated quantitative easing as "printing money" and dismissed it as "the last refuge of failed empires and banana republics." This, as I hope to address, need not be the case; but I'll save that for later.
What really got my Fail Sense going was they absolutely equated "the deflation" as "the prices of the things we buy go down." Wrong, wrong, and for the last time wrong! The Federal Reserve does care about price deflation, but has very little in the way of power to combat it. Price deflation is related to what the Fed can affect, monetary deflation, in that when dollars are in short supply people can only afford to spend so much on consumables; when this happens the prices of these consumables decline. Price deflation is therefore a symptom of monetary deflation, just as the speed of a car on the road is a symptom of how much fuel is being delivered to the engine, which itself is a symptom of how much pressure the driver is applying to the accelerator pedal. (More on this analogy in a bit.)
But to simplify our entire economy by saying "the deflation" is "the prices of the things we buy go down" does more to hurt the veracity and therefore the trustworthiness of the video than anything else the video, however valuable, has to offer.
To be fair, much of what the video notes is absolutely true. Quantitative easing is indeed "printing money," as this instructive blog post tries to explain:
Economists - at least some economists - believe that when you want to improve the economy you need to get more money out there, circulating around.
The problem is, there are only a few ways to do this.
I'm going to jump in here and note troubling word choices. My most troubling is the "at least some economists" qualifier. This implies there are those out there who would disagree with this statement, which is true. Ah, but why the scary separation with the dashes? Why not just say quite bluntly "Some economists believe. . . ."? I think readers are savvy enough to know that a divergence of opinion exists in the world. I'll hopefully go into why I think this qualifier is there in a later post.
The second sentence is also troubling, but I'll address that at the end of this post. Continuing:
One way: Have the government spend money by, say, paying people to build roads or install solar panels. That would get money into people's pockets.
But we already did that, with the big stimulus last year - and it's a politically unpopular idea at the moment, so Congress isn't about to do it again.
Option two: The Federal Reserve can cut interest rates, which makes it cheaper to borrow. So people borrow more, buy more, build more new things.
But we already did that, too. The Fed lowered interest rates all the way down to zero. Can't go any lower.
For almost all of modern economic history, policy makers have used those two tools - government spending or Fed interest rate cuts. That's it. But with this financial crisis, for the first time in U.S. history, those two tools won't work.
Enter quantitative easing, an idea the Fed is borrowing from Japan, which used it a decade ago when it had a similar problem.
Me again, jumping in. All of the above is true . . . sort of. The government did offer some limited tax credits to improve the energy efficiency of our society. They also incurred debt to "build roads". I don't think they went far enough, but they did do this. Option one has been tried. It could be tried again, and at a much greater level of involvement, and -- very importantly -- with a different focus; but the piece is also correct that this is "politically unpopular" and therefore unlikely.
Judging option two is more problematic for reasons I've recently mentioned but that haven't been, I believe, even considered by the Planet Money reporters, let alone by chief regulators. For this reason, we must regard their exact phrasing with suspicion. For example, note that they said cutting the Fed prime rate "makes it cheaper to borrow." True; but it makes it cheaper for banks to borrow, not for consumers. Therefore, the following sentence, "So people borrow more, buy more, build more new things," must be regarded as inaccurate. Some people indeed have had their interest rates on home loans and credit cards lowered. Those that could qualify for mortgage refinancing -- ie. people whose homes have not gone "under water" and whose incomes still enable them to attract a bank's attention -- are sitting pretty right now.
But the majority of banking profit comes not from these people but from those teetering on the edge of financial disaster. Those people have not enjoyed the lower rates a cut in the prime rate should have brought. That absolutely should have been noted by the reporters.
When the commercial banks were free to pursue lending that was not "self-liquidating" by merging with investment banks and emphasizing credit card and payday loan debt, the power the Fed had over economic growth diminished. Commercial banks for the first time since the Banking Act of 1933 could legally increase their net worth and therefore their lending power outside the constraints established by the Federal Reserve system; they could become their own lender of last resort as long as the economy was good and investments did not sour. I noted it in that post, but it bears repeating.
At one point in the boom, Greenspan himself tried to slow the growth of money by raising the prime rate just a bit. It didn't have the effect it should have had, probably owing to the easy money speculators could produce from this incestuous relationship between the commercial and investment banks. What did Mr. Greenspan do? Did he make some calls and ask folks why this might be happening? Oh, no. That wouldn't be very libertarian of him, after all. Instead, he scratched his head and decided to let things just happen, without a clue as to what might be causing these anomalies:
"As the historical relationship between measured money supply and spending deteriorated," Greenspan acknowledged, "policy making, seeing no alternative, turned more eclectic and discretionary."
(Thomas Homer-Dixon, The Ingenuity Gap, Alfred A. Knopf, 2000, p. 296.)
"No alternative?!?" Homer-Dixon continues, stating for all what should have been obvious for Greenspan:
Greenspan's remarks on this and other occasions have been disconcerting. He is at the very pinnacle of economic policy-making, and if he doesn't know how the economic system actually functions, who does? Reading his remarks, one gets the sense that the elite policy-makers at the Federal Reserve are standing on constantly shifting ground, and are repeatedly forced to react to situation "in which incoming data have not readily conformed to historical experience." And because they are often unsure which indicators are most important and deserve most attention, they are in a situation a bit like the one (of the struggling cockpit crew in the damaged plane): they are pushed harder -- their cognitive load is greatly increased -- because they must pay attention to a much wider range of factors than they would if they had a better understanding of the economic system.
(Homer-Dixon, ibid.)
Which brings us to actual quantitative easing. As the video states, the Federal Reserve -- actually, the banks that comprise the reserve -- were tasked with buying assets from banks with created money. Back to the Planet Money piece:
It works like this.
A big bank - Bank of America, say - has $50 billion in government bonds. They'd sell those bonds if anyone would pay enough for them, but nobody is willing to pay that much. So the bank just holds on to them.
With quantitative easing, the Fed comes along and says, "Hey, Bank of America, we'll buy those bonds for a little more than anyone else is willing to pay." Bank of America says, "OK, great, send us the money."
This is where the Fed gets to use central-bank magic. They pay for that $50 billion purchase in new money. They just invent it. That's what the Fed - but nobody else - gets to do.
"Nobody else" gets to "invent" money? Really? That needs to be qualified. Yes, the Fed has this power in its role of lender of last resort. Greg Ip of The Economist magazine (sort of) explains:
Without a central bank, private and state-owned banks could issue their own currencies, convertible in theory on demand to gold. In practice, one bank's dollar might be worth more than another's if investors had more faith in its stability.
(Greg Ip, The Little Book of Economics: How the Economy Works in the Real World, John Wiley & Sons, 2010, p. 137, emphasis mine.)
So far, this confirms what I've noted elsewhere. Banks do create money in exchange for assets. The amount they are legally allowed to create is limited by their reserves, by their ratio of good to bad assets. Ip further notes that the Fed is empowered to oversee the actions of individual banks in the country:
The (Federal Reserve Act) said that the Fed's job was to furnish an "elastic currency." This does not mean it's supposed to print $20 bills on spandex; rather, it means expanding and shrinking the money supply as needed. This gives the Fed two powerful roles:
Click to viewI tripped across it some time ago and dismissed it as, well, wrong. When you base your criticisms on elements that are factually inaccurate, you fail. It's as simple as that. Sadly, last night I caught up a bit with my podcast list and heard kmo chatting with Jim Kunstler about the current failings our economy is suffering, and heard once again that video, now spliced as audio into the middle of the podcast. I think Mr. Kunstler understands far better than most why that video is factually inaccurate, but he chose not to address the inconsistencies and instead shared a hearty chuckle.
But understanding the video's failings proves key, for me, to understanding our economy's failings well enough to even attempt thinking about ways to improve things for the future. First and foremost, the video equated quantitative easing as "printing money" and dismissed it as "the last refuge of failed empires and banana republics." This, as I hope to address, need not be the case; but I'll save that for later.
What really got my Fail Sense going was they absolutely equated "the deflation" as "the prices of the things we buy go down." Wrong, wrong, and for the last time wrong! The Federal Reserve does care about price deflation, but has very little in the way of power to combat it. Price deflation is related to what the Fed can affect, monetary deflation, in that when dollars are in short supply people can only afford to spend so much on consumables; when this happens the prices of these consumables decline. Price deflation is therefore a symptom of monetary deflation, just as the speed of a car on the road is a symptom of how much fuel is being delivered to the engine, which itself is a symptom of how much pressure the driver is applying to the accelerator pedal. (More on this analogy in a bit.)
But to simplify our entire economy by saying "the deflation" is "the prices of the things we buy go down" does more to hurt the veracity and therefore the trustworthiness of the video than anything else the video, however valuable, has to offer.
To be fair, much of what the video notes is absolutely true. Quantitative easing is indeed "printing money," as this instructive blog post tries to explain:
Economists - at least some economists - believe that when you want to improve the economy you need to get more money out there, circulating around.
The problem is, there are only a few ways to do this.
I'm going to jump in here and note troubling word choices. My most troubling is the "at least some economists" qualifier. This implies there are those out there who would disagree with this statement, which is true. Ah, but why the scary separation with the dashes? Why not just say quite bluntly "Some economists believe. . . ."? I think readers are savvy enough to know that a divergence of opinion exists in the world. I'll hopefully go into why I think this qualifier is there in a later post.
The second sentence is also troubling, but I'll address that at the end of this post. Continuing:
One way: Have the government spend money by, say, paying people to build roads or install solar panels. That would get money into people's pockets.
But we already did that, with the big stimulus last year - and it's a politically unpopular idea at the moment, so Congress isn't about to do it again.
Option two: The Federal Reserve can cut interest rates, which makes it cheaper to borrow. So people borrow more, buy more, build more new things.
But we already did that, too. The Fed lowered interest rates all the way down to zero. Can't go any lower.
For almost all of modern economic history, policy makers have used those two tools - government spending or Fed interest rate cuts. That's it. But with this financial crisis, for the first time in U.S. history, those two tools won't work.
Enter quantitative easing, an idea the Fed is borrowing from Japan, which used it a decade ago when it had a similar problem.
Me again, jumping in. All of the above is true . . . sort of. The government did offer some limited tax credits to improve the energy efficiency of our society. They also incurred debt to "build roads". I don't think they went far enough, but they did do this. Option one has been tried. It could be tried again, and at a much greater level of involvement, and -- very importantly -- with a different focus; but the piece is also correct that this is "politically unpopular" and therefore unlikely.
Judging option two is more problematic for reasons I've recently mentioned but that haven't been, I believe, even considered by the Planet Money reporters, let alone by chief regulators. For this reason, we must regard their exact phrasing with suspicion. For example, note that they said cutting the Fed prime rate "makes it cheaper to borrow." True; but it makes it cheaper for banks to borrow, not for consumers. Therefore, the following sentence, "So people borrow more, buy more, build more new things," must be regarded as inaccurate. Some people indeed have had their interest rates on home loans and credit cards lowered. Those that could qualify for mortgage refinancing -- ie. people whose homes have not gone "under water" and whose incomes still enable them to attract a bank's attention -- are sitting pretty right now.
But the majority of banking profit comes not from these people but from those teetering on the edge of financial disaster. Those people have not enjoyed the lower rates a cut in the prime rate should have brought. That absolutely should have been noted by the reporters.
When the commercial banks were free to pursue lending that was not "self-liquidating" by merging with investment banks and emphasizing credit card and payday loan debt, the power the Fed had over economic growth diminished. Commercial banks for the first time since the Banking Act of 1933 could legally increase their net worth and therefore their lending power outside the constraints established by the Federal Reserve system; they could become their own lender of last resort as long as the economy was good and investments did not sour. I noted it in that post, but it bears repeating.
At one point in the boom, Greenspan himself tried to slow the growth of money by raising the prime rate just a bit. It didn't have the effect it should have had, probably owing to the easy money speculators could produce from this incestuous relationship between the commercial and investment banks. What did Mr. Greenspan do? Did he make some calls and ask folks why this might be happening? Oh, no. That wouldn't be very libertarian of him, after all. Instead, he scratched his head and decided to let things just happen, without a clue as to what might be causing these anomalies:
"As the historical relationship between measured money supply and spending deteriorated," Greenspan acknowledged, "policy making, seeing no alternative, turned more eclectic and discretionary."
(Thomas Homer-Dixon, The Ingenuity Gap, Alfred A. Knopf, 2000, p. 296.)
"No alternative?!?" Homer-Dixon continues, stating for all what should have been obvious for Greenspan:
Greenspan's remarks on this and other occasions have been disconcerting. He is at the very pinnacle of economic policy-making, and if he doesn't know how the economic system actually functions, who does? Reading his remarks, one gets the sense that the elite policy-makers at the Federal Reserve are standing on constantly shifting ground, and are repeatedly forced to react to situation "in which incoming data have not readily conformed to historical experience." And because they are often unsure which indicators are most important and deserve most attention, they are in a situation a bit like the one (of the struggling cockpit crew in the damaged plane): they are pushed harder -- their cognitive load is greatly increased -- because they must pay attention to a much wider range of factors than they would if they had a better understanding of the economic system.
(Homer-Dixon, ibid.)
Which brings us to actual quantitative easing. As the video states, the Federal Reserve -- actually, the banks that comprise the reserve -- were tasked with buying assets from banks with created money. Back to the Planet Money piece:
It works like this.
A big bank - Bank of America, say - has $50 billion in government bonds. They'd sell those bonds if anyone would pay enough for them, but nobody is willing to pay that much. So the bank just holds on to them.
With quantitative easing, the Fed comes along and says, "Hey, Bank of America, we'll buy those bonds for a little more than anyone else is willing to pay." Bank of America says, "OK, great, send us the money."
This is where the Fed gets to use central-bank magic. They pay for that $50 billion purchase in new money. They just invent it. That's what the Fed - but nobody else - gets to do.
"Nobody else" gets to "invent" money? Really? That needs to be qualified. Yes, the Fed has this power in its role of lender of last resort. Greg Ip of The Economist magazine (sort of) explains:
Without a central bank, private and state-owned banks could issue their own currencies, convertible in theory on demand to gold. In practice, one bank's dollar might be worth more than another's if investors had more faith in its stability.
(Greg Ip, The Little Book of Economics: How the Economy Works in the Real World, John Wiley & Sons, 2010, p. 137, emphasis mine.)
So far, this confirms what I've noted elsewhere. Banks do create money in exchange for assets. The amount they are legally allowed to create is limited by their reserves, by their ratio of good to bad assets. Ip further notes that the Fed is empowered to oversee the actions of individual banks in the country:
The (Federal Reserve Act) said that the Fed's job was to furnish an "elastic currency." This does not mean it's supposed to print $20 bills on spandex; rather, it means expanding and shrinking the money supply as needed. This gives the Fed two powerful roles:
- Lender of Last Resort. A bank that has run out of money to repay its creditors can borrow from the Fed. . . .
- Carrying out Monetary Policy. By manipulating the supply of dollars to banks, the Fed can raise or lower interest rates with the goal of holding down inflation and preventing recessions, a set of responsibilities called monetary policy.
(Ip, ibid., p. 138.)
Elsewhere in his book, Ip notes that the Fed is not a central bank, that it is instead "a politically appointed board in Washington and 12 regional banks" (Ip, ibid, p. 142.) When it came to explaining quantitative easing, however, look what he writes: "When a central bank shifts its focus to expanding its balance sheet through bond purchases rather than targeting short-term interest rates, it is called quantitative easing (Ip, ibid, p. 159, bold emphasis mine.)
Without a central bank, individual banks create money through lending. We in the United States have no central bank. The Fed is empowered to execute quantitative easing, true; it was also created to leaven the effects, the boom and bust cycles, complete autonomy tends to create when individual money lenders/creators work completely in their own interest; but money creation is not the Fed's exclusive power. Ip, however, has fallen in the largely libertarian economist trap of obfuscating our economic system. This continuing obfuscation leads to misunderstandings like the one in the video, misunderstandings that redirect righteous indignation and anger to, perhaps, all the wrong recipients.
So, where should we direct our anger? The video kinda has that one right. Someone in charge of the Fed's decision to purchase securities from "the Goldman Sachs" probably shouldn't be a former employee of that firm. That is just wrong.
Furthermore, wouldn't it make more sense to spend this created money directly into the economy, rather than use it to prop up an individual bank's capital reserves? After all, there is no guarantee the bank will actually lend it. It does society at large no good to see new money rotting in a vault.
Here's where the car's engine analogy from earlier comes into play. Our economic engine is revving, but strangely we aren't going anywhere. Those record profits banks are enjoying show someone, probably the federal government, has their foot firmly on the accelerator, pumping fuel into the engine. Sadly, we have created an economic system where all of the government's money must go through the banks instead of flowing directly to the economy's drive train. For example, take Treasury Bonds, the instruments the federal government uses to "overspend". When federal government spending exceeds tax revenues, the balance is made by selling these bonds, which will be paid back over a fixed period with interest. Remember what Thomas Edison said about this arrangement?
If our nation can issue a dollar bond, it can issue a dollar bill. The element that makes the bond good, makes the bill good also. . . . Both are promises to pay, but one fattens the usurers and the other helps the people. If the currency issued by the Government was no good, then the bonds would be no good either. It is a terrible situation when the Government, to increase the national wealth, must go into debt and submit to ruinous interest charges. . . .
Those banks buy lots of bonds, and are therefore the "usurers" to which Edison referred. Back to the Planet Money post. Both actions described in option one, "paying people to build roads or install solar panels," affect the budget either by forcing bond sales (to pay for road construction) or by lowering revenues (to allow tax credits to pay for panels) that could hasten a bond's repayment. Both are therefore interest bearing in ways that enrich the bond holders and impoverish the taxpayers. Quantitative easing does exactly the same thing only more directly, paying banks with real cash for assets of questionable value.
Why not cut out the middleman? Why not put our economy in gear, as it were, by putting the power, the quantitative easing-created dollars, directly into stimulus spending? As long as the projects created by this money were of value to society -- upgrading rail, replacing aging infrastructure like schools and firehouses -- and not monstrous mistakes (like The Maginot Line), there would be no negative effects such as those experienced when "failed empires and banana republics" use printed money without restraint to simply excuse a government whose spending is completely out of control.
Let me give this some emphasis: Any project that would have been funded through interest-bearing debt incurred by the taxpayer can be more efficiently funded through a quantitative easing-style mechanism, and for less money to the taxpayer.
Benjamin Franklin did this. Abraham Lincoln did this. Spending with created money can work. It will probably not happen anytime soon, though.
There are too many barriers to consideration -- misunderstandings, misinformation, and obfuscation -- currently in place, forcing our economy's engine to rev while we as a society roll backwards. A commenter to kmo's post summed it up nicely: "The [job of] people at Goldman Sachs . . . is to make money, not make moral decisions for the betterment of society and it seems to me that those who give their money to that industry do so primarily because they expect a profit."
As long as profit remains the over-riding concern of monetary policy, there can be no change. And as long as Planet Money and other reporters insist that there are only a limited number of ways to improve the situation -- by failing to consider other ways, even if they impinge on their sponsor's right towards profit -- no one will be the wiser.
When Alan Greenspan didn't follow the mandate of his office and investigate why traditionally effective tools used by the Fed, such as raising interest rates, no longer seem efficacious, I guess I should grant NPR reporters, popular economy authors and YouTube publishers the same forgiveness. I should . . . but I can't.
We need the facts. We need them now.