January 9th, 2011
in Op Ed
by John Lounsbury
Federal Reserve Bank Vice Chairman Janet Yellen gave a lengthy speech in Denver Saturday discussing the monetary policies of the Fed in response to the financial crisis and The Great Recession. She discussed many aspects of the economy but, most interesting to this analyst, was what she had to say about the expanded balance sheet of the Federal reserve, currently more than $2.4 trillion, which is headed into the stratosphere somewhere above $3 trillion in 2011. Follow up:
Here is the news summary of the Yellen speech:
Econintersect: Denver, January 8, 2011 - Federal Reserve Vice Chairman Janet Yellen defended the central bank’s asset purchases, saying they will ultimately result in increasing private payroll jobs by 3 million. See graph below for effects of QE2 only. She said the purchases have prevented the country from slipping into deflation.
“Inflation is currently a percentage point higher than would have been the case,” Yellen said in a speech Saturday, January 8 in Denver. “In the absence of such purchases, the economy would now be close to deflation.” Text of the speech is available from the Federal Reserve.
The process of asset purchases falls under the technical name "qunatitative easing" (QE). The Fed creates additional dollars for the purpose of purchasing assets, such as MBS (mortgage backed securities) and U.S. Treasury securities. The objective is to supply liquidity when private sources of capital have dries up because of contracting (and defaulting) debt. The Fed completed a QE process in early 2010 that totaled $1.7 trillion and announced a second round, QE2, in the fall of 2010, which will amount to $600 billion upon completion later this year. Some call the process "printing money". Fed officials have called the process "creating credit".
The above description is rather broad brush. A more detailed description of QE is available at The New York Times.
Some economists have objected to QE2 by arguing that there has been an increase in structural unemployment that is not amenable to government intervention. Other critics say the Fed is risking future inflation by vastly increasing the quantity of reserves that banks hold at the central bank. Still other critics say the Fed’s new strategy might generate future financial imbalances like the housing bubble that peaked in 2006. A fourth line of criticism says that the Fed will hamper growth in foreign economies by driving down the value of the dollar.
Critics, both domestic (often political) and foreign (primarily governments), have suggested that QE has incumbent problems:
- Creates inflation risk because increased reserves at the central bank might unleash an uncontrolled flurry of lending.
- Establish conditions for a new asset bubble like the housing bubble of the early 2000s.
- Fail to address the major economic issue of unemployment, which, critics say, is structural and not cyclical.
- Produce leakage of liquidity into other countries where there are high inflation pressures that would flare further with more dollars as fuel.
Economists are divided on these issues because there are conflicting "theories" on monetary policy. The area with the most unanimity is that the risk of dollar devaluation is real, an idea supported even by some Fed governors.
Yellen gave a detailed accounting of the benefits the central bank sees from its November decision to start a second round of asset buying, adding her voice to a defense of the policy by Chairman Ben S. Bernanke and the FOMC. Yellen responded to criticisms (above) by saying,
"...net private capital flows to Latin American and Asian EMEs (reported as a share of the aggregate GDP of those EMEs) were substantial in the second half of 2009 and the first half of 2010 but were not obviously outsized compared with levels prior to the crisis."
See her graph, below.
Yellen dismissed concerns that inflation will flare up, saying weak labor demand will be helpful in “mitigating the risk” and the Fed can “tighten policy when needed” by increasing the interest rate it pays on excess bank reserves. Yellen spoke at the Allied Social Science Associations annual meeting in Denver.
Source: Speech transcript from the Federal Reserve.
Here we go into the world of counterfactual argument again. Show me the jobs! Show me the proof that deflation would have occurred!
The demands above are rhetorical. If you don't have a control sample to compare to, then the proposition that a monetary policy action did or didn't do something is an argument based on whatever assumptions are chosen. Those assumptions and those arguments constitute the counterfactual, which is the substitute (and generally a poor one) for experimental control.
A couple of months ago, Steve Hansen discussed QE2 as a double edged sword which touches on some of the points that Yellen covered. Mike Shedlock has posted (at Mish) a particularly scathing criticism of Yellen's projections. Ah yes, the problem with counterfactuals.
But something that Mish uses as a focus of his argument caused me to go back and look at the speech transcript. Here is what Mish wrote:
Now Janet Yellen thinks the Fed is going to create 3 million jobs by the end of this year. Let's do that math, too. 3 million divided by 12 is 250,000 jobs a month. Does anyone believe that?
I certainly don't believe that. If the recovery strengthens and we do average 225,000 a month job growth this year, I don't believe that can be attributed to QE. And certainly not all of the job growth should be so attributed.
However, I can't find where Yellen is forecasting 3 million aditional jobs in 2011. Here is what I find in the transcript:
I (Yellen) would also like to note that the same research paper analyzed the macroeconomic effects of the FOMC's full program of securities purchases, including the first round of purchases that was initiated in late 2008 and early 2009, the modification of the reinvestment policy that was announced last August, and the second round of purchases that was initiated in November. Those simulation results indicate that by 2012, the full program of securities purchases will have raised private payroll employment by about 3 million jobs.
She is attributing the 3 million jobs over a period of three years (2009, 2010 and 2011) if you interpret "by 2012" to mean the beginning of that year, or four years if the she means the end of the year.
Of those 3 million, she says that Fed research indicates that QE2 will add 700,000 jobs. From the first graph in the news summary, it appears that the bulk of these will appear in 2011. The implication is that 2.3 million jobs exist right now that would not otherwise as a result of the first series of QE actions.
So Mish overstates his case regarding effects of QE on employment in 2011. Spreading 700,000 jobs added over 12 months is 58,000 a month, actually less than the measurement error of BLS and ADP measurement processes. So, tracking this effect monthly will be nearly impossible; only when the year is nearly over can the question can be revisited.
Finally, Mish does an interesting job of summarizing employment improvement claims of the Fed and the administration. Using the numbers he has tabulated, here is a list of the claimed employment improvements:
- 2.3 million from QE (3 million total - 700k yet to come)
- 3.5 million from stimulus actions
This is a total of 5.8 million jobs that now exist that wouldn't exist if the fiscal and monetary actions taken over the past 2 1/4 years had not been done - if you believe the estimates, that is. Mish has done a good job of detailing some of the numbers and I won't repeat here all that he has already done. However, I will tell you what the end result would be if you assume the counterfactual implication:
- Non-farm payrolls for December, 2010 would be 124.9 million (reported 130.7 m)
- Total employment for December, 2010 would be 133.4 million (reported 133.4 m)
- Unemployment rate (assuming same labor force) 13.2% (reported 9.4%)
My numbers differ from Mish only that I have not included the 700k added employment which I interpret is yet to come and he did include.
So the point is not whether Mish (or my rehash of his numbers) is correct. The point is that we will never know who is correct. This entire economic policy morass is encumbered with lack of experimental control. There is no way to know if the claims of the Fed and the government are realistic or inflated (or even understated). Unemployment levels of 13.2% or worse are not impossible; we have been there before in The Great Depression. Would we have gone there this time? I challenge anyone to prove the case one way or the other. And I mean prove, which excludes modeling and hypothetical counterfactuals.
My challenge is not likley to be taken up by anyone who understands the concept of proof.