by Edward Harrison, Credit Writedowns
OK. I am going to try to churn this post out as a thought piece based on previous work I have done. And since this is a thought piece and not market analysis, I’m going to make this generally available and not behind the newsletter paywall. I have a few threads here to connect so I hope I can do that in a limited space. Excuse me for using lots of technical jargon.
Here’s the lead in:
- QE is not about changes to the real economy. It is an asset swap of financial assets – Treasuries or MBS or what have you for reserves (How Quantitative Easing Really Works).
- Federal Reserve officials have made speeches in the past telling us that QE – in its post QE1 form – was not the Fed’s attempt to provide liquidity to dislocated markets and act as a lender of last resort. Rather, the Fed intended to support economic activity, plain and simple.
- All forms of QE post-QE1 (including Operation Twist, employment targeting, lengthening the zero rate timeframe) are versions of this ‘support economic activity’ paradigm of QE.
- So, with QE, the Fed for one has said point blank that it’s not trying to get at the real economy directly. Instead the Fed really just wants to artificially suppress risk premia in a bid to alter private portfolio preferences.
- This is the Fed’s way of saying that it knows QE is just an asset swap, but that by buying up one asset and selling another, it changes the supply and demand for those and related financial assets in a way that promotes risk and potentially the creation of private credit
- Taking this from an Austrian view on credit cycles, this is a bad thing. The Austrians would say the Fed is amplifying the amplitude of credit risk within the credit cycle by artificially shifting risk and time preferences toward riskier and more roundabout projects for capital investment.
- The Austrian would say this leads to undesirable malinvestment at business cycle troughs when monetary policy normalises. Fed officials would say we need to spur demand and risk-taking because it is ‘artificially’ low due to the post-crisis psychology.
- Now the question is how these portfolio preference shifts actually occur
So that’s the lead. Last night I was talking to some friends of mine about this and my thesis that you need supply and demand side adjustments in a post-credit bubble environment. Keynesians would tell you that its about demand and tell you to use fiscal and monetary policy. Austrians would tell you its about supply and tell you to let market forces adjust them. Post-Keynesians would tell you it’s about demand and tell you to concentrate mostly on fiscal. And market monetarists, in my view, are closet Keynesians telling us its about demand but using monetary policy instead of fiscal. I’m saying it’s about supply and demand and that you need what I would call aggregate demand-supported liquidationism, for lack of a better word.
For example, do you really think there isn’t a huge supply of shadow housing inventory? Seriously. The stocks of home builders are vaulting higher on the premise that this shadow inventory doesn’t exist and we are in a full bore sustainable recovery, with housing at the fore. My view is that the shadow is there but government largesse has added demand by ‘artificially’ suppressing interest rates. If this support were removed, the excess inventory would re-appear. Think of it as a subsidy for homeowners over potential homeowners now renting, sort of like reaching into the renters’ pockets taking money out and giving it to the homeowners. If you had a policy that favoured allowing that shadow inventory to reach the market at so-called market clearing prices, you would work through that inventory and the potential of disaster once policy support was removed would lessen. That’s a supply side problem.
On the other hand, there’s the fact that millions of people are in debt up to their eyeballs, often because of huge mortgage debt. Now, clearly some of those people could default and that would stop their debt problem. But who wants to do that? Most people would rather cut spending and pay down the debt. And since that’s what they are doing, there is a demand problem too. Right now the stress associated with this increased net savings to reduce debt has been attenuated somewhat because government deficits are buoying the economy. Take away that prop and the stress comes back full bore, making the demand side problems become more acute.
Enter QE, this portfolio-preference-shifting asset-swapping wonder that will reduce unemployment, increase asset prices, boost demand and bring back the good ol’ days – no fiscal interventionism necessary! Here’s the problem: how does this actually work. Let’s look at the fictitious bank Financial Rock as an example.
Financial Rock is a simple company with 10 units of capital and 100 units of assets. Its purpose as a bank is to serve the community by making loans and its asset base is a good mix of 73 units of loans, 7 units of reserve balances, and 20 units ofTreasury securities. On the other side of its balance sheet Financial Rock has 70 units of deposits and 20 units of bonds it has issued.
Now, its 2007 and interest rates are high. It’s earning an average of about 6% on its assets while it pays an average around 4% on its deposits and bonds including expenses. It has a whopping 2 units of profit for a return on equity of 20%. Nice.
Now, it’s 2013 and the Fed is keeping rates at zero and is doing QE. People love Financial Rock and it now has 15 units of capital on 150 units of assets. But its balance sheet has changed a lot. See, the demand for credit is weak and the Fed is busy buying up Treasuries. So, now Financial Rock has 80 units of loans, 25 units of Treasury securities and 35 units of reserves. It owes 110 units of deposits and 25 units of bonds.
The problem for Financial Rock is that its ROE sucks. See, the Rock earns only 2.5% on its assets and it pays about 1% on its liabilities, which is a lower spread and the ROE doesn’t come out as nice as a result. All of those excess reserves earning 0.25% kinda suck.
Bottom line: Shareholders are pissed. Financial Rock’s return on equity is punk and people seem to be agitating for a new CEO.
What would you do then?
Would you a. shift your ‘portfolio preferences’ and buy some junk bonds instead of Treasuries; b. lower your standards of which applicants for credit are qualified for loans; or c. keep earning a lower return?
It’s hard to say what happens though I believe it is a combination of all of the above. But the point is that this is the effect QE has. It’s an asset swap. No new net financial assets are introduced into the private sector in contrast to when the government deficit spends and does add new net financial assets. So for it to have all of those seriously beneficial effects everybody says it has, you need it to shift what people are buying and selling and doing in the financial markets and private credit system. Otherwise, it’s not going to work.
P.S. – This quick little blog post is fully consistent with the concept of endogenous money. The increased reserve balances at Financial Rock do not give the bank the ability to make more loans. Banks are not reserve constrained as the central bank targets yields and must supply all the reserves desired at that yield that the private credit system requires based on its loans to so called creditworthy applicant. What we are seeing here is that the excess reserves give the bank an impetus to reach for yield and take on more risk because its return on equity is suppressed by having a larger percentage of its assets earning near zero return.
P.P.S – For investors generally, the impetus to shift portfolios is similar. While I have talked about a bank here, largely to show that QE could shift portfolio preferences at capital-constrained financial institutions and promote financial speculation, you can see the same risk seeking return mentality elsewhere. When nominal yields are low, inflation eats away a lot of the return. This makes the desire to shift portfolios into higher yielding, higher risk assets greater.