Yardeni via Mauldin on QE2:
Why QE Doesn’t Work
By Ed Yardeni
BULLET POINTS: (1) Fed study buries textbook money multiplier. (2) The Treasury’s lap dog. (3) Kohn’s exit speech admits Fed is clueless. (4) In 1988, Bernanke questioned money multiplier model. (5) The fiscal multiplier is also baloney. (6) The administration’s stimulators are jumping ship. (7) Profitable companies, not bloated governments, create jobs. (8) No double dips in Earnings Month. (9) Double dip in consumer sentiment. (10) No recovery in housing industry.
I) MULTIPLIERS: Wow, there are Existentialists at the Fed! Two economists, Seth B. Carpenter and Selva Demiralp, recently posted a discussion paper on the Federal Reserve Board’s website, titled “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” (See link below.) The authors note that bank reserves increased dramatically since the start of the financial crisis. Reserves are up a staggering 2,173% from $47.3bn on September 10, 2008, just before the financial crisis began, to $1.1tn now. Yet M2 is up only 11.4% since September 10, 2008, and bank loans are down $140.2bn. The textbook money multiplier model predicts that money growth and bank lending should have soared along with reserves, stimulating economic activity and boosting inflation. The Fed study concluded that “if the level of reserves is expected to have an impact on the economy, it seems unlikely that a standard multiplier story will explain the effect.”
That not only repudiates the textbook money multiplier model but also raises lots of questions about the goal of the Fed’s quantitative easing policies. As I discussed yesterday, under QE-1.0, Bernanke & Co. offset the shrinking of the Fed’s emergency liquidity facilities with purchases of mortgage securities. QE-1.5 was adopted at the August 10, 2010 FOMC meeting when it was decided that maturing mortgage securities would be offset by purchasing Treasuries. If the Fed decides to implement QE-2.0, as was suggested by Tuesday’s FOMC statement, then it is widely presumed that the Fed would expand its balance sheet again by purchasing $1.0tn of US Treasuries.
The Carpenter/Demiralp study implies that QE-2.0 won’t be any more successful in boosting M2 growth and bank lending than QE-1.0. If so, then the Fed should be renamed “Feddie.” Like Fannie and Freddie, Feddie now owns lots of mortgages. If Feddie buys another $1.0tn of Treasuries, it is simply enabling the US government to continue down the road of reckless deficit-financed spending. The Fed then becomes the lap dog of the Treasury. No wonder that the price of gold is at a new record high this morning.
The Carpenter/Demiralp study quotes former Fed Vice Chairman Donald Kohn saying the following about the money multiplier in a March 24, 2010 speech: “The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. . . . [W]e will need to watch and study this channel carefully.”
Isn’t that wonderful? Fed officials are clueless about how quantitative easing is supposed to impact the economy. They aren’t even sure if it has any effect on the economy. The Fed study cited here confirms this known unknown. The Bank of Japan tried quantitative easing to revive their economy and avert deflation, but it didn’t work. By the way, Kohn’s March 24 speech was titled, “Homework Assignments for Monetary Policymakers.” (See link below.) He just retired after spending 40 years at the Fed.
Here are more shocking revelations from the study under review: “In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found. The argument against the textbook money multiplier is not new. For example, Bernanke and Blinder (1988) and Kashyap and Stein (1995) note that the bank lending channel is not operative if banks have access to external sources of funding. The appendix illustrates these relationships with a simple model. This paper provides institutional and empirical evidence that the money multiplier and the associated narrow bank lending channel are not relevant for analyzing the United States.”
Did you catch that? Bernanke knew back in 1988 that quantitative easing doesn’t work. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.
So why hasn’t it worked just when we need it most? My theory is that the Keynesian apparatchik in both Japan and the US welcome economic and financial crises as great opportunities to grab power. So they come to our rescue with massive spending programs financed with lots of borrowed money. The Japanese government built roads and bridges to nowhere that nobody needed. The US government can’t seem to even do that. Instead, the stimulus spending has been focused on keeping unionized public workers employed. The government’s intrusion into the economy, with its huge deficits and mounting debt, depresses the private sector. Watching the central bank enable it all by purchasing some of the government’s debt is even more depressing. This is why quantitative easing doesn’t work.
So the textbook model of the money multiplier is irrelevant. Early last year, I argued that the textbook model of the fiscal multiplier is also baloney. In the February 9, 2009 Morning Briefing, I wrote: “I can’t think of a more tired old theory than the Keynesian notion that $1 of additional government spending will generate $1.5 of real GDP. This ‘multiplier effect’ is taught in every introductory macroeconomic textbook. Yet, it is both theoretically and empirically questionable.” I then went on to quote the supporting evidence for my view in an OECD working paper by Roberto Perotti titled “Estimating the Effects of Fiscal Policy in OECD Countries,” which is linked below.
College students should be required to read a paper written by Christina Romer and Jared Bernstein, titled “The Job Impact of the American Recovery and Reinvestment Plan,” dated January 9, 2009 (linked below). When the Obama administration came into office, Romer chaired the Council of Economic Advisors and Bernstein became the chief economist for VP Joe Biden (seriously). The Romer/Bernstein analysis was based on a super simplistic Econ 101 fiscal multiplier model. The government boosts spending by $800bn. GDP rises by 1.5 times as much, i.e., $1.2tn. That creates 4mn jobs. It’s that simple. Sadly for the millions of Americans who are out of work, economists who were skeptical were right to be so. The American Recovery and Reinvestment Act did not work as advertised. Now, some of the major proponents of the fiscal multiplier are leaving the administration, including Romer, Orszag, and Summers.
* Mortgage Market (weekly): What’s happening in the mortgage market? (1) The MBA applications new purchase index fell for the second straight week, down 3.3% in the week ending September 17 following a 0.4% decline the prior week. The index had increased 8.9% over the previous three-week period. The 4-wa rose for the third straight week, but remains around 14½-year lows. (2) The refinancing index fell for the third straight week, down 0.9% w/w and 14.3% over the three-week span. That followed a five-week climb of 29.8%. The level is still more than double the reading at the start of the year. (3) The rate on 30-year fixed mortgage (FRM), based on Freddie Mac data, edged up 5bps the past two weeks to 4.37% from 4.32%, a low for the series going back to 1972. The spread between the FRM and the 10-year Treasury yield is around its historical average, while FRM remains high relative to the federal funds rate.
II) STRATEGY: If the monetary and fiscal multipliers are figments of the imagination of macroeconomic textbook writers, what works? Profits! The Fed does not create jobs. The Treasury can’t do it either. Profitable companies create jobs and expand their capacity to hire more workers when they are optimistic about the outlook for profits. Profitable companies can drive up the stock market even if investors aren’t doing so. They can do that by using their record cash flow to buy other companies and to buy back some of their shares.
The Q3 earnings season is set to begin soon. The bottom-up consensus estimate for the S&P 500 is currently $20.68 per share, up 26.4% y/y. The estimates during the previous six earnings seasons just before companies started to report were all too low by 10.0% on average, in a range of 4.6% to 15.4%. Another underestimate is likely this quarter.
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