A lower level of economic activity would have, indeed, been fine as long as employment had picked up quickly and the lower wages were able, in conjunction with lower prices, to preserve a level of consumption consistent with calm but steady recovery. Alas, the success of the banking sector in ensuring that monetary policy was tuned toward their interests, just like in the good old (pre-2008) times, guaranteed that endogenous growth was out of the reach of American society. When taken together with (a) Europe’s suicidal dallying with Herbert Hoover-like austerity (at a time when half of the continent is in the clasps of its own Great Depression), and (b) China’s structural failure to stimulate domestic demand, it is no great wonder that the Crisis remains with us.
Chapters 7&8 of my Global Minotaur described vividly the Rise of Bankruptocracy; the way in which bank failures armed the failed bankers with remarkable extractive, predatory, political power; a power to extract a larger part of a shrinking national income at rates proportional to their banks’… black holes. We have already seen (see Chapter 7) the manner in which the American public was betrayed and misled by the Geithner-Summers Plan; how the Fed’s strategy was no more than an overt campaign unconditionally to re-float Wall Street; the half-hearted stimulus package introduced by the Treasury which, when the rapid contraction of state spending is taken into account, amounted to no more than a trickle of funding entirely inadequate to arrest the fall in aggregate demand for goods and services within America.
Very quickly, the Obama administration had lost the political momentum. The obscene sight of those who had played a major role in setting the scene for the Crash (men like Larry Summers, Tim Geithner, Ben Bernanke), effectively returning to the scene of the crime as ‘saviours’, wielding trillions of freshly minted or borrowed dollars to lavish upon their banker ‘mates’, was enough to turn off even the hardiest of Mr Obama’s supporters. The result was predictable: As it often happens during a deflationary period (think of the 1930s, for example), those who gain politically do not come from the revolutionary Left. They come from the loony Right. In the United States it was the Tea Party that grew on the back of a disdain for bankers, a denunciation of the Fed, a clarion call for ‘honest’, metal-backed money, and a repulsion toward all government.
Ironically, the rise of the Tea Party increased the interventions of the Fed that the movement denounced. The reason was simple: Once the Obama Administration had lost its way, and could not pass any meaningful bills through Congress that might have stimulated the economy, only one lever was left with which anyone could steer America’s macroeconomy: The Fed’s monetary policy. And since interest rates were dwelling in the nether land of the first liquidity trap to hit the United States since the 1930s (recall Chapter 2 here), the Fed decided that quantitative easing or QE – the strategy that Chapter 8 was described in the context of the 1990s ‘Lost Japanese Decade’ – was all that was left separating America from a repugnant depression.
Did Mr Bernanke have good reason to act? Most certainly so! From 1990 to 2008 aggregate demand in America hovered around a narrow band (between 98% and 104%) of its long-term trend level. In 2009 it fell off a cliff and, to this day, has not recovered. Presently, aggregate demand remains 14% down compared to where it would have been (its trend level) without the Crisis. This is a huge gap which, taken together with (a) the debt under which households are labouring and (b) the banks’ reluctance to lend, guarantees not just high unemployment but also that many Americans will soon fall through society’s cracks becoming permanently unemployable.
When Mr Bernanke adopted QE, in a bid to put some oomph back into American aggregate demand, he inadvertently offered the Tea Party, and later the Republican mainstream, an excellent target; a wonderful opportunity to portray QE as the devil’s attempt to corrupt the nation’s soul; to debase its currency; to give a nation addicted to the debt-drug another dose that sinks it deeper into dependency from Mephistopheles’ cruellest instrument: the printing presses which can provide only temporary relief at the expense of medium term hyper-inflation.
Of course none of that is true. While QE can be branded ineffectual, for reason that follow below, the assertion that the Fed’s QE will push America onto another 1970s-like period of ever accelerating prices is ludicrous. Yet truth is not the currency in which the recalcitrant Right trades: terrifying impressions (that can be employed further to boost private appropriation of publically produced wealth) are!
Quantitative Easing as the most complex form of wishful thinking
At the time of writing this, the third round of quantitative easing, QE3, was in the air. It is worthwhile taking a look at what it means because a great deal of false accounts circulate whose profound error is particularly instructive about the nature of our Crisis.
According to the Fed’s own announcement, every single month (until further notice) America’s central bank will be buying $40 billion of paper titles backed by mortgages (so-called mortgage backed securities, or MBS). Who will the Fed buy these MBS titles from? From private banks and other financial institutions, of course. And how will the Fed pay for them? Simply by crediting electronically the accounts that those institutions have at the Fed with the sums necessary to take these pieces of paper (the MBS) off their books. However, this new balance of dollars in the banks’ Fed account cannot be lent to customers or business. They can only be swapped with other paper assets held by other banks. This is crucial for understanding why QE is not the same as money printing. Despite the technical nature of the ‘transactions’ involved, it is worthwhile taking a close look at it.
When the Fed buys $1000 worth of MBS paper from Bank X, $1000 is taken out of the bank’s ‘assets’ column in the Bank X’s balance sheet and is replaced by $1000 spending money held at a ‘reserve account’ Bank X keeps with the Fed. The said account is called ‘reserve’ because of the conditions the Fed attaches to its uses. To be precise, the Fed stipulates that this $1000 can only be lent to other banks or used to buy other paper titles from other banks. Thus, the only way that the Fed’s purchase of this $1000 ‘worth’ of MBS can find itself into the economy is if Bank X wants to buy some other piece of paper from another bank, say Bank Y. But even if it does, the money will enter the real economy only if that piece of paper title is new; e.g. if the Bank Y had just lent $1000 to some customer and passed this loan on to Bank X. If the paper title concerned is old, pre-QE, debt, all that QE would accomplish is that a paper title worth $1000 would pass from the books of one bank to the books of another. The $1000 would simply never enter the circular flow of income.
This is precisely why QE cannot fuel inflation. Indeed, it is the reason why the 2012 US inflation rate is lower than it was two years ago – despite the massive volumes of QE1 and QE2 that preceded. So, what was the logic behind QE? Mr Bernanke’s stated purpose is that the Fed’s purchases of MBS will increase their price, setting off the following chain reaction:
- increased MBS prices will push down the interest rates people demand from them before purchasing MBS paper (since they will now sport more attractive price-growth potential)
- the lower interest rates associated with MBS paper will translate into lower interest rates for new mortgages
- the lower interest rates on mortgages will boost the demand for new homes
- the extra demand for housing will push up house prices
- the increasing house prices will reduce the number of American families whose home is worth less than the mortgage that they have out on it, turning them into mortgage-slaves).
If all this transpires, the next hope is that a reduction in the incidence of mortgage-bondage in American society (‘negative equity’ in the parlance of financiers) will cause more families to spend more readily, many to sell up and move to an area where they can find work more easily, others to slow down the rate at which they pay down existing debt (and spend some more) and, importantly, a shift investors from MBS paper purchases to corporate bonds (i.e. more lending directly to corporations). This is, dear reader, Mr Bernanke’s heroic theory of how his QE3 will deliver the nation from recession.
- What’s wrong with it? One simple omission: that for QE’s virtuous wheel to start turning, a multiple coincidence of impossible beliefs must occur.
- Jack and Jill, who are Bank Y’s customers, must trust that the real estate market has bottomed out in the medium term and that their job is secure, so as to dare ask Bank Y for a mortgage.
- Bank Y must be willing to take the risk of stretching its already large ‘assets’ column, by lending Jack and Jill to buy a house in the hope that some other bank, Bank X, will buy that iffy mortgage from it using its QE-funded ‘reserve account’ at the Fed.
- Firms that are thinking of employing people like Jack and Jill (in the medium to long term) must believe that Bank X will indeed buy Jack and Jill’s mortgage from Bank Y and, moreover, that this sort of transaction will increase demand for their products, thus justifying more hires.
To cut a long story short, a great deal of believing must occur before QE delivers on its promise to boost employment and help the real estate market recover. Alas, given the prevailing state of self-confirming pessimism, to expect that these beliefs will flood into the different agents’ minds at once is to believe in miracles.
To recap, ever since America became ungovernable (with a White House and a Congress at loggerheads), the Fed was the only branch of government with any capacity to act upon the recession. QE helped to some extent slow it down, if only because someone was doing something ‘big’. It was like cortisone that diminished the pain and lessened the symptoms without however providing a cure. As long as it did nothing directly to reduce the size of the debts people faced, or to increase the wages whose low levels was (from the 1970s onwards) a fundamental root-cause of the problem (recall Chapter 4), QE was never going to work.
While QE’s side effects may be nowhere near as toxic as the Fed’s ardent rightist opponents make them out but, nonetheless, they are real: Mainly, QE gives bankers an incentive to lend overseas, just like Japan’s QE in the 1990s led to the carry trade that boosted the capital flows into the United States. As a result the exchange rate of developing currencies (Brazil being a case in point) appreciates fast, with the result of higher commodity (particularly food) prices that worsen the circumstances of the less well off Americans and threaten developing nations with rapid capital inflows which (as South East Asia, Ireland and Spain can testify) can quickly turn into an exodus that leaves nothing standing behind its wake.
Perhaps America’s greatest tragedy, as these words are written, is that the public debate is ensnared in a cul-de-sac. By focusing on QE, on the pros and cons of a new Gold Standard, on the unsustainability of the federal debt, on whether the solution lies perhaps in a large reduction in living standards, Americans are thrown off the key point: the cause of their distress is the fact that, for the first time since World War II, the United States lost its capacity to recycle the planet’s surpluses. Without an alternative mechanism for achieving this recycling, America’s (and the world’s) capacity to recover is severely circumscribed.
(To be continued)