Tuesday, August 5, 2014

How Quantitative Easing "Works" -- The Mainstream Still Doesn't Get It

August 5, 2014

How Quantitative Easing “Works” - The Mainstream Still Doesn’t Get It

I’m not going to lie to you. I have had a mild case of writer’s block the past month. I have found that there is nothing better to summon my muse than to read what mainstream economic analysts/commentators are writing about current issues. Typically, I can find something they are saying that I vehemently disagree with.

Sure enough, it worked. While thumbing through my most recent copy of The Economist (August 2nd – 8th), I came across the Free Exchange section entitled “The Exceptional Central Bank.” The header on the article is: “The European Central Bank should adopt quantitative easing now rather than as a last resort.” I don’t have any disagreement with this header other than I would argue that the ECB should have adopted quantitative easing (QE) five years ago. No, what lit my fuse was the following:

“One of the main ways that QE has boosted the American economy is by lowering corporate borrowing costs. As the Federal Reserve bought Treasuries and government-guaranteed mortgage securities, pushing down their yields, investors turned to corporate bonds, in turn driving down their yields (emphasis added).”

Really? This is how QE has boosted the American economy, by lowering corporate bond yields? I disagree with this analysis on both empirical and theoretical grounds. Let’s start with the empirical evidence. Let’s observe how the yield on corporate bonds has behaved in relation to Fed purchases of Treasury coupon and agency mortgage-backed securities. These data are shown in the chart below. The Fed stepped up its securities purchases early in 2009. By the second quarter of 2010, its first phase of QE had ended. Corporate bond yields fell as the Fed ended QEI. The Fed again stepped up its securities purchases in the fourth quarter of 2010, terminating QEII in the second quarter of 2011. As the Fed initiated QEII, corporate bond yields trended higher. Following the termination of QEII, corporate bond yields plummeted. With the initiation of QEIII in the fourth quarter of 2012, corporate bond yields started rising. So, Fed purchases of securities in recent years have tended to be positively correlated with corporate bond yields. That is, when the Fed has stepped up its purchases of securities, corporate bond yields have tended to rise; when the Fed has cut back on its securities purchases, corporate bond yields have tended to fall. I guess the editors of The Economist hold to the maxim, “never let the facts get in the way of a good story”.

Except that it is not even a “good story” on theoretical grounds. Suppose one morning, all households decided to cut back on their spending by 10% and use these saved funds to purchase corporate bonds. Corporate bond yields would surely fall. For the sake of argument, assume that businesses in the aggregate increased their borrowing and spending by an amount equal to what households cut back on their spending (increased their lending). In this extreme case, the decline in corporate bond yields would elicit a net change in total spending in the economy of zero. In a more likely case in which the saving behavior of households was positively correlated with the level of interest rates (i.e., the supply curve of household lending sloped upward and to the right), all else the same, the increase in business borrowing/spending resulting from an outward shift in the household lending supply curve would be less than the cut in household spending (increase in household lending). So, a decline in corporate bond yields, in and of itself, is no guarantee of a net increase in aggregate spending on goods and services.

But what if there were an increase in credit that did not entail households cutting back on their current spending? What if some entity could create credit, figuratively, out of thin air? That is exactly what the Fed does when it purchases securities. Suppose the Fed purchases $100 worth of securities from a pension fund. The Fed pays for these securities by crediting the pension fund’s bank account by the amount of the securities purchase, $100. The pension fund has $100 more of deposits and $100 less of securities. The Fed has $100 more of securities, an asset to the Fed, and $100 more of reserves, a liability the Fed, owned by the pension fund’s bank. The pension fund’s increase in deposits and the increase in reserves owned by the pension fund’s bank were created by the Fed, figuratively out of thin air. If the pension fund decides to purchase some securities to replace those it sold to the Fed, then it will be using funds created by the Fed out of thin air to increase the supply of credit.

Assume that the pension fund purchases $100 of newly-issued corporate bonds to replace the $100 of securities it sold to the Fed. Further assume that the corporation issuing these bonds uses the proceeds of the bond sale to purchase $100 of new equipment. In this case, the increase in credit will result in a net increase in aggregate spending on goods and services because the increase in credit was created out of thin air, not as a result of households cutting back on their current spending in order to purchase the newly-issued corporate bonds.

The main way QE has boosted the American economy has been by the Fed creating credit out of thin air, enabling some entities to increase their current spending without requiring any other entities to cut back on their current spending. Contrary to what the editors of The Economist and many mainstream economic analysts assert (but don’t verify), QE has not boosted the American economy by lowering corporate bond yields.

Note: The views expressed in this commentary solely reflect those of Econtrarian, LLC.

Paul L. Kasriel
Econtrarian, LLC
1 920 818 0236
Senior Economic and Investment Advisor
Legacy Private Trust Co., Neenah, WI


  1. Mr Kasriel--nice to have you back. I speak for hundreds if not thousands. You get it. Most commentators do not. Most analysts think that QE did 2 things--(1)kept interest rates repressed so that big corporations could borrow at abnormally low rates and then use the proceeds to buy back shares. This keeps stock prices up making the rich and bear rich even richer. (2) put a lot of reserves in the big banks so that a 2008 disaster would not happen and everyone could relax, also go for the stock market.
    My question is this--what do you expect as QE ends, perhaps for good ("never say never") and perhaps short term rates rise however slowly. Seems to be a new era--or a return to pre-2009 normalcy. It would seem that both the stock and bond markets will have to adjust to this new reality. Your comments are always welcome. Robert Millman

  2. I guess, with the latest productivity numbers, chances of a return of a writer's block are slim... http://blogs.ft.com/andrew-smithers/2014/08/bad-us-productivity-is-it-a-trend-or-a-blip/

    I believe that the authorities shouldn't even try to stimulate borrowing by lowering interest rates because debt is (part of) the problem. Not the (long term as opposed to short term) solution. On the contrary, the authorities should increase interest rates and lower taxes (drastically) and finance the whole operation with sound QE, i.e., purchases of government bonds from the treasury (paid interests are returned to the treasury).

    Expanding the credit bubble even further is definitely not the solution and yet, everybody implicitly agrees that it should be expanded, i.e., that we need credit growth, one way or the other. There exists a name for this weird but very common cognitive phenomenon: double think.

    Mainstream QE seems to me to primarily inflate asset prices: much of the credit, created out of thin air, doesn't stimulate the economy but is used to purchase high risk assets in the US and abroad.

    1. Mr./Ms. Koen:
      I agree with you that QE inflates asset prices. But I disagree with your assertion that QE does not stimulate the economy. Since the inception of QEIII, the US manufacturing PMI index has trended higher and the number of people receiving unemployment insurance has trended lower. Light motor vehicle sales have trended higher. I cite these three variables because, in my years of observing US economic data, they have been the most reliable in gauging the current state of the U.S. economy and are revised minimally, if at all.

      "Everybody implicitly agrees that … [the credit bubble] should be expanded"? Who is everybody? Not I. Mr./Ms. Koen, if you had read my NTRS commentaries staring in mid 2004, you would know that I was warning investors that credit-induced housing bubble was forming and that the inevitable bursting of that bubble would wreak havoc on households and, as importantly, on financial institutions. I warned that the economy would go from a surplus of thin-air credit to a scarcity of it. I was critic of Fed Chairman Greenspan's excessive credit creation policies long before it was fashionable.

      But, as I warned, once the housing bubble burst, thin-air credit creation collapsed. If one desired that the U.S. economy post-2008 suffer the same depth and duration of recession as it did post-1929, then, by all means, the Fed should not have engaged in QE. Conversely, if one desired that the U.S. economy mount a moderate recovery from the bursting of the housing bubble, then QE was just the sort of policy Professor Milton Friedman had argued the Fed should have pursued in the early 1930s and the Bank of Japan should have pursued in the mid 1990s. When depository institutions are unable to create "normal" amounts of thin-air credit, then there is a role for the central bank to temporarily step up its creation of thin-air credit to compensate for the lack of "normal" (not excessive) thin-air credit creation from depository institutions. Once depository institutions are once again creating "normal" amounts of thin air credit, which U.S. depository institutions now are doing, then it is time for the central bank to pare back its creation of thin-air credit, which the Fed currently is doing. Perhaps others are calling for a continuation of excessive thin-air credit creation, but I am not. I am not familiar with "double think". I have heard of "group think", something I have rebelled against since my youth many decades ago.

      One last thing. Whenever I comment on an article, blogpost, etc., I always identify myself, Paul Kasriel, rather than maintaining anonymity through a username. Why are so many commenters like yourself, Mr./Ms. Koen, afraid to come out of the shadow of anonymity?
      Paul Kasriel

  3. Given the corporate yield dropped from about 5.3% in 2009 to below 4.3% currently, I think it's hard to argue QE didn't lower corporate yields. You would have to argue QE did not lower the 10 year treasury yield. The 10 year mirrors the corporate yield curve offset by the risk spread (see link). The market is anticipatory and the Q4 2012 to Q4 2013 rise in yields was in anticipation of QE ending in my opinion. In my view, one impact of QE was to help bolster corporate balance sheets through lower borrowing costs.