Did QE work?

by Filipe R. Costa

A few days after the quantitative easing program was effectively terminated in the U.S. (or at least put on hold for some time), it is time to look back and learn a lesson or two about its effects.

Did it work? That is the million-dollar question that unfortunately doesn’t have a clear and definitive answer and deserves a look into its different perspectives and points of view.

If you ask that question to Ben Bernanke and Janet Yellen, I’m positive that the answer would be a clear and transparent “Yes, it prevented the collapse of the whole financial system and helped boost the real economy, as reflected by the current unemployment rate below 6%”.

It is true the unemployment rate is much lower now, after hitting 10% at the peak of the crisis. Both events happened at the same time, QE and unemployment decline, so I guess they are somewhat related.

If you ask the same question to a billionaire, he would undoubtedly answer “YES, that was one of the best times in my life (at least financially)”, as the successive quantitative easing programs helped double the number of global billionaires due to the boost given to financial assets. Just take a look at the article here

But you don’t need a PhD to guess that people owning a large part of their wealth in financial assets are now much richer than before.

The chart presented below shows the performance achieved by S&P 500 since the peak of the crisis. A level of 100 is attributed to 9th March 2009, which represents the bottom for U.S. equities. The index now shows a reading of 300. In five and a half years, the S&P 500 doubled, so did the fortune of these billionaires.

If you ask the same question to savers, they would eventually insult you, as they’re no longer getting any decent yield or interest on their savings. During the last 10 years, it has been tough for pension funds to achieve their long-term goals if investing solely in the highest rated assets. Savers are now required to either set aside a lot more funds than before or to just accept a decrease in their living standards upon retirement.

Inflation has been under control since the 1990s after the central banks abandoned the old-fashioned monetary-targeting and adopted a new inflation targeting policy (with New Zealand being a big example of the success). But the real interest rate was sometimes negative and we just don’t know what will really happen to it in a few years. Savers are accepting very low interest rates on debt, as if risks were lower, but the risks are just artificially lower, not effectively lower.

What is pushing the price of debt higher is the artificial demand coming from central banks, not any decline in credit risks. As governments are hugely indebted and growth is pale, credit risks are rising. When central banks stop demanding these assets, either the government puts a decent real growth to repay the debts and keep risks low or it will have to push for inflation as a way of repaying debt. The odds for savers losing purchasing power are very high, I would say.

After this perspective view about some of the QE effects, it is now tougher to conclude that it worked without qualifying the statement. It worked for some but not for others as the transmission mechanism failed.

Traditionally it is accepted by academics (with Ben Bernanke being one of them) that monetary policy has no real effects in the longer-term. Any attempts to increase long-term growth through monetary policy are deemed to fail. That’s the main reason why central banks are usually mandated to achieve medium-term price stability, not growth.

But, that’s not incompatible with any attempt to smooth the business cycle in the short-term. The problem is that five years is too much and the Fed has probably created so many distortions that only the future will tell about them all.

The only reason why the central banks buy financial assets is because they believe this will push yields on safer assets lower and push investors to the equity market and other riskier assets.

Through the transmission mechanism investment is expected to pick up and with it unemployment to decline and the economy to grow. But even after more than five years I have serious doubts the Fed achieved such a perfect transmission.

The increase in the number of billionaires is an indication that global and prolonged expansionary monetary policy creates huge wealth redistributions. The nearest you are to the transmission mechanism, the more you benefit from it, which is plain wrong. These investors have not put a lot into the real economy otherwise we would be experiencing significant growth, which is not the case. While the latest GDP number coming from the US has been good, when we take the whole recovery period, we observe that growth has been much lower than it was in the aftermath of past recessions.

Then we can look at the job market.

Numbers have been good so far, with unemployment claims at the lowest since 2000 and the unemployment rate near 5.9%. But a large part of the improvement comes from a decrease of the work force participation rate and a substantial increase in the number of people just marginally attached to the job market and people employed in part-time for economic reasons.

The U6 measures adds these two groups to the unemployment rate in the U.S. and is sometimes seen as a measure of job “quality”. While both the unemployment rate and the U6 measure have been decreasing since 2009, a huge gap has formed between the two, which has not retreated with the decrease in the number of unemployed. So, in the end, we have a deterioration of the job market (at least qualitatively).

While the central bank should do something to avoid a financial collapse, I am not sure about the case where the central bank replaces the government. Monetary policy has been working in the past through standard tools, like the interest rate, because the underlying conditions were much different than they now are. Ben Bernanke had to push for extraordinary and unconventional measures because he exhausted the traditional measures without any relevant success. The same happened to the BOJ.

The problem is that our world is too much indebted.

Governments now hold debt-to-GDP ratios higher than 100% and these ratios have been rising even under the current scenario of very low interest rates, meaning they are unable to sustain them. A monetary policy conducted with near zero interest rates and massive purchases of government debt is an incentive for governments to increase debt forever and a huge tax on savers.

We are at a junction where we need to admit that we cannot artificially manage the economy forever. We need to allow for interest rates to rise for people to take the right decisions regarding the industries/sectors they should invest on and for the market to get rid of the over-investments of the past. We need credit to contract, not to expand artificially and to continue contributing to over-investment.

But that is not what governments want…

There’s only two ways to pay their debts. One is through growth, which they just are not able to achieve. The other is through inflation. They desperately need the central banks to buy their debt to be able to pay low interest rates and to eventually generate inflation and make it easier to service debt. As Kindleberger says in the sixth edition of its acclaimed book Manias, Panics, and Crashes, the burst of a bubble in one country leads to a bigger one in another one.

We are not really solving the problem but trying to get rid of it over time and space, letting the future generations and other neighbour countries with a bigger problem to solve. While the BOJ buys unlimited assets, the Eurozone imports their inflation. Then the ECB needs to lower interest rates and to buy assets to push the euro down and exports up.

But then comes the US.

For now, corporate earnings have been great so far in the country, but I don’t even want to think about what will happen over the next few quarters when these companies have to exchange their euro revenues into US dollars, at the rate of 1.20 or even less.

My guess is that the Fed will have no other option than to jump again into the purchasing world with a fourth version of its QE program. The current management of global monetary policy is disastrous and highlights why someone, someday in the past, attempted to implement a gold standard. Not that I am recommending a gold standard to be applied now, but the past gold standard reminds us about the need to create a global monetary system with very clear rules to avoid these currency wars and neighbour-thy policies, which are leading us from crisis to crisis.

Regarding the financial markets, it is now almost Christmas so I think I will buy just a little bit more. The Fed is out but the BOJ and the ECB are in. I know the current prices are irrational and don’t reflect fundamentals, but how can I fight against it when the central banks are on the other side? After all, they can print money without going to jail, which is not exactly my case.