Dialogue with the Alter Ego on the dilemma of Quantitative Easing
We believe that the Fed should not shrink its balance sheet all the way back to a size that would have been considered normal prior to the global financial crisis but should instead leave a larger amount of liquidity in the financial system on a permanent basis. (…) by keeping the balance sheet more elevated than otherwise, the Fed would be providing a greater amount of liquidity to the financial system, allowing it to potentially operate with better efficiency and reduced risks. In our view, this proposal would improve the transmission of monetary policy to the overall economy and would provide the Fed with flexibility to respond to future crises with its balance sheet as it sees appropriate. – Joseph Gagnon, Brian Sack: Monetary Policy with abundant liquidity; published by the Petersen Institute, January 2014 (see: http://www.iie.com/publications/pb/pb14-4.pdf)
Question by Alter of Ego of Noah denkt™ (AE): In our previous dialogue on the systemic risk posed by the super high US public debt, Noah denkt™ argued that the danger of bond markets flipping over this debt level isn’t as imminent as some would have us think. In particular, you said that governments at this time do not deserve to be severely punished by financial markets since most of their money printing rescue efforts isn’t being motivated by a reckless pursuit of personal gains but rather by a serious concern for the stability of the financial system. [ “… the money printing that is going on in the US and elsewhere isn’t being done for personal gains or out of recklessness. Much rather is it being pursued because those responsible shy away from submitting their people to the severe hardship that an honest correction would entail. That may be a big analytical mistake, but it certainly isn’t a morale failure of Biblical proportions. “] If we, however, look closely at previous systemic risks created by first world governments [see, for instance, the fatal housing policy decisions of successive US administrations that turned the GSEs into a seemingly guaranteed secondary market for securitized mortgages], we will very rarely find that these government programs are inspired by populist recklessness. Instead, it tends to be the genuine, perhaps sometime naive desire of these governments to improve the livelihoods of their most vulnerable citizens that drives these fatal initiatives. So the question is: At what point do inadequate government actions cross the line and become a serious systemic risk that inevitably will be punished by financial markets?
Answer by Noah denkt™ (Nd): Well, it’s hard to generalize about that. But certainly the amount of naivety, the degree in which circumspection, courage and due diligence are lacking in these decisions, and the measure at which populist considerations drive them have something to do with the eventual damage they cause in the market. Ultimately, it is probably the particular spread between populist calculations, naivety and lack of circumspection on one side and genuine conviction on the other that determines the potential damage inherant in these decisions.
AE: It is a personal call though to determine that spread, isn’t it?
Nd: In a way, yes. But don’t forget that government activity tends to be covered by public debate. And that debate should in deed provide a general reference point for determining the populist-conviction-spread at the time.
AE: There wasn’t too much public opposition though to the Community Reinvestment Act and/or the burgeoning role of Fannie Mae and Freddy Mac in the run-up to the 2008 crisis, was there?
Nd: Well, there was some objection to the GSEs albeit not necessarily on the front burner. It should have been clear to political and economic insiders though that you can’t twist market logic for ever.
AE: Obviously, it’s easy to say that with 20/20 hindsight. Let’s, therefore, look into the future instead. Is it possible, from our vantage point, to determine a threshold where an originally well intentioned money printing/quantitative easing policy would turn into an unacceptable, toxic risk?
Nd: We think so. In fact, we believe that the now emerging argument according to which central banks should not shrink their balance-sheets to “normal”, i.e. pre-crisis levels but leave larger amounts of liquidity in the system for stability’s sake would in deed turn what once was a legitimate policy response into a very damaging morale hazard. ( see also: The Economist, Buttonwood Column, April 5, 2014)
AE: Why is that?
Nd: Because the initial need to avoid serious market mayhem which drove the introduction of quantitative easing in the first place, would now be giving way to an argument of convenience that prefers maintaining a feel-good sensation over the need to return to an open market that allows for enough constructive destruction. After all, it cannot be denied that even the banking sector does need its fair share of shake-out to stay healthy. The Petersen Institute proposal, however, would hamper just that by shoring up support for the established players while severely disadvantaging those that operate on the fringes (i.e. the long-term unemployed, self-made entrepreneurs, maverick start-up businesses).
AE: Nevertheless, it is also true that any serious tapering would seriously put in danger the still fragile recovery we are witnessing at this time.
Nd: Of course. But the danger that sustained tapering creates is nowhere near the previous “falling off a cliff”- risk that originally sparked the introduction of quantitative easing. No, no, the more we get used to operating in a market whose fundamentals are distorted by big brother protection the less we will be able to grow out of that regressive need for additional pampering and patronizing. Just look at the market as it presents itself now: Is it not true that the competitive space is highly tilted in favor of the established players? Is it not true that legions of university graduates, no name pioneers and Linkedin members are eternally scrambling to get just a minimum of attention and credibility while those who have made it into the big format talk shows luxuriously busk in their glory? And is it not true that search engine algorithms heavily favor those who have already been covered in mainstream media while those who blog away in their self-made austerity live by the bread crumbs falling off the table of the famed and prosperous?
AE: True. But it isn’t the job of central banks to make marketing easier!
Nd: Well, it is the government’s job to create a viable framework for a competitive and dynamic economy. Safeguarding the status quo doesn’t do that.