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Quantitative Easing (QE): The Neoclassical Response to an Economic Crisis

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Michael Ivy

on 11 December 2013

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Transcript of Quantitative Easing (QE): The Neoclassical Response to an Economic Crisis

Department of Economics, University of Lethbridge
March 22, 2013

The Mandate of the Federal Reserve
And Every Other Central bank

The Neoclassical Response to an Economic Crisis
Quantitative Easing (QE)
The Mechanics of Quantitative Easing (QE)
Lucas Ushers in the Austrians
The Austrian Takeaway
The Elephant in the Room
Living the Consequences of Unintended Consequences
What happens if and when QE ends?
Contents
"The Congress established the statutory objectives for monetary policy--maximum employment, stable prices, and moderate long-term interest rates--in the Federal Reserve Act……In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate."
The Mechanics of Quantitative Easing (QE)
Bank Reserves
TBs, MBS,CDS
FRB New York
“Primary Dealers……18 in all”
What is QE and how does it work?
Economy
Real
Capital Markets
-Stocks, Bonds, LBOs
-Options, Hedge Funds
-Debentures
-Derivatives
Hold Funds
-Keep reserves w/FED
Loan Funds
-Commercial
-Personal
-Mortgages
What is QE and how does it work?
Side Bar:

Does the Money Supply (MS) Increase under QE?
The Mechanics of Quantitative Easing (QE)
Capital Markets
-Stocks, Bonds, LBOs
-Derivatives, H-funds
-Debentures
-Commodities
Subsidize Operations
-Expansions
-One time charges
-Legal
-Stock Options (bonuses)
Hold Funds
-Keep reserves w/FED
Loan Funds
-Commercial
-Personal
-Mortgages
QE itself has no effect on MS
Exchanged longer dated notes for shorter notes
Unless and until the additional bank reserves become:
The Mechanics of Quantitative Easing (QE)
Capital Markets

Stocks (Equities) > 100% since the 666 low of 2009 on SnP
Bonds (Commercial debt) has seen 7% yields appreciate 5%/annum
Derivatives have grown to over $630 T (40 X USMS)
Most financial assets have risen in price, including commodities (cereal grains, feedstock, materials & PMs, and fuel)
The Mechanics of Quantitative Easing (QE)
6.5%
3%
1%
2%
3%
4%
5%
Phillips Curve (6.5 and 2)
"The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957". (1958)
6.5
2
TBs, MBSs, CDSs
Bank Reserves
Subsidize Operations
-Expansions
-One time charges
-Legal
-Stock Options (bonuses)
QE4
Dec ‘12 $85B MBS/M
QE3
Sep ‘12 $40B MBS/M
Sep ‘11 (Op. Twist) $400B 6-30Y Bonds
QE2
Nov ‘10 - $600B LTTB
The Mechanics of Quantitative Easing (QE)
QE1
Mar ‘09 - $750B MBS
Banking Operations
Bank Profitability - $40T to +$30T in < 2 years
Compensation (Bonuses) 2011 $156 billion. Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, US Bank, and Wells Fargo Investment Bankers
Majority of Bank profits are attributed to their Trading Desks and the suspension of Mark to Market Accounting standards
The Mechanics of Quantitative Easing (QE)
So, it must have been a result of all the new business development………
Mark to Market Accounting Relaxed
April 2, 2009
The Mechanics of Quantitative Easing (QE)
The Real Economy
Small Business Lending: modest growth since 2008, most occurring 2011-12
The Mechanics of Quantitative Easing (QE)
The Real Economy
BANK RESERVES – Virtually none of it has been put to work in the real economy.
The Mechanics of Quantitative Easing (QE)
And, not to put too fine a point on it here…………………..
The Mechanics of Quantitative Easing (QE)
The Economic
Methodology

…………………………Or here
The Mechanics of Quantitative Easing (QE)
In less than 2 years, banks recovered $70T return to profitability (175%)!
So.........

Where's all the Money Gone?
QE 1
"Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models." (Lucas Critique, 1976)
So that,
Robert Lucas (1995 Nobel Prize Economics), challenged the static constructs of neo-classical macro econometric modeling
Must take into account changes in rational behavior (expectations) that occur in response to systemic policy changes (monetary/fiscal), or,
Lucas Ushers in the Austrians
6.5%
3%
1%
2%
3%
4%
5%
THIS………..Phillips Curve (6.5 & 2)
Unemployment
Inflation
12%
10%
6.5%
3%
2%
4%
6%
8%
10%
MIGHT ACTUALLY LOOK LIKE
THIS………..Phillips Curve
(6.5 & 12, OR, 10 & 2)
Trading a little inflation for a reduction in unemployment
So, for Lucas, monetary policy may have no discerning effect on aggregate demand (employment and output)
If firms know what the monetary policy of the government is/will be, they will recognize the policy for what it really is – price inflation, since all else equal, nothing real has changed. (Volume remains the same)

As asset prices are bid up, input costs rise as well, encourages firms to actually produce the same but with less inputs (labor) – partially explains why corporate profits continue to improve while sales revenues, unemployment and GDP remain stagnant.

Consumers, faced with the prospect of higher prices (and taxes) will purchase less, given a decrease in short term real income expectations.

In the absence of market driven growth (demonstrated preferences), monetary policy has very much the opposite effect on real employment & GDP growth.
Lucas Ushers in the Austrians
The government was aiming for this……………...
Q1
P2
Aggregate Demand
Aggregate Supply
Price
Quantity
P1
Q2
Lucas Ushers in the Austrians
………..but wound up with this instead
Q1
P2
Aggregate Demand
Aggregate Supply
Price
Quantity
P1
Q2
Lucas Ushers in the Austrians
A praxeological explanation
of the Lucas Critique
The Austrian Takeaway
Price is largely a monetary phenomenon and not necessarily a response to real economic growth

2008 demonstrated that increased prices (2003 - 07) were a product of speculation - that the correction was a "reconciliation" of price with real demand

Falling prices are always the silver lining to a recession. Propping up failed business models robs resources from productive areas of the economy

Central bank planning and price fixing of interest rates creates behavioral distortions by systematically mispricing risk EVERYWHERE:

because prices and fixed low interest rates are not a product of the market place (demonstrated preferences)
So…….where’s all the money gone?
The Elephant in the Room
Nixon closes the Gold window
(End of Bretton Woods)
Here’s where it has gone!
The Elephant in the Room
In the end, the Treasury dumps the bill onto the tax payer which has to be paid for by the REAL ECONOMY, currently $16.7 TRILLION
Bank Reserves
1.
3.
2.
FED buys Treasury debt and whatever other toxic instruments banks care to dump
For Cash
Banks buy Treasury debt then swaps for increased bank reserves of which they can do whatever with (Stock market, high yield junk bonds, etc.)
Sells to
Treasury issues debt then spends cash on
Entitlements
Regulation & Bur.
GSE’s
Health, Ed., etc.
How Does this Happen?
The Elephant in the Room
Why isn’t it working?
The Elephant in the Room
QE sustains unemployment and diminishes economic growth because government spending:
Reduces real aggregate demand (stuff/price) ↓
Encourages firms to hire less and do the same with less because of price expectations (Lucas)
Encourages consumers to consume less (save more) because of real wage declines (wage/price) ↓
Creates perverse incentives, dislocates capital and invites speculation
Punishes savers
Government spending is a short term panacea:
Has the effect of raising prices
Competes for scarce resources with other peoples money
Employment and aggregate demand are choked off by rising prices
The Elephant in the Room
(Austrian Takeaway II)
To Austrian Economists, Quantitative Easing allows for (ENABLES) wasteful (unproductive) government spending:

Misallocates scarce resources because of an absence of economic calculus that is replaced with moral hazard
It has to take resources from productive areas of the economy to achieve (pay for) its desired ends, and
Encourages speculation – a byproduct of government and the public suffering from fiscal illusion and easy access to credit
But, the government is the real economy,……isn’t it?
The Elephant in the Room
Does the debt ceiling really matter?
No!!

If dGDP/dGov > 0, then GS would be a permanent line item on the government's Income Statement.
NWG
NWG
WG
Living the Consequences of Unintended Consequences

-rise with speculation
-mispricing of risk
-TBTF = moral hazard
QE
-stagnant or diminishing real GDP
-agg. demand & real wages fall
-firms do more with less
-unemployment flat to rising
-misallocation of resources
-increasing debt obligations
-increasing tax burden (TBTF)
Living the Consequences of Unintended Consequences
Real Economy
↑Speculation
↑Moral Hazard
&
Fiscal Illusion
QE...
Chasing Higher Prices & Higher Yield
Increasing Taxes & Higher ↑Input $
Its going to be:

"He who sells first, sells best!"
-Asset prices will be crushed and speculative gains will be punished unless crystalized
-Bond market will call out the government with higher interest rates reflecting the true cost of capital
-Assets will exchange hands from less to more efficient producers
-Government (size and scope) will be severely reduced
-Prices will fall (wage & price adjustments), but those quick to adjust will prosper
-Economy returns to producing and exchanging meaningful goods and services
-Resources will be returned to wealth generating activities
What happens when QE ends?
99% of the economy won’t notice anything substantive at all
An Axiomatic Result:
Real Economy
Michael P. Ivy (M.Sc), General Manager
Apeetogosan (Métis) Development Inc.
Edmonton, Alberta

Government Spending
Asset Prices
Real Economy
Capital Markets
-Stocks, Bonds, LBOs
-Options, Hedge Funds
-Debentures
-Derivatives
NO!
So what has the FED delivered?
So what has the FED delivered?
Debt
Gov. Spending
Asset Prices
The Illusion of Wealth Creation
In Decline
There is No Free Lunch
I1'
I2
U2'
I1 I1'
I1
I2'
I2 I2'
2 Guys, 2 Indifference Curves, Interest Rate Falls
U2
U1
Future Consumption
Present Consumption
U1'
I1'
I1 I1'
I1
Michael Ivy’s Indifference Curve – Interest Rate Falls
U2
U1
Future Consumption
Present Consumption
I1'
I1 I1'
I1
Jeff Davidson’s Indifference Curve “Woo Hoo!!” – Interest Rate Falls
U1'
U1
Future Consumption
Present Consumption
0
0
Nixon closes the Gold Window
There is no REAL commitment from the market place!
Full transcript