Post by unlawflcombatnt on Nov 12, 2010 18:16:16 GMT -6
Excerpted from Hussmanfunds.com via Patrick.net
The Recklessness of Quantitative Easing
John P. Hussman, Ph.D.
Oct 18, 2010
"With continuing weakness in the U.S. job market, Ben Bernanke confirmed last week what investors have been pricing into the markets for months - the Federal Reserve will launch a new program of "quantitative easing" (QE), probably as early as November. Analysts expect that the Fed could purchase $1 trillion or more of U.S. Treasury securities, flooding the financial system with additional bank reserves.
A second round of QE presumably has 2 operating targets. One is to directly lower long-term interest rates...in hopes of stimulating loan demand and discouraging saving. The other is to directly increase the supply of lendable reserves in the banking system....[with the] objective of increasing U.S. output and employment.
Economics is essentially the study of how scarce resources are allocated. To that end, one of the main analytical tools used by economists is "constrained optimization" - we study how consumers maximize their welfare subject to budget constraints, how investors maximize their expected returns subject to a various levels of risk, how companies minimize their costs at various levels of output, and so forth. To assess whether QE is likely to achieve its intended objectives, it would be helpful for the Fed's governors to remember the first rule of constrained optimization - relaxing a constraint only improves an outcome if [that] constraint is [limiting]....
In other words, removing a barrier allows you to move forward only if that particular barrier is the one that is holding you back.
On the demand side, it is apparent that the U.S. is presently in something of a liquidity trap. Interest rates are already low enough that variations in their level are not the primary drivers of loan demand. Loans are desirable when businesses see opportunities to make profitable investments that will allow the repayment of the loan, without too much uncertainty. Similarly, loans are desirable when consumers see opportunities to shift part of their lifetime consumption stream toward the present (or to acquire durable items such as autos or homes which provide an ongoing stream of benefits), and where they also believe that their future income will be sufficient to service the debt....
[But] neither businesses nor consumers are finding attractive borrowing opportunities, or have sufficient confidence that they will be able to repay the loans and end up better off. A few years ago, individuals did have the confidence to shift a portion of their lifetime consumption to the present because the values of their homes and other financial assets gave them the impression that their future consumption needs were well covered. Lax lending standards created a feedback loop of soaring mortgage debt, consumer debt, home values, and consumption. At the corporate level, the return on equity capital was progressively boosted by taking on increasing leverage, which eventually reached catastrophic levels in the financial sector. The subsequent collapse forced the recognition among consumers and businesses that their ability to service debt, based on expectations about the future value of their assets, was not as strong as they previously believed.
Instead, businesses and consumers now see their debt burdens as too high in relation to their prospective income. The result is a continuing effort to deleverage, in order to improve their long-term financial stability. This is rational behavior. Does the Fed actually believe that the act of reducing interest rates from already low levels...will provoke consumers and businesses from acting in their best interests to improve their balance sheets?
On the supply side, the objective of quantitative easing is to increase the amount of lendable reserves in the banking system. Again, however, this is not a constraint that is [limiting].... The liquidity to make new loans is already present. U.S. commercial banks already hold $1.066 trillion of reserves with the Fed, and another $1.626 trillion in Treasury and agency securities (thanks to Greg Weldon for the graph below). Many banks may very well be insolvent in the sense that their liabilities would exceed their assets if the remaining assets were booked at levels properly reflecting their fair market value, but bank liquidity is not a binding constraint on the U.S. economy here....
Meanwhile, the corporate sector is already holding large precautionary balances in cash and marketable securities. Yet aside from predictable upgrades of information technology, the use of this liquidity has been limited to acquisitions, which simply transfer the ownership of existing assets, do nothing to increase output, and may even result in reduced employment.
In short, further attempts at QE are likely to have little effect in provoking increased economic activity or employment. This is not because QE would fail to affect interest rates and reserves. Rather, this policy will be ineffective because it will relax constraints that are not [limiting]...in the first place.
Opacity masquerading as solvency
One of the arguments for quantitative easing is the notion that the Fed's purchase of $1.5 trillion of Fannie Mae and Freddie Mac debt somehow "pulled the U.S. economy back from the abyss" of a Depression. But a closer examination of the past 19 months suggests that a much more specific mechanism - suspension of truthful disclosure - was actually the key element. Unfortunately, the benefits of this suspension are also impermanent, because the underlying solvency problems have been left unaddressed."
The Recklessness of Quantitative Easing
John P. Hussman, Ph.D.
Oct 18, 2010
"With continuing weakness in the U.S. job market, Ben Bernanke confirmed last week what investors have been pricing into the markets for months - the Federal Reserve will launch a new program of "quantitative easing" (QE), probably as early as November. Analysts expect that the Fed could purchase $1 trillion or more of U.S. Treasury securities, flooding the financial system with additional bank reserves.
A second round of QE presumably has 2 operating targets. One is to directly lower long-term interest rates...in hopes of stimulating loan demand and discouraging saving. The other is to directly increase the supply of lendable reserves in the banking system....[with the] objective of increasing U.S. output and employment.
Economics is essentially the study of how scarce resources are allocated. To that end, one of the main analytical tools used by economists is "constrained optimization" - we study how consumers maximize their welfare subject to budget constraints, how investors maximize their expected returns subject to a various levels of risk, how companies minimize their costs at various levels of output, and so forth. To assess whether QE is likely to achieve its intended objectives, it would be helpful for the Fed's governors to remember the first rule of constrained optimization - relaxing a constraint only improves an outcome if [that] constraint is [limiting]....
In other words, removing a barrier allows you to move forward only if that particular barrier is the one that is holding you back.
On the demand side, it is apparent that the U.S. is presently in something of a liquidity trap. Interest rates are already low enough that variations in their level are not the primary drivers of loan demand. Loans are desirable when businesses see opportunities to make profitable investments that will allow the repayment of the loan, without too much uncertainty. Similarly, loans are desirable when consumers see opportunities to shift part of their lifetime consumption stream toward the present (or to acquire durable items such as autos or homes which provide an ongoing stream of benefits), and where they also believe that their future income will be sufficient to service the debt....
[But] neither businesses nor consumers are finding attractive borrowing opportunities, or have sufficient confidence that they will be able to repay the loans and end up better off. A few years ago, individuals did have the confidence to shift a portion of their lifetime consumption to the present because the values of their homes and other financial assets gave them the impression that their future consumption needs were well covered. Lax lending standards created a feedback loop of soaring mortgage debt, consumer debt, home values, and consumption. At the corporate level, the return on equity capital was progressively boosted by taking on increasing leverage, which eventually reached catastrophic levels in the financial sector. The subsequent collapse forced the recognition among consumers and businesses that their ability to service debt, based on expectations about the future value of their assets, was not as strong as they previously believed.
Instead, businesses and consumers now see their debt burdens as too high in relation to their prospective income. The result is a continuing effort to deleverage, in order to improve their long-term financial stability. This is rational behavior. Does the Fed actually believe that the act of reducing interest rates from already low levels...will provoke consumers and businesses from acting in their best interests to improve their balance sheets?
On the supply side, the objective of quantitative easing is to increase the amount of lendable reserves in the banking system. Again, however, this is not a constraint that is [limiting].... The liquidity to make new loans is already present. U.S. commercial banks already hold $1.066 trillion of reserves with the Fed, and another $1.626 trillion in Treasury and agency securities (thanks to Greg Weldon for the graph below). Many banks may very well be insolvent in the sense that their liabilities would exceed their assets if the remaining assets were booked at levels properly reflecting their fair market value, but bank liquidity is not a binding constraint on the U.S. economy here....
Meanwhile, the corporate sector is already holding large precautionary balances in cash and marketable securities. Yet aside from predictable upgrades of information technology, the use of this liquidity has been limited to acquisitions, which simply transfer the ownership of existing assets, do nothing to increase output, and may even result in reduced employment.
In short, further attempts at QE are likely to have little effect in provoking increased economic activity or employment. This is not because QE would fail to affect interest rates and reserves. Rather, this policy will be ineffective because it will relax constraints that are not [limiting]...in the first place.
Opacity masquerading as solvency
One of the arguments for quantitative easing is the notion that the Fed's purchase of $1.5 trillion of Fannie Mae and Freddie Mac debt somehow "pulled the U.S. economy back from the abyss" of a Depression. But a closer examination of the past 19 months suggests that a much more specific mechanism - suspension of truthful disclosure - was actually the key element. Unfortunately, the benefits of this suspension are also impermanent, because the underlying solvency problems have been left unaddressed."