Wednesday, November 10, 2010

QE0:private QE2:keynesian

At the risk of becoming a QE-bore, I want to write about current discussions on the topic. The topic of how money gets created is so counter intuitive to most people even confusing and sometimes so disgusting that it bears repeating.

Basically I grew up taking for granted the "store of value" component of modern fiat money. In a word, you work for your money and the money represents the value you have created and amassed. This is usually where people conflagrate morals with money.

But the truth is that fiat money is created out of thin-air. First by the monetary authority and second by the banking system. Basically the FED creates "high-powered" reserve money and then the bank create "credit" money on top of it.

The banks are not *really* constrained in how much money they can create. The fractional reserve mechanism has been turned on its head. First the banks create loans and then seek reserves to match them. And second the securitization mechanism has enabled them to distribute the loans into the system without restraint or legislative oversight. Derivatives have exploded the liquidity levels.

So QE0 can really be understood in terms of the banking system creating massive amounts of liquidity. As much as the system demanded while riding an asset bubble (equities, real estate).

QE1 was kicked in, by the FED during the crash following QE0. I have argued in the past and will repeat the point here, that the impact of QE1 has been on the dynamics of the crash. Simply put during a debt-deflation crash, the value of assets can fall faster than you can deleverage your debt, leading to the contradiction that TRYING to decrease your leverage in fact increases your leverage as you trash the asset markets in the middle of the equations. This is known as the Fisher moment. QE1 successfully stopped that dynamic.

QE2 is of a different nature. It is more akin to QE0. It is a pure inflationary contribution of the monetary mass. A monetary expansion. The net effect are
a/ prop asset prices. the attempt from QE2 is to shore up asset prices and therefore the balance sheets of the banks who still hold a lot of the assets from the bubble . It is a trickle down approach to economic stimulus.
b/ retire debt. By buying bonds with the newly minted money, the FED is decreasing the leverage while increasing asset prices, quite the opposite of the fisher moment.

The difference between QE0 and QE2 is in WHO is creating the money. QE0 was a private effort, decentralized and market based. In QE0 the dominant ethos was that markets would always do better. Let the market decide where to allocate the money, it will always decide best. Well, we know now, that while the market may be the best at sniffing out risk in the normal stages of bubbles, by the end of a minsky debt cycle, the money is allocated to the casino itself. Witness the fact that by 2007, 40% of corporate profits came from finance. So basically the bubble runs its course in a blaze of glory. In other words, the markets self-destruct in boom-bust cycles.

QE2 is the keynesian equivalent. Where the central authorities step in and maintain liquidity levels. Of course a centralized planning can suffer from corruption and non-effective allocations. It becomes a political allocation as opposed to a market based allocation. Think about how many schools, roads, hospitals, research, gasp *fighter planes*, $1T buys.... right now the FED is printing money and, unilaterally, giving it to bondholders (China and guys like me). In other words, one of the most impactful social programs is being conducted by the FED. Personally, I cannot help but think it would be better spent directly on mainstream america.

So there is a certain logic to the QE stream. Basically it says "keep on printing, keep on working". The main problem I have with QE2 as implemented now is a moral one as 1/ store of value 2/ who gets it.

PS: As I write this, Leo my 8 year old is sick at home and reading "asterix and the golden knife" and bursts out laughing... He comes and tells me "so they pay this artisan who makes golden knifes. They pay him with golden coins! and what does he do with the golden coins? he makes more golden knifes!!!" as he finds this absolutely hilarious. I still struggle to put my finger on nerve of this one. Something about a conflict between the store of value and the exchange value.

7 comments:

Bob Bickel said...

Trying to make my mind bend back 30+ years to my Econ classes. I too have found the past couple of years fascinating. The one point to add is what I remember being the macro economy is equal to the money supply times the velocity of money = MV. So if the velocity of money flow slows down - people use less credit, or take longer between buying cars - then for the economy to stay equal the money supply has to make up for it.

So the trick to keeping a stable economy, at a very high macro-economic basis, is for the Fed to play with the money supply dial as velocity changes. Tough game...

Bob Bickel

Marcf said...

Hey bob,

I think that is exactly right, the velocity of money is zero. However the problem today is not the quantity of money, the banks have 600B of reserves, It is

1/ the fact that everyone is sitting on cash. QE2 is purely aimed at the velocity of money. I think the fed is clearly trying to smoke us out of cash by inducing asset inflation and killing bond yield.

2/ Some decry this approach as "pushing on a string" (touched upon it briefly 2 posts ago point 5). Meaning that putting more money in reserves doesn't spur lending if people don't see capacity for returns domestically.

oogifu said...

Marc,

How do you relate this to the currency war that is happening (and started years ago) between China and the USA?
http://www.slate.fr/story/29859/guerre-monnaies-europe-masochiste

Marcf said...

Hey,

I do talk about "currency wars" in other posts. I got to be honest though, while i like the narrative of "war" it is far from it. US has about 4T outstanding treasury debt plus another 3t in reserves outside which is about 40% of GDP. The debt is thus around 2% interest of GDP. A drag for sure but not a trap. However, I do believe that QE2 is aimed at retiring a good T of that debt.

I did not know Gerard horny and I quite like the way he writes and what he writes about. The last article on trichet and his inactivity (what the article you link is about) is mostly due to the fact that the ECB really cannot do as much QE. So i dont relate to the personal attacks so in vogue in the US as well. Anyway the EU does do some QU they did announce they were going to buy member debt when the greek crisis hit. The other articles (on demographics) are great though.

Jean-Luc Vanhulst said...

Marc,

How do your 'about 4T' numbers come back in this most recent chart?

http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds102010.pdf

Isn't the the total more like 9? Or am I looking at the wrong numbers?

Marcf said...

Thanks this is interesting. It may correspond to the "intragov holdings" which are shown here at 4.5T?

They show as non-marketable...

oogifu said...

This also reminds me of this http://www.amazon.co.uk/Petrodollar-Warfare-Iraq-Future-Dollar/dp/0865715149/