The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Friday, September 10, 2010

What is "quantitative easing" and does the US need more of it?

First, what is exactly is "quantitative easing"? A good definition is as follows:

"The term quantitative easing (QE) describes a monetary policy used by central banks to increase the supply of money by increasing the excess reserves of the banking system. This policy is usually invoked when the normal methods to control the money supply have failed, i.e the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

A central bank implements QE by first crediting its own account with money it has created ex nihilo ("out of nothing"). It then purchases financial assets, including government bonds, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money, and thus a hopeful stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system.

Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio."

Second, does the US need more QE, or QE2 as it is commonly described? My own intuition, for what it is worth, is no. It is like pumping more gas into a car that actually has problems with its wheels.

There is a truck-load of liquidity in the US financial system right now. Banks are all sitting on mountains of cash. The problem in the US is that nobody is really willing to lend.

I put this thesis to one of the biggest US money managers in a recent meeting, and he agreed. He further added that the reason banks in the US were rationing credit was because of the extreme regulatory uncertainty. He said he had met with all the CEOs of the biggest US banks, and they commented that they could not lend because: (a) they did not really know what institutions would end up regulating them; and (b) how the loans they make would be treated under Basel III and the waves of new regulation hitting the US.

My issue with the Goldman Sachs & Co advocacy of QE is as follows: QE ain't gonna do anything if banks aren't extending credit. This is really the fundamental issue at hand. There is no point putting downward pressure on long-term interest rates if borrowers are struggling to get access to those rates. Furthermore, the whole QE process creates a range of difficult-to-control risks, such as future moral hazard, inflation risks, and so on.

Surely a much better policy option for the Fed is to focus on giving the banking system the certainty it needs in order to feel more comfortable advancing credit? (See here for my analysis of the structural problems with the US financial system.)

Goldman have been beating the quantitative easing drum real hard in the US. See here and here. The FT summarises Goldman's views as thus:

"As should now be obvious, Goldman Sachs is very keen on the idea of QE2. In fact, barely a day goes by when it is not discussed by the bank.

Already this week, Goldman’s chief US economist Jan Hatzius has told the world why a further $1,000bn of QE is justified, even though recent US economic data points more towards a slow down than a double dip."

For mine, this is a limited approach that does not address the real economic bottlenecks that are constraining US activity.