Some Thoughts on Quantitative Easing

The need for Quantitative Easing shows the inadequacy of the macroeconomic model that underpins all Fed policy. They need to go back to the drawing board.

I wrote an answer to questions today from my friend Michal Stupavsky at the Prague Financial Institute and thought you might like to see the long version of my answer.

Question:

1. What is your view on quantitative easing?

2. Do you think it really helps the real economy in a structural and fundamental way?

My answers:

1. I don’t like it.

2. no.

I’m so old I remember when Quantitative Easing was just called printing money because that’s exactly what it is.

Since the time of Walter Bagehot (1826-1877), editor of the Economist and the most famous British journalist of all time, central banks have always had two priorities:

1) intervening where necessary to provide liquidity to preserve financial stability. In complex systems terms this means preventing a credit crisis, a cascading network failure of the financial network. This can require quite dramatic temporary injections of liquidity to accomplish. Emphasis on the word “temporary”.

2) Protecting the value of money over time, also known as controlling inflation. This requires making sure that the liquidity injections to preserve stability do not become permanent.

Led by the Fed, central banks have been partly successful with the first priority. I say partly because they have been rather good at firehosing enough money while prices are falling to turn it around but they are also responsible for the big runs ahead of the crises by letting leverage, multiple, and prices get out of hand.

They have totally failed their second priority. The result of the massive reserve injections after the subprime debt crisis and since we all first learned the word COVID has been virtually runaway asset price inflation which, ironically, increases the chances of tripping into the next financial crisis. As both Bagehot and Minsky knew, asset prices rising too much for too long result in people behaving badly, making bad judgments and taking silly risks, all of which are present in current news reports.

Asset price inflation has also been divisive. Most people do not own meaningful amounts of assets; they live paycheck to paycheck. The result has driven a wedge between the net worth of a small number of asset owners and everybody else. What is typically referred to as “income inequality” is actually the diverging fortunes of apital owners and capital users.

It is worth noting that the only reason the term “Quantitative Easing” exists is that the Fed stopped talking about money supply and switched entirely to targeting interest rates during Ben Bernanke’s tenure as Chairman. That’s because, at the same time, they adopted the DSGE (Dynamic Stochastic General Equilibrium) model as their principal analytical tool (which Bernanke had helped develop). That model characterizes monetary policy as simply “setting the interest rate” and assumes the economy is in, or close to, general equilibrium at all times. It also illustrates why I believe that the Chairman of the Federal Reserve Board should never be an academic economist—they put too much faith in specific economic models.

DSGE models are the progeny of a body or work seeking to identify the micro foundations of macroeconomics in an attempt to map every major movement in the macro economy to some rational decision of an economic agent. Unfortunately, in order to make the resulting models tractable, they had to throw out the now thing that makes macroeconomics interesting, the unplanned interactions among all of the economic agents that force people to throw their plans out the window when crisis hits. In macroeconomics, just as in thermodynamics, it is the interactions that really matter.

Misplaced confidence in DSGE models blinded the Fed to the possibility of a financial crisis—a far from equilibrium event—and set up the 2008 subprime debt crisis. Remember the days when Fed governors gave speeches taking credit for “The Great Moderation?” Until someone replaces the DSGE model with something capable of helping policy makers understand why credit crises happen more we will stuck win the revolving door of alternating financial crises and ever-growing quantitative easing. I will write more about possible alternatives in a later post.

Dr. John