In the legendary German tale, Faust makes a bargain with the devil by which he obtains various worldly advantages for a limited term of 24 years in exchange for forsaking the benefits of heaven for the rest of eternity. In economic terms, a Faustian bargain is a metaphor for a "destruction of value" whereby a transaction is undertaken in which the present value (PV) of foregone future benefits is greater than the PV of the benefits obtained as consideration. In other words, the Net Present Value (NPV) of a Faustian bargain is negative.
This essay sets out to answer one question: Is QE3 a Faustian bargain for the US economy?
Just as with any bargain, in order to determine its NPV, we must measure the estimated contemporary benefits of QE3 against its estimated future costs.
The Economic Benefits of QE3
At the right time and under the right circumstances, a policy of Quantitative Easing (QE) can be extremely valuable to a national economy. At least since the publication of Lombard Street: A Description of the Money Market, by Walter Bagehot in 1873, it has generally been understood that providing liquidity to solvent economic agents during a liquidity crunch is an important if not the most important function of any central bank.
Indeed, I was a strong early supporter of QE1 because, in my view, under the conditions of financial and economic emergency that operated at the time, the benefits of liquidity provision via QE clearly outweighed the costs. Or put a different way, the costs of not implementing QE would have been far greater than any benefits gained from not doing so. In my article, "When QE Made Sense," I explain in detail the clear economic benefits of QE1 at the time.
The critical difference between QE1 and QE3 is that the former supplied liquidity at a time when liquidity was extremely scarce relative to demand. Furthermore, the expected net societal cost of supplying the liquidity at that time was very low. By contrast, QE3 is supplying liquidity at a time when liquidity is already in extreme abundance (in oversupply, in fact). And as we shall see later in this essay, the net cost to society of providing more excess liquidity is uncertain, at best.
Since it is clear that money markets are oversupplied with liquidity (hence negative real interest rates), what economic benefit does the Fed believe it is providing via QE3?
Two broad categories of theories have been cited as the main benefits of QE3.
Rationale #1: Lower long-term interest rates = GDP stimulus. The Fed can keep short-term interest rates low through its control of the Fed Funds rate. However, the Fed cannot control long-term interest rates through the Fed Funds rate, which is merely an overnight interbank lending rate. Therefore, in order to artificially suppress interest rates at the long end of the interest rate term structure, the Fed purchases long-duration benchmark securities with the objective of reducing supply in the marketplace, and hopefully inducing prices to rise and yields to fall. In turn, this artificial suppression of long-term interest rates is supposed to stimulate the economy by reducing the debt burden on debtors and also by inducing households and business to take out long-term loans for purposes of consumption and/or investment.
The theory supporting the benefits presumably derived from this policy has never been particularly strong for three reasons.
- Zero-sum effects. At a time when competitive credit and money markets are functioning well, artificially suppressing long-term interest rates will not create any long-term economic value. Nobody seriously debates this. The only debate is about whether there is a significant short-term boost to consumption and investment that can temporarily boost GDP. The fundamental problem with this theory is this: The presumed achievement of a boost to consumption and investment by debtors by raising their disposable incomes via lower interest rates is largely (though not entirely) offset via the diminished corresponding disposable income that would otherwise accrue to savers. While it is argued that there is a benefit to short-term economic activity via the higher marginal propensity to consume on the part of debtors, it is clear that the net short-term benefit to the economy of raising the disposable income of one group at the expense of another is modest, even under the most optimistic assumptions about the marginal propensity to consume and empirically credible Keynesian spending multipliers. A more plausible argument for a short-term benefit to the economy might derive from the fact that a significant proportion of US debt is held by foreigners and that there is therefore a non-trivial zero-sum benefit that accrues to US debtors. However, lower US interest rates have caused global interest rates to decline, and US businesses and households are still net global creditors. Therefore, any benefit from lower long-term interest rates will be muted by various zero-sum off-sets.
- You can lead a horse to water … It is clear that productive investment has not been hindered by interest rates being too high; it has been held back by a dearth of positive NPV investment opportunities as perceived by business managers. Otherwise a healthy demand for investment funds stemming from profitable opportunities in the real economy would be reflected in positive (i.e. healthy) real interest rates as opposed to historically low (i.e. sickly) real interest rates. Thus, in such an environment of already-low interest rates (reflecting unattractive opportunities for productive investment), manipulating nominal long-term interest rates lower by another 50-100 basis points would be unlikely to spur any significant increase in productive investment in the real economy. On the contrary, decimating the real yield on low-risk bonds could merely be expected to fuel a potentially dangerous flow of capital towards speculative financial assets rather than stimulating substantial investments in the real economy. This, in fact, seems to be occurring right now.
- Misallocation of capital. Artificially low long-term interest rates tend to encourage the misallocation of capital into overvalued and otherwise unproductive investments that ultimately destroy savings and wealth.
Rationale #2: Wealth Effects. It is argued that the portfolio effects of asset purchases cause inflation in the value of various investment assets such as the stocks that comprise the S&P 500 index. It is assumed that as economic agents "feel" wealthier as a result of this asset price inflation, they will consume and invest at a more robust rate, thereby stimulating short-term economic growth. However, this rationale is extremely tenuous since it is clear that no actual "wealth" is created by the inflation of the prices of investment assets, only an illusion of wealth. Therefore, targeting an illusory "wealth effect" amounts to a wager by the Fed that households and businesses can be "fooled" into believing that they are more wealthy than they really are.
This merely begs the question: What is gained by "fooling" people into thinking that they are wealthier than they are? Even if folks can be duped in this way, it is clear that the putatively beneficial effect on consumption and investment expenditures can only be temporary at best and that any short-term benefit becomes reversed in the not-too-distant future when the value of the inflated investments revert downwards towards their long-term fair values. At that point, the value of household and corporate savings will have been decimated through a combination of asset price declines and overconsumption in the period of illusory wealth preceding it. This necessarily implies a sacrifice in economic growth in the succeeding period. The imminent crisis that the US currently faces as a result of underfunded retirement savings by households is just one manifestation of the Faustian bargain of inducing artificial illusions of wealth in order to boost short-term consumption.
Therefore, the "wealth effects" rationale for QE3 is premised on a Faustian bargain, which, even under the most optimistic assumptions, will only work to boost short-term economic growth if households and businesses are so foolish as to confuse their true wealth with the value quoted for their current holdings of SPDR S&P 500 (SPY), SPDR Dow Jones Industrial Average (DIA) and PowerShares QQQ (QQQ) in their latest brokerage statements.
It's a sorry economic policy indeed whose "success" depends on the stupidity of its citizens.
In sum, the theoretical foundations for QE3 are quite weak. But how about empirical evidence regarding the effectiveness of QE?
Well, according to a study publicized by the San Francisco Fed, QE has had a negligible impact on economic growth. The authors estimate that a QE2 style 12-month $600 billion program of Large Scale Asset Purchases could be expected to have a 0.13% annualized impact on real GDP in the first quarter of the program, gradually fading to near zero by the fourth quarter - and they emphasize that even this hypothesized impact is quite uncertain. This level of economic impact amounts to no more than a rounding error.
So, the best theoretical and empirical evidence available suggests that the contemporary economic benefit of QE3 is uncertain and small, to the point of insignificance. So the question now is: What are the potential costs of QE3 in the current environment?
The Costs of QE: Perhaps Not As Uncertain As Advertised
Fed Chairman Ben Bernanke has emphasized on many occasions that the costs of QE are uncertain - that the Fed does not fully understand what the impact of QE on the US economy will ultimately be. Furthermore, he has acknowledged that Fed policies have placed the US economy in "uncharted territory."
It would be swell if "uncertainty" were the only economic cost incurred by the Fed's stewardship of the US economy into "uncharted territory." But, alas, it is not likely to be the only cost. The fact of the matter is that the impact of excess liquidity on national economies is not actually "uncharted territory" at all, and I believe that it can be dangerously deceptive to conceive of the issue in this way.
There is ample historical precedent in both the US and globally that clearly points to the fact that excess liquidity can have nefarious long-term micro and macro effects on an economy. One needs to look no further than the examples of the US in 1999 and the 2004-2006 to see how excess liquidity can be a powerful source of long-term economic damage to an economy via wealth destruction, physical and human resource misallocation and long-term unemployment.
In an article entitled, "Beware of Long-Term Damage of Stock Market Bubble Forming Now," I explain how the excess liquidity injected into the economy via QE3 is currently inflicting this sort of damage. In this regard, it is important to understand that the ongoing detritus will not necessarily manifest via the type of general price inflation that myriad pundits have been (incorrectly) predicting for many years on end; it is more likely to manifest via distortions in relative prices that are far more damaging to the economy than across-the-board price inflation.
The long-term damage that I refer to is not a matter of idle futuristic speculation. Some of this damage is already manifesting right before our eyes as we witness the initial phase of destruction of wealth and savings caused by the decline in the market values of various financial assets such as long-term Treasury Notes (TLT) and junk bonds (JNK) that were mispriced due to the US Fed's policy of artificially suppressing short and long-term interest rates. Right now, this destruction of wealth is mainly being felt in the bond market. But as more excess liquidity flows toward increasingly mispriced "risk assets" (stocks and real estate, for example) we are witnessing in real-time the front-end of a process of value-destruction via the incipient formation of a bubble in these sorts of assets.
Most people think of the damage of asset price bubbles as occurring when the bubble bursts and/or being caused by the bursting of the bubble. This is an unhelpful way of conceiving of this phenomenon. The damage caused by asset price bubbles actually occurs while the bubble is inflating and everybody is happy.
Readers, please engrave this in your brain: The true causes of an economic crisis are to be found not in the unfolding of the crisis itself but in the economic conditions that preceded it. It is unhelpful to think of the bursting of an asset bubble as the cause of economic problems. The bursting of an asset bubble is merely a denouement, a consequence of a build-up of problematic economic conditions that preceded it, not the cause of the subsequent fundamental economic problems per se.
When chairman Bernanke talks about the uncertain costs of QE, I believe he is mainly being influenced by a cultural and political fixation on measures of consumer prices. In this regard, I agree with Bernanke that the impact of QE on future consumer price inflation is unclear. However, I believe that if Bernanke's attention were directed toward the ongoing relative distortions in the prices of consumer, producer and investment goods that are currently occurring, he would be impressed by the clear historical precedents and be able to presently apprehend the damage being done to the economy by QE3 in real-time.
A Faustian bargain is struck when relatively meager present benefits are obtained in exchange for the sacrifice of relatively more valuable future benefits and/or the assumption of relatively more burdensome future costs.
Economic theory, empirical investigation (by Fed economists, no less) and long-term historical precedent indicate that QE3 is almost certainly a Faustian bargain. Guiding the US economy into "uncharted waters" in exchange for a transient boost to GDP that amounts to no more than a rounding error is a venture with a negative NPV if only due to consideration of the high discount rate implied by the uncertain impacts of the policy. Furthermore, both economic theory and history suggest that the costs of QE3 could be less uncertain than Mr. Bernanke has advertised. Historically, excess liquidity has proven to be an enabler of relative price distortions (including asset price bubbles) that can have highly deleterious effects on the US economy.
Economic value is destroyed when savings are misdirected by errant price signals and invested in over-valued and/or otherwise unproductive assets - i.e. assets that are incapable of providing future benefits that exceed (in present value terms) the value of the capital and human resources that are being expended on them presently. Furthermore, economic value is destroyed when economic agents are fooled by errant price signals to under-save and/or over-consume.
The misallocation of resources for trifling and transient gain is at the heart of QE3, the Fed's Faustian bargain.