3 Questions About QE Answered; No One Is Ducking Anything

by: Robert Wagner

By far one of the most misunderstood macro concepts that apply to the markets and the economy is monetary policy. Equally misunderstood is the organization empowered to implement our monetary policy, that being the Federal Reserve. The reason I'm so interested in this idea isn't so much for its applicability to investments, but more its impact upon society. Policies regarding the Federal Reserve and how monetary policy is administered have astronomical impacts upon our society, economy and financial stability. Betting wrong on this issue can destroy America's standing in the world, our reserve currency status and send the entire world into a global depression.

This simply isn't the kind of issue you tinker around with unless you know what you are talking about. Encouraging millions of young people to chant "End the Fed" without offering a system to replace the Fed with is naive at best, dangerous at worst. The Federal Reserve was designed to be the lender of last resort, and our chosen system is an elastic fiat currency. That system is essential for stopping bank runs. Under a gold standard, you can't "print gold out of thin air." If a bank run occurs, once the bank is out of gold, the bank collapses, the panic spreads and soon the entire economy is in a depression.

It has happened many many many times between our founding and the ending of the Great Depression. While the Fed failed miserably to act as a lender of last resort during the Great Depression, 1987, 2001 and 2008 have proven beyond a doubt that they have learned from their mistakes. Facts are there is only one way to battle bank runs and panics, and that is an elastic currency. Until the Fed critics can explain how an alternate system will stop bank runs and panics, they simply shouldn't be taken seriously, and are best ignored. Finding out the hard way the consequences of not having a lender of last resort would likely be a global depression. That is a huge cost to pay just to prove to some people just how astronomically wrong they are.

Because of my interest in this subject and eagerness to defend the Fed and its QEfinity program, I was pleased to find an article on SA asking someone to do just that. I gladly take up the challenge.

Here are three related questions that I've never heard asked at a Fed press conference. Are there any QE advocates out there who can answer them?

The author listed 3 questions that supporters of the Fed and QE have been "ducking." I'll do my best to answer them, and shed some light on the topic.

Question #1:

1) U.S. wages are stagnant due to the international fungibility of labor. As people can't get a raise because their jobs can be exported, why is the Fed targeting 2% inflation and not 0.5% to 1%?

Answer to Question #1:

My first thought was "what does labor fungibility have to do with monetary policy?" Monetary policy is a passive policy, it simply lowers rates so that people and corporations can borrow at lower rates if they choose. Monetary policy isn't a solution to all problems. Wage growth is mostly related to worker productivity, not interest rates. How monetary policy does impact wages is through making capital less expensive. Lower rates allow industry to increase the capital-to-labor ratio, leading to greater productivity and ultimately higher wages. Lower rates also allow for greater refinancing, so the debt service of a family is lowered, resulting in a higher disposable income. Higher disposable income results in more spending on goods and services. Lower rates may also stimulate more construction and business expansion, creating more jobs and increasing the demand for labor. Those are the classic relationships between labor, employment, wages and monetary policy.

If domestic wage stagnation is the problem, one has to look at why they are stagnant. The US has a problem with immigration. An influx of low-skilled workers compete for low-skill jobs, driving wages down. Monetary policy can't fix a broken immigration policy or improve border security.

Many high-tech jobs are being exported to countries like China and India, but that has nothing to do with monetary policy. China and India simply have more high-skilled workers, many of them educated here in the US, but because of our broken immigration system they get sent back to their home countries and take jobs with them. Monetary policy can't fix a broken immigration system that sends the best and brightest minds back to their home countries to take American jobs.

Here, on the domestic front, the US educational system falls far below many other industrial nations. Education is essential for higher wages, and our extremely expensive educational system simply fails to generate students with the necessary skills. Monetary policy can't fix a failed educational system.

The test results, which were released yesterday, present a damning assessment of American students in their last year of mandatory schooling: In both subjects, their scores ranked close to last among the 21 nations that participated. And their showing was much worse than the marks that American elementary and middle school students have earned on similar international exams in the past two years.

Even the scores of academically elite American students -- those who take either physics or advanced math courses in high school -- were a disappointment.

Many of our current regulatory bodies are severely restricting job growth. The EPA is greatly hindering the coal, oil and gas industries. Nothing monetary policy can do can reverse the damage done by job-killing regulations.

Why does the Fed target 2% instead of 0.5% or 1%?

First of all, a higher inflation rate would weaken the US dollar, which would make US Imports more expensive and US Exports less expensive. Higher inflation and the resulting weakness in the US dollar is good for domestic jobs and wages, especially those in the export industries. Additionally, because of the way the CPI is calculated, 2% is essentially stable prices, with a little extra to ensure we don't fall into deflation. 2% is a low, stable and manageable level of inflation. Once the economy can stand on its own feet, the Fed could then lower the target, but when in the situation of trying to emerge from a deep and long recession/depression, the Fed is justified in setting the target at the high end of the range. It can always be cut back, if needed. Right now, too much inflation is a problem we should be wishing for. Inflation rarely takes root unless wages are driving it.

Last comment about the wages and the inflation target. The biggest misunderstanding people have about the Fed and monetary policy is what it is intended to accomplish. Monetary policy isn't intended to put "a chicken in every pot, a car in every garage." People simply expect monetary policy to fix problems that it isn't designed to fix. This is where the real damage is done. Instead of directing the attention and focus onto the real issues and real solutions, the attention and focus on monetary policy distracts from them. If people think monetary policy will improve wages, we will never support policies that will improve wages. Instead of improving education and gaining higher job skills, workers will vote for the person that will "End the Fed," and their wages will never improve.

Question #2:

2) In 1980, U.S. household debt to income was only around 60%, which meant there was a lot of buying power available to create a boom. Now it's near 100%, and if you include the Federal debt (which eventually falls on the backs of households), it's much worse. Under these conditions, how can the consumer possibly have the kind of buying power required to create a sustainable improvement in the economy?

Answer to Question #2:

Once again, my first thought was "what does that have to do with the Federal Reserve and monetary policy?" Monetary policy is to act as a governor that adjusts the growth rate of the economy to maintain a level consistent with stable prices and full employment. Personal debt and National debt are totally unrelated. Congress spends money as they see fit, and in fact, most of the money they spend is unfunded through entitlements. Monetary policy didn't hinder the US Government from funding wars and entitlements. Congress doesn't consider monetary policy and interest rates when they pass a budget.

Consumer debt is largely due to credit cards. Credit cards don't have low interest rates. People typically don't alter their credit card purchases based upon the interest rate they are paying.

Student loan debt has relatively low interest rates, but it is because of Sallie Mae, not the Federal Reserve.

Most household debt is due to mortgages. Those rates are low because of a national initiative of affordable home ownership. Those rates are kept low by Federal programs and organizations like Freddie, Fannie and Ginnie. Other Federal programs encourage home ownership as well. Nothing the Fed can do will change those programs.

What role the Federal Reserve does have in individual and Federal debt is maintaining stable prices and low inflation. The low inflation helps keep debt service to a minimum, resulting in an increase in disposable income. Blaming the Federal Reserve for individual and Federal debt is like blaming fast food, soda and candy for America's obesity problem. Just because the Federal Reserve works to maintain low interest rates doesn't mean it forces people to go out and spend like drunken sailors. It is important to note back in the 1980s, rates were much higher and people still had sizable debt loads. Having a debt/income ratio of 60% when rates are double-digits isn't much different from having a debt/income ratio of 100% when rates are near 0%. The disposable income may actually be higher with the 100% debt/income level.

Question #3:

3) In light of question #2, how can QE create SUSTAINABLE economic improvement rather than simply maxing the credit cards out even more and thereby taking us ever further away from sustainability?

Answer to Question #3:

Once again, my first thought was "what does that have to do with monetary policy?" Monetary policy is and always will be a passive tool. Monetary policy is like "pushing on a string." Monetary policy can only create the environment that will support a sustained recovery, it will not create the sustained recovery. Business owners need the confidence to borrow and spend and expand their businesses, and consumers need to confidence to go out and spend. Unless that happens, monetary policy will be ineffective. The best example I can think of is a mule used to plow and seed a field. The mule can plow and seed every inch of a field, prepare it for an ideal growing season, but if the farmer chooses to fertilize the field with salt, all the work done by the mule is moot. No amount of successful monetary policy can compensate for failed and contractionary fiscal policy. Fiscal policy is a fist or stick, monetary policy is a carrot. The stick easily defeats the carrot.

The second part of the question is the most important, and it highlights the point of greatest confusion regarding the Federal Reserve and monetary policy. The Federal Reserve and monetary policy has absolutely nothing to do with the Federal debt, nada, zip. Congress, and only Congress can spend taxpayer money. The Federal Reserve spends exactly $0.00 US Tax dollars not authorized by Congress. If you have a problem with the debt, blame Congress, but mostly blame the voters. Blaming the Federal Reserve simply distracts from the real source of the debt problem. Never in my life have I seen a Congressman on CSPAN say he was voting against a spending bill because the interest rates set by the Fed were too high. Never. Reagan's critics often point to his expansion of the debt. During the Reagan era, interest rates were mid-to-low double-digits to high single-digits, and that didn't matter a bit to Congress.

As far as individual debt, that, once again, is a personal decision, not the Fed's. If rates are low and I decide to leverage up, that is due to my decisions, not the Fed. I like to eat ice cream but I don't because I know it will make me fat. If I did become fat from eating ice cream, I certainly wouldn't blame the ice cream maker.

Lastly, what people don't understand about monetary policy is that the Fed doesn't "print all this money out of thin air." What the Fed does is convert illiquid assets to liquid assets, and then back again. The wealth and spending power of the Nation doesn't change, only the ease at which that wealth can be spent. The Federal Reserve implements monetary policy through something called the Federal Open Market Committee, or FOMC.

The name isn't an accident, it is to signal to the markets that the Federal Reserve manages monetary policy through the open market. The significance of that fact cannot be overstated, but is totally missed by all the Fed critics. Have you ever been in a conversation and the person you are conversing with is so convinced with their position that they simply can't catch their own error or reach the truth and full understanding? You keep trying to explain the basics to them, but because they don't understand the complexity of the system, the words just go in one ear and out the other? The best example I can think of is Doc trying to tell Lightening McQueen that on a dirt track you have to "turn left to turn right." Doc could repeat that concept 1,000 times and it would never sink in. Trying to explain the importance of open market operations to a Fed critic is like telling them to "turn left to turn right." They will just never get it.

The reason open market operation is so important is because to be purchased on the open market THE DEBT MUST ALREADY EXIST! The Fed purchases debt that already exists. The Fed has absolutely nothing to do with expanding the debt. The Fed is prohibited from buying bonds directly from the Treasury. The Fed cannot "monetize" the debt. If the Fed purchases a bond, someone else must have already first purchased it.

Right now, the Fed has a balance sheet of treasury bonds and mortgage bonds. Under normal circumstances, the Fed usually holds nothing but short-term treasuries. What QEfinity did was alter the size, duration and composition of the Fed's portfolio, it did not add to the debt.

What QE does is take a newly-printed US dollar and use it to purchase a Treasury or mortgage bond on the open market. The seller of the bond gets a US dollar and the Fed gets a bond. What really changed? Not much. The bond seller's wealth didn't change one iota, they simply exchanged an illiquid asset for a liquid asset. The Fed's assets increased by one bond, but so did its liabilities of the newly-issued Federal Reserve Note. The only thing QE does is increase the likelihood that a US dollar will be spent or borrowed, that is it. If I sell my bond to the Fed and turn around and put that money into a bank that isn't lending, the real impact of those newly-printed US dollars in nil. That is in fact what has been happening, and why QE has been so ineffective. Dollars not being used for commerce don't really have any impact on the economy at all. If I bury a US dollar in the backyard, it is as if it was never printed at all. If the Fed prints new US dollars and all they do is wind up as bank excess reserves, it is as if the US dollars were never printed at all.

The one thing this "private bank owned by banksters" does not do is print up money so its owners can go on a spending spree. This isn't Zimbabwe or the Weimar Republic. Newly-printed money is only spent through the open market on bonds, it is not used to purchase commercial goods or to build palaces for a dictator. Profits made by the Fed's operations get returned to Congress, not its "owners." There is absolutely zero profit motive for the Fed to implement monetary policy one way or the other. The chairman of the Federal Reserve and all its employees are government workers, and in no way benefit from the profits the Federal Reserve may generate. Financial TARP, by the way, made the US taxpayers a fortune, GM, Fannie and Freddie not so much, but they weren't part of the Fed's responsibilities. The way the Fed was designed is actually extremely thoughtful, and addressed many of the concerns critics are raising today. If the critics took the time to understand the structure and operations of the Fed, they would understand most of if not all of their concerns have already been addressed.

What harm then does QE do? The harm of QE is purely theoretical. The only real thing to fear about QE is inflation, but because QE hasn't resulted in a robust recovery and a substantially increased demand in the US, that fear isn't supported by any current data. The real fear is that once the economy does start to recover, the extreme level of excess reserves will suddenly spring to life and get loaned out. The excess reserves are like kindling and gasoline, and a recovery would be like a flame or spark.

The theory goes that QE hasn't resulted in inflation, but it has resulted in latent inflation. Problem is, latent inflation may manifest itself tomorrow or in 10 years, we just don't know. What we do know with 100% certainty is that QE hasn't triggered unwanted inflation at any level. Arguing against QE and the Fed because inflation might develop is pure nonsense to me, and can result in some disastrous consequences. Falling into deflation is infinitely worse than generating mild inflation.

What if banks do start lending and consumers do start spending? What happens if the recovery does light the fire of inflation? Don't worry, if there is one thing the Fed knows how to do, it is fight inflation. The Fed has 100 years of experience successfully fighting inflation. They are extremely effective at fighting inflation. Deflation, on the other hand, is a different story. They have very little experience in fighting deflation, and what experience they do have, The Great Depression, is considered their greatest failure. There are no highly-effective monetary tools to fight deflation. Pushing on a string doesn't usually accomplish much. Fighting inflation, however, is another story. The Fed has a huge balance sheet of bonds it could dump on the market at any time, driving up interest rates, slashing the money supply and stifling growth. Slowing down an economy isn't a problem for the Fed, speeding it up is. The Fed works far better as a break than an accelerator.

In conclusion; critics of the Federal Reserve are right to be upset with the slow pace of economic recovery, stagnant wages, a failed educational system, a failed immigration system, runaway government and household debt, but they aren't right to blame the Fed for these problems. Burning witches rarely solved the problems the witches were supposed to have been causing. Anger at the Fed today is simply misdirected and misguided. If the debt is the problem, blame the voters. If the educational system is the problem, blame the voters. If stagnant wages is the problem, blame the voters. If immigration is the problem, blame the voters. There are plenty of major problems facing this Nation, but QE isn't one of them. As long as Fed critics fail to properly diagnose the problem, they will continue to offer failed solutions to our problems. If we "End the Fed" or "End QEfinity," wages will still be stagnant, our school system will still be ranked at the bottom, the debt will still be huge and continue to grow. If we "End the Fed," 100% of our problems will still exist, but we will no longer be able to stop bank runs and panics, and we would almost certainly lose our reserve currency status. Those are huge costs for little or no gain.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.