We Now Have Proof That Government Stimulus Does Not Work

by: Jeremy Blum

Summary

Quantitative easing was used 3 times during and after the last recession. Each time, it failed to lower interest rates or increase bank lending.

Fiscal stimulus prolonged the recession by pulling forward demand and added over a trillion dollars to our debt.

Lower Fed funds did help but had many nasty side effects and remained in place too long.

Less stimulus has been more effective in prior recessions.

Quantitative Easing Background

GOV Many economists, politicians and financial writers have credited the Federal Reserve's recent quantitative easing for getting the economy going. In fact, it has done nothing to stimulate the economy while creating other risks. You cannot connect the dots from the Fed's quantitative easing to the pickup in economic activity. The reasons for the recent economic improvement lie elsewhere. Our recovery and expansion since the 2007-2009 recession have been below average, indicating stimulus had little positive impact.

Quantitative easing (QE) is the process where the Federal Reserve creates money which it uses to buy government bonds and other financial assets, in order to increase the money supply and the excess reserves of the banking system. The goal is to reduce interest rates and stimulate lending. A secondary purpose is to move money out of cash and into riskier areas such as capital investment and stock purchases. Historically, QE has only been used after the Fed's primary tools, lowering Fed funds and discount rates, proved insufficient to stimulate the economy.

QE Actual Results

QE primarily works in two ways, by lowering longer-term interest rates and by stimulating lending. By both measures it has failed. I looked at 5-year treasuries, since most commercial real estate loans are five years, and 30-year treasuries, since the majority of residential mortgages are 30-year fixed. The chart below shows that both rates actually increased during all three QEs.

5-Year Treas. Rate

30-Year Treas. Rate

QE1

Started 12/16/08

1.34%

2.55%

Ended 3/31/10

2.86%

4.72%

QE2

Started 11/3/10

1.11%

4.09%

Ended 6/30/11

1.76%

4.38%

QE3

Started 9/13/12

0.65%

2.95%

Ended 10/29/13

1.29%

3.62%

Click to enlarge

Source: Rates from treasury.gov, QE dates from calculatedriskblog.com.

At best it can be said the Fed reduced the rise in interest rates.

I then looked at bank lending during the QEs. The nearest quarter end was used since bank lending data from the FDIC is quarterly.

Total Bank Loans

Annualized

Date

in Billions

Increase

12/31/08

$6,684

-2.54%

3/31/10

$6,472

9/30/10

$6,384

-0.41%

6/30/11

$6,371

9/30/12

$6,742

4.18%

9/30/13

$7,024

Click to enlarge

Source: FDIC

As shown above, bank lending actually declined in the first two QEs. The increase in the third QE was below average despite being in the peak of the expansion. The chart below shows bank lending before and after the QE periods. For the "before," I used just before the recession to get an expansionary period.

Total Bank Loans

Annualized

Date

in Billions

Increase

12/31/03

$4,351

11.10%

12/31/05

$5,317

12/31/05

$5,317

11.50%

12/31/07

$6,540

9/30/13

$7,024

5.99%

9/30/15

$7,865

Click to enlarge

Source: FDIC

As shown above, lending expanded much more rapidly before and after the QEs. If you want to look at lending during 2008, a recession year, it expanded by 2.24%, much greater than the QE that followed where lending declined by 2.54%.

Why didn't QE increase lending? Well as a former career banker, I can tell you bank lending is primarily determined by two factors, neither of which involves liquidity. They are demand, and the health of the lender's loan portfolio. When the lender has a high level or increasing volume of problem loans, it tightens lending standards. Even if it doesn't want to, it is often forced to tighten by government examiners. Having more liquidity on the bank balance sheet has very little direct impact on lending. It indirectly impacts lending as it increases demand for Treasuries and mortgage-backed securities. However, if a bank just sold those to the Fed, they are probably not looking to buy more.

Regarding lending, this is a case where the economic textbooks just plain have it wrong. Fed buying of treasury and other securities has little or no impact on lending, because banks don't need the liquidity. Liquidity is not a serious issue for most banks. Even banks close to failure usually have plenty of liquidity. A hundred years ago, liquidity was a major issue. Today, banks have many sources of funds beyond their depositors. They can pledge Treasury and mortgage-backed securities and borrow repurchase agreements. They can pledge loans and securities to the Federal Home Loan Banks and get bank advances. They can borrow unsecured from other banks with Fed funds. They can borrow unsecured directly from the Fed. They can tap equity or debt markets.

Printing money through QE can lead to a money printing war with other countries. This in fact is what has happened. Following our example, just about every developed country and many emerging markets have moved to debase their currency. This has had the opposite effect on our currency than the Fed intended, creating a stronger dollar. The stronger dollar has now led to a decline in manufacturing and exports. Many major countries including China and Russia are openly talking about moving away from the dollar as a reserve currency as a direct result of quantitative easing and our deficit. This would take away one of the intended effects of QE.

Quantitative easing can also create bubbles in asset classes such as commodities. This in fact happened and subsequently created a bubble that is still popping. The move by others to imitate us and debase their currency has led to a stronger dollar and much lower commodity prices.

As a result of the three QEs, the Federal Reserve now has $4.2 trillion (as of 11/30/15) of Treasuries and mortgage-backed securities on its balance sheet. These assets will be paid off or sold at some point. Both will put upward pressure on interest rates.

The Folly of Government Stimulus

Federal government fiscal stimulus programs failed miserably during the last recession. The first stimulus was the tax refunds in the summer of 2008. The economy fell off a cliff immediately after these refunds stopped. The next large stimulus was housing tax credits. These drove up home sales a bit and slowed the decline of home prices. Once the tax credits ended, home sales resumed their decline at an even faster rate. The government also tried cash for clunkers to stimulate car sales. Automobile purchases immediately returned to their former depressed rate once this stimulus ended. The Federal government also tried to stimulate the economy by transferring hundreds of billions to the states. This led to states' dependence on federal dollars, at a time when state revenues were declining. The ultimate result was delays by the states in cutting expenditures or raising new revenues. It also increased our Federal debt by over $1 trillion.

The positive impact of all this stimulus was negligible as proven by the historically slow recovery and expansion we have had since the recession. These stimuli actually made things worse by pushing forward demand for housing and cars and not allowing the market to find its natural level of support.

Fed Funds Stimulus

The Fed's monetary stimulus using Fed funds had a mixed impact. On the positive side, the lowering of the Fed funds rate did lower short-term interest rates. This allowed borrowers to pay less on adjustable rate debt and healthy borrowers were able to refinance to lower rates on fixed rate term debt.

Low Fed funds hurt in at least four ways. It hurt people and institutions reliant on fixed income. A whole generation of seniors have had to dip into their savings instead of living off the interest. There is no help on the horizon for them. Lower interest rates forced investors to look for riskier assets to get the yield they needed to live on or were accustomed to. This led to more money in stocks, junk bonds and real estate. Junk-bond yields were pushed unusually low and that bubble has recently popped. Low rates hurt pension funds by lowering their income and increasing their targeted asset values, which increased their shortfalls. Low interest rates also hurt the earnings of most banks and insurance companies.

The Fed kept Fed funds close to zero for way too long. They should have started raising them two years ago when GDP was increasing by 2-3%. Raising rates then would have given them ammo to fight the next recession, since QE is ineffective. Now they don't have that tool and the Fed is toothless.

Prior Government Stimulus

Barron's, in an article published last week, discussed the four deepest recessions in the past 100 years. "As the president said, the U.S. has the strongest, most durable economy in the world. As he didn't say, that was just as true in 2009, 1981, 1933, and 1921. The main difference among them is that in 1921, the government didn't move to cure the economy. Our former colleague Jim Grant told that story very well, with a clear eye on lessons for the other crisis years and for the present, in his book "The Forgotten Depression: 1921: The Crash That Cured Itself."

The two downturns listed above that had the slowest recovery were 1933 and 2009, also the two with the most government stimulus. The recession with the least stimulus was 1921, which is now forgotten due to how fast things recovered. Fiscal stimulus was muted in 1981, which was followed by the strongest expansion of the past 50 years.

Effect of Government Stimulus

Recessions have a pattern. We enter a recession, several months later the government starts stimulus, and eventually we exit the recession. So it is easy to conclude that government stimulus led to the ending of the recession. As shown in the paragraph above that is not the case; let's explore why. First of all, we almost always have a recovery and expansion after a recession, regardless of the amount of stimulus. Pent-up demand is one of the most powerful economic forces out there. Eventually things wear out and need to be replaced and people get tired of austerity. Recoveries happen regardless of how much government stimulus there is. The pickup in spending eventually increases the number of people employed. However, employment is a lagging indicator. To those who say it is no coincidence, the consumer started spending when QE started, I say, connect the dots between the QE and consumer spending. You can't. You can't show how government stimulus increased sustained consumer spending, only that they somewhat appear to happen at similar times.

Government stimulus is a slippery slope. We don't want to be addicted to stimulus like Japan, which has now had 25 years of economic malaise during which the government has employed repeated stimulus. Economic stimulus in Japan has done little to invigorate the economy; it has only loaded the country with debt.

Many stimulus programs cause more problems than they resolve. Extending unemployment benefits incents people not to look for work. Modifying the mortgage payments of delinquent borrowers prolonged the problem by keeping people in homes they can't afford, and by rewarding bad behavior. A high level of people with government-modified mortgages became delinquent again, which just prolonged the problems in the residential real estate market. Better to get it over with. Recessions are needed to eliminate excesses. If you keep the excesses around, you prolong a recession. Government needs to look at cause and effect and what is being incented with each program.

Conclusion

The Fed gets too much credit when the economy is good and too much blame when it isn't. Their efforts to improve the economy through QE completely failed. Their efforts to improve the economy through low Fed funds rates helped, but stayed too long and created many nasty side effects. The government's fiscal policy to improve the economy only prolonged the recession, slowed the recovery and added to our debt.

Disclosure: I/we 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.