Seeking Alpha contributor Avery Goodman produced a long article titled "QE, Inflation, And The Case For Precious Metals", we started to write a reaction as comment, but realized soon enough that this would develop into quite a long comment, so we put it into a separate article. Let's start from some very basic principles first,:
This author vociferously disagrees with most of the principles of the Keynesian school of economics. In truth, government spending does not restore economic activity, except in an unsustainable fashion.
Vociferous as his disagreement might be, it entirely lacks substantiation. While we're not Keynesians ourselves, we do believe Keynesians policies have their uses, especially under the present circumstances.
Balance sheet recession
First of all, the author seems to conflate monetary and fiscal policy and subsume it all under the banner Keynesianism, so some explanation is warranted. This requires a diagnosis of what actually happened to the economy in 2008 onwards. A short overview:
- The economy experienced a "balance sheet recession," that is, economic activity is subdued because households took on too much debt, based on asset values (real estate) that have imploded while the debt remained. They are repairing their balance sheets.
- That means that they spend less, saved more, and credit demand was very tepid despite record low interest rates.
- Companies, faced with a large reduction in demand for their output, cut back investment and laid off people, which reinforced the crisis (yes, this is the Keynesian multiplier).
That savings glut produced very low interest rates and a very large demand shortfall, leading to a large output gap (potential output when all resources are utilized minus actual output) and a large increase in unemployment (or large decrease in the employment/population ratio):
Click to enlarge
In short, a recession. But, like we argued, no ordinary recession. Ordinary recessions are usually triggered by the Fed hiking interest rates to cool the economy. In a balance sheet recession, people save more and spend and borrow less in order to repair their balance sheets.
Balance sheet recessions, which are the consequence of a financial crisis, are particularly nasty. They take much longer than normal recession to repair, as it's difficult to repair balance sheets overnight.
The 1930s and a debt-deflationary spiral
Balance sheet recessions (the result of financial crisis) are also particularly risky. The initial collapse in asset prices can, if nothing is done, create a Fisherian (after Irving Fisher who wrote a seminal paper in the 1930s about this) debt-deflationary downward spiral in which:
- Asset prices keep on falling, worsening balance sheets further and triggering more forced liquidations
- Leading to even less borrowing and spending, ending in deflation (falling prices) which increases the real value of outstanding debt, leading to yet worse balance sheets.
- Bad debts accumulating at banks, leading to bank collapses and bank runs.
This is what happened in the 1930s as well as in Japan in the 1990s, but luckily enough, the authorities learned the lessons (Bernanke is a keen student of both periods of financial crisis) and they intervened on a rather massive scale.
In the figures below, you can see that the fall in economic variables was as steep or steeper than in the 1930s, until something arrested that fall. If not for the policy interventions, what else could have achieved this? Nothing.
So the first conclusion is that Bernanke, the villain in Mr. Goodman's article, actually saved us from experiencing a much worse economic crisis. A second conclusion is that if Mr. Goodman had his 'hard money' way, the Fed wouldn't have intervened with "all that money printing filling the coffers of primary dealers and the government." We would have had a repeat of the 1930s depression.
If you still don't believe us, simply realize that the Fed didn't intervene in the aftermath of the 1929 stock market crash, and look what happened. Japan's central bank, the BoJ, was late in its reaction and let deflation set in the system. Two decades onwards, they've still not been able to get rid of it.
Falling prices increase real debt burdens, and Japan could only keep the economy going by a long-drawn out fiscal stimulus (a much bigger but shorter stimulus would have been much better but that is another matter).
Policy lessons in the aftermath of the financial crisis
Having saved us from a 1930s style depression, the jury is still out whether we can avoid a Japanese style lingering deflationary economy. A right economic diagnosis of the crisis (asset price collapse followed by a balance sheet recession) would be a good start.
There are a number of important policy consequences following from that analysis. For instance, when debtors (households) are spending less, somebody else has to spend more in order to maintain economic activity. According to Mr. Goodman (see quote above), public spending cannot restore economic activity. But why not?
What is the difference between consumers borrowing and spending on output that companies produce, like they did with abandon in the previous decade, or the public sector borrowing and spending on output that companies produce?
Economically, there isn't actually any difference in economic effect. It doesn't matter who the buyer is, as long as there is demand for output.
Although we have come across many a quote like that of Mr. Goodman, invariably any explanation as to why government spending should be considered different in principle from private spending is always assumed as a matter of faith and never explained.
In fact the government has some advantages:
- It faces considerably lower borrowing cost than the average consumer
- It can time its spending decisions with respect to the economic conditions, smoothing out business cycles and filling the spending gap left by households in a balance sheet recession (like the past couple of years)
- It gives some of those excess savings a place to go
- It can spend on stuff like education, research and development, and infrastructure. Not only does this increase output in the short-term but it simultaneously increases the productive capacity of the economy in the long-run. It is difficult to imagine there aren't public investment opportunities that generate returns over and above the 2% or so that 10 year public bonds now command.
While public spending in practice tends to be considerably more messy (more often than not it is ruled by political, rather than economic expediency) that doesn't mean we couldn't try some of the above, especially when the alternative is risking a 1930s-style depression.
Monetary policy in a balance sheet recession
Where we are slightly more in agreement with Mr. Goodman is that there are good reasons to assume that monetary policy in a balance sheet recession is pretty useless (even if we disagree with almost all of the specifics mentioned by Mr. Goodman). There is a simple reason for that.
Go back to the figures above that show how private savings greatly exceed private investment. There is a savings glut. Even zero rates cannot equate savings and investment; this is a condition that is actually familiar to Keynesians, called a liquidity trap. If households want to repair balance sheets, they're paying off debt, rather than taking on new credit, reducing their spending in the process, no matter how low the interest rates are.
If households reduce spending, there is little reason for companies to increase productive capacity, as there won't be any demand for the output the new capacity produces. No matter how low the Fed pushes interest rates, households and firms are not borrowing more, and monetary policy is pretty powerless.
Which is why central banks everywhere have resorted to quantitative easing (QE), buying assets. This isn't doing much either, as the result is that the banking system is stuffed with reserves. But Mr. Goodman argues the following with respect to that:
Keynesian economists believe that an increase in the monetary base can stimulate the economy, and that the end justifies the means.
He couldn't be more wrong, as without an increase in credit demand, this just sits there as base money. Here it is:
Keynes himself compared this situation to "pushing on a string," indicating the powerlessness of monetary policy in a liquidity trap.
Some hope for some mild positive effect via asset markets, but there is hardly any evidence for that and we already argued that it's difficult to argue that shares are overvalued.
So monetary policy is pretty powerless under a balance sheet recession, but let's not forget that the Fed interventions in 2008 were extremely helpful in stemming the rot in the financial sector and preventing a 1930s-style depression in the first place. Let's also not forget that all that QE isn't doing much harm, either.
Interest rates would be low anyway (there is a savings glut, remember) as we have experienced in the US, the UK and Japan. It hasn't led to accelerating inflation, let alone hyperinflation anywhere, as many pundits have argued for years. But don't expect any miracles from it either.
No, the right course of action is fiscal stimulus. The same super low interest rates that make monetary policy rather impotent actually supercharge fiscal policy. And since there is a shortfall in demand (the mirror image of the savings glut), spending should come from somewhere until households are done repairing their balance sheets.
It worked in China, it worked to a certain extent in the US (it was way too small with respect to the output gap and partly offset by spending cuts at the state and local level), it worked in the Great Depression (until the folly of the fiscal retrenchment in 1937), and it worked in Japan.
Since there is a large output gap (a lot of idle resources), there isn't any danger increased public spending would have crowded out private sector spending; in fact, it would have crowded private-sector in. Increased demand increases production, which needs new productive resources, employing otherwise unemployed people, who start to spend more as they earn, etc., etc.
Theft and currency debasement
While our (mild) objection to QE stems from its ineffectiveness, Mr. Goodman has much stronger objections, expressed in, well, unusually firm language. Before we get into that, what never ceases to amaze us is that we find people without formal economic training (Mr. Goodman is a lawyer) often have such strong opinions and take on people like Ben Bernanke with really strong language.
We would think twice (or several times over) before we would express ourselves in such strong terms on issues of the law in which Mr. Goodman is a specialist, let alone taking on a supreme court lawyer, but that could just be a matter of personal taste.
Now, what has Mr. Goodman against QE (whether sterilized or not - we'll leave those subtleties aside)?
QE is a tax imposed by the central bank without consent of the legislature, which shifts wealth by debasing the currency in which the wealth is denominated. Proponents seek to avoid the desire for vengeance that naturally arises in the hearts of victims of theft by cloaking the scheme in a fancy name, and with a veil of deceit. For example, when Bernanke talks about QE and interest rate manipulation, he never fails to refer to it as "accommodation." But it is not accommodating anything. It is merely theft, nothing more.
Enthusiastic supporters of Keynesian economics seek to transfer the value of money from middle America, and specifically from people living on fixed incomes, to the government and the biggest banks.
There is much more, but this is about the essence of it. The usual stuff. We've come across these kind of rants with some depressing frequency (often in the comment section of our own articles). Invariably, these things are stated as a matter of fact. They are deemed so evident that they don't warrant substantiation, neither in argument nor data. But a normal debate about issues substantiation is king.
For starters, after numerous years in numerous countries practicing QE, where is that currency debasement? We had this discussion numerous times with the likes of Mr. Goodman, and the "arguments" invariably come down to:
- The inflation statistics are all a scam (Goodman suggests this with his currency debasement argument)
- Hyperinflation is just around the corner, and the financial system will collapse
- Gold and other commodity prices are up
We haven't yet seen any other variety. We already dealt with the hyperinflation nonsense in another article (for starters, using a prediction that hasn't materialized isn't a particularly strong argument in favor of a particular theory, to say the least). We'll leave the inflation statistics are a scam for what they are. If the foundation of one's economic outlook depend on that, good luck to you.
- There is rising demand from emerging markets
- Enough rich people actually belief the hyperinflation nonsense, exerting real demand for precious metals (?)
Mr. Goodman argues that the oil price has spiked, despite a "glut of supply," suggesting the spike in the oil price isn't real but a result of QE. If the oil price would indeed be artificially high, there should be way more supply than demand (indeed a glut), but where is it? There should be a host of inventory that is rapidly increasing, but that simply isn't the case.
Could it be that the oil price is high because supply is rather inelastic and demand from emerging economies like China rises faster than demand from the US and Europe falls?
Why, for instance, isn't there a similar price rise in natural gas, rather than the ever falling price the US is experiencing? Could it be because that gas isn't exportable to emerging economies like China. Could that explain why LNG prices in Asia are four times higher, that is, could it be that commodity prices can largely be explained by normal supply and demand?
Where is the theft Mr. Goodman mentioned above? He argues that this lies in those poor bond holders getting such a low interest rate as rates are manipulated. We already showed above that under a balance sheet recession, there is a savings glut so rates are low, no matter what the central bank does.
Did rates dramatically rise when the Fed stopped QE1 and QE2? No. Simple as that. QE has made little or no difference to bond prices. People predicted a crash in bond prices towards the end of both QE1 and QE2. It hasn't happened. It is always useful to check one's assumptions against the main economic variables that these are supposed to affect.
Also, even if the Fed actions would have inflated bond prices, wouldn't that be a bonus to bond holders, rather than a theft? He argues that they are suffering (theft!) but in fact, if he's right their asset value (that is, bond prices) would have increased. Some theft that is! Where can we sign up?
In the end, he predicts in true ZeroHedge fashion (day-in, day-out, for years and years) that the whole financial system will collapse and will be replaced by sound money based on gold. We already wrote how a return to the gold standard would be a disaster, we're not going to repeat ourselves here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.