Bubbles and Busts'  Instablog

Over at Mike Norman Economics, Mike Norman poses the question, "Would rates be higher if the Fed hadn't done QE?" Before I get to his answer, let me acknowledge that this question has crossed my mind a number of times over the past couple years. The answer I have settled on is that rates would be lower and let me explain why. There is a broad misconception about what QE (effectively open-market-operations) really means on an operational basis. I've tried to explain this many times but Mike offers a succinct explanation:

In so doing the Fed changes the composition and duration of the financial assets held by the public. It's not stimulus, it doesn't enable gov't spending and it's not money printing. These are asset swaps, that's it, pure and simple.

QE reduces the default risk and shortens the duration of financial assets held by the private sector (i.e. public). Assuming risk preferences do not change significantly during this process, the private sector will likely counter QE by shifting other assets to higher risk and longer duration securities. The result is a smaller tradable supply of Treasuries and decreasing demand. Since a significant portion of QE has and continues to involve purchasing Agency-MBS instead of Treasuries, my intuition is that the demand effect trumps the change in supply. Without QE, the demand and supply of Treasuries would therefore be higher, with the larger demand effect pushing up prices and lowering rates.

A significant portion of Mike's argument is worth highlighting (my emphasis):

when the government spends it adds to the level of bank reserves in the system and this accumulation of reserves causes the Fed to engage in monetary operations on a fairly regular basis (like, daily) to maintain reserves at a level that is consistent with whatever target interest rate they have decided upon. If the Fed were to allow reserves to build and build and build as a normal consequence of ongoing gov't spending, then the overnight lending rate (Fed Funds) would quickly fall to zero and all other rates out along the term structure would follow suit.

So the fact of the matter is the Fed has to work quite hard to KEEP RATES FROM FALLING TO ZERO ON THEIR OWN if the banking system were just left alone without its intervention. Those who say the Fed is keeping rates "artificially low" have got it backward. On the contrary, high rates or rising rates for a currency issuing nation are artificial.

The first statement in bold is often overlooked or misunderstood but critical to understanding monetary operations and its impacts. Clarifying Mike's point, since taxation actually decreases the level of reserves, government spending in excess of revenues causes reserves to build. Scott Fullwiler addresses this issue in a fantastic paper on Interest Rates and Fiscal Sustainability:

When a deficit is incurred, in order for the Fed's interest rate target to be achieved either the Fed or the Treasury must sell bonds in order to drain the net addition to reserve balances a deficit would create. If no bonds were sold, the deficit would generate a system-wide undesired excess reserve balance position for banks. (p. 17)

Based on this analysis, the conclusion is pretty clear:

The notion that rates would have been higher if the Fed had not done QE is false.

Related posts:

Fullwiler - "The main shortcoming of the money multiplier paradigm"
Bubbles and Busts: Why QE2 Failed, Part 1
Modern Money Regimes Redefine Fiscal Sustainability
Fed's Treasury Purchases Now About Asset Prices, Not Interest Rates
"Interest-On-Reserves Regime" Will Rule Monetary Policy For The Foreseeable Future

Since the ACA ("Obamacare") was enacted, a significant portion of my friends and family have been pleased with the extra benefits accrued at seemingly no cost. Although the cost may be difficult to perceive today, it is certainly present and will become increasingly relevant in the coming years. Setting that debate aside for the moment, readers should be aware of a couple significant loopholes in the ACA pointed out by the typically liberal Yves Smith of naked capitalism:

It will cover people with preexisting conditions. Um, maybe, until you need costly care. The ACA preserved a loophole you can drive a truck through: But the bill has a giant loophole: insurers can continue to cancel policies in the case of "fraud or intentional misrepresentation" as they do now. And the bar for fraud, per established case law, is remarkably low. Forgetting to tell your insurer about a past ailment, no matter how minor, qualifies. Say you forget to tell your new insurer that you had acne or a concussion in your teen years. That will more than do.

…

Your health care will be (mainly) covered. Hahaha. I know high functioning people (as in couples where both spouses had advanced degrees, and one was on the board of a major medical devices company) who've been stuck with huge hospital bills. They'd thought everything was covered, and somehow items that were in the tens of thousands (in one case, totaling $75,000) wasn't. And then there's the "out of network" problem, highlighted this weekend by a New York Times story of parents who had a baby that had trouble sleeping and the pediatricians they saw were at a loss. The doctor who specialized in that sort of problem didn't accept insurance. While he was able to help the baby, the parents had to foot all of the $650 bill.

Prior to reading Smith's post, I had expected the second loophole but was surprised by the first. Individuals with pre-existing conditions unfortunately cannot alter potential past misrepresentations, but should proceed with greater care in divulging their medical histories.

Smith goes on to argue against a third area of praise for the ACA, which may provide an opportunity for investors:

Health insurer profit margins are capped. That is technically accurate but substantively misleading. The health insurer have been engaged in price gouging over the last two decades. Health insurers as of the early 1990s spent 95% of health care premiums on medical expenditures. They now spend less than 85%. The ACA requires them to spend 80% on health care costs. So the bill institutionalizes an egregiously fat profit margin.

The major health insurers, Wellpoint (WLP), UnitedHealth Group (UNH) and Cigna (CI), continue to trade off their pre-ACA highs despite rising profitability. Many analysts and investors appear convinced that the ACA will hurt future profits, when in reality it may ensure strong profits going forward.

Related posts:
The Relative Strength of US Health Care
Auerback & Wray: America Needs Healthcare, Not Health Insurance

Disclosure: I am long WLP.

As frequent readers of this blog are well aware, my approach to understanding business cycles is most closely associated with the Post-Keynesian sub-disciplines of Monetary Realism (MR) and Modern Monetary Theory (MMT). The order of appearance is intentional since I find myself more frequently in disagreement with MMT when its proponents stray too far from their monetary operations expertise into the realm of policy recommendations. Though I support the government's ability to offset private sector deleveraging with budget deficits, I find it troubling that more specifics on the distribution of funds and current tax laws are often omitted from the discussion.

Although these disagreements are meaningful, they do not discount the shared goal of promoting multi-sectoral analysis of business cycles. Thornton (Tip) Parker, at New Economic Perspectives, puts forth two ideas to further this goal. His first idea revolves around the issue of wealth and income concentration that I noted above:

The wealthy use much of their money just to make more money by gambling through hedge funds, leveraged buy-out funds, and other financial schemes. They take some out of the economy by spending in other countries and hiding from taxes with off-shore accounts. They are not using much to make productive investments to create more jobs that would provide good pay and benefits in this country. Too much of what high earners receive leaks out of the Main Street economy to Wall Street, and often to other countries.

I do not think that MMT and MS consider the leak adequately. They explain why the government must create more new dollars to offset private sector and foreign surpluses. But they do not explain how to prevent many of those dollars from flowing up and increasing the wealth concentration. I suspect that more dollars flow out of the Main Street economy through the leak than as payments for net imports. Just the need of many middle and lower income families to borrow ensures that some of their income will flow up in the form of interest and finance charges. (Margrit Kennedy has recently estimated that thirty-five to forty percent of all purchases go to interest.)

The effect of concentration might be analyzed by dividing households into two subgroups, one for the wealthy (say top 10%) and one the rest. Showing each subgroup's surplus or deficit in relation to the rest of the private sector and the foreign and government sectors would show how much of a problem inequality really is.

I know of no easy way to do that, but conceptually, it would debunk the idea that income inequality is an envy, special pleading, or made-up class warfare issue. It would also show that taxes can do more than just prevent inflation, they can be used to limit the leak of money out of the productive parts of the economy.

Though this research project faces significant challenges, the potential results could vastly improve current policy discussions both among Post-Keynesians and in the broader political arena.

Related posts:
Debt Inequality Remains Major Headwind To Growth
Bubbles and Busts: IMF - Leveraging Inequality
Bubbles and Busts: Forgotten Lessons from Japan's Lost Decades
Hayekian Limits of Knowledge in a Post-Keynesian World