QE2 or Titanic?

The Federal Reserve has launched a second round of “quantitative easing”–QE2.   How is it that this “easing” leaves me uneasy?

Macro is not my thing.  But economics is economics, and I know enough to have serious questions about quantitative easing.  I may not be able to tailor a magnificent macro suit, but I can pretty much tell when the king is naked, and I think that’s the case here.

Bernanke is arguing that easing is needed because of deflationary concerns.  But has there ever been a deflationary episode during which commodity prices spurted ahead?  Definitely not during the 1930s.  Not in the 1920-1921 crash (which at its outset was more severe than the Great Depression).  Not in 1893.  In all of these episodes, commodity prices crashed.  So if this is deflation, it is a weird deflation.

Bernanke was asked about this specifically at a presentation at Jacksonville University.  His answer was not comforting:

Asked by a student if “skyrocketing” commodities prices may threaten his inflation outlook, Bernanke said rising commodities prices are “the one exception” to a broad reduction in inflationary pressures. Overall, excess slack in the economy will make it difficult for producers to push through higher prices to consumers, he said.

Well, exceptions can be pretty damned informative.  Anomalies are the things that should make you question your analysis.  If there is “excess slack” why is the demand for commodities high?

Relatedly, in what deflationary or near deflationary episode has the country facing the more severe deflation problem seen its currency depreciate, rather than appreciate?  Japan’s skyrocketing yen is consistent with deflationary pressures there.  Commodity prices have risen little, if at all, in yen terms.  But the dollar has cratered.  How is that consistent with a US deflationary episode?  Another anomaly in the deflation story.

Bernanke is known primarily as an expert on the Great Depression.  It is pretty clear that that is the mental model he is relying on when deciding that QE is necessary.  But there is always the possibility that he is the general fighting the last war.  Or that he is the master with the hammer, but the current problem isn’t a nail.  Before plunging ahead with a radical scheme, I’d want to have a better understanding why these anomalies exist, and what they mean.  To me, they suggest that the Depression template is a very bad fit.  But it is driving his thinking.  I am worried when people fix monomaniacly on things that confirm their priors and dismiss those that don’t.  That’s not the recipe for wise decisions.

Bernanke acknowledged in a WaPo oped that the 2008 crash was a global phenomenon, but that the slow recovery is primarily an American (and Japanese) one.  In the Jacksonville talk, he acknowledged that emerging markets are booming.  Parts of Europe, especially Germany, are growing smartly.  Even the UK has bounced back better than the US.  So what makes the US different?  Is this difference something that can be addressed by QE?

I have my doubts, particularly in an open economy: a lot of the stimulus will spill over to–is spilling over–to emerging markets.  I think that there is a good possibility that America’s economic sluggishness is a reflection of the grim fiscal situation and the spate of regulatory and other government burdens that have been piled on in the last 2 years.  If that’s the case, then QE2 will not correct stagnation, and risks stagflation.

I also have my doubts as to how this is going to work, exactly.  In his WaPo oped, Bernanke touts the interest rate channel.  That’s hardly persuasive.  He also mentions boosting the stock market, and I think that is more accurately reflective of his true strategy.  QE2 is a hair of the dog gambit: asset bubbles got us into this mess, an asset bubble will get us out.  He’s not Helicopter Ben–he’s Bubble Ben.

I could see–barely–this working if QE were to boost housing prices.  This would ease pressure on household balance sheets, drying out underwater mortgages, which could spark an increase in consumption.

But although Ben can open the monetary floodgates, he’s powerless to direct where the flood of money goes.  Right now it’s heading to emerging markets, commodities, and to some degree stocks.  Housing does not seem to be benefitting.  And this could be contbuting to the QE decision loop.  The Fed and Bernanke point to the CPI as evidence that there is little inflation, and that we are on the cusp of deflation.  But CPI has a large housing component (about 25 percent, if memory serves).  This could be giving a misleading picture of true inflationary pressures.

I wonder what the monetary channels are now.  One possibility is that easing leads to asset price inflation first and foremost, and that goods price inflation occurs with a lag.  By the time that monetary pressures show up in the goods price measures that the Fed/Bernanke are monitoring, it may be too late to intervene to prevent a big inflationary spurt, or any such intervention may crater the economy.  The dilemma that I disussed in late-08 to early-09–where the Fed is faced with the grim choice between rampant inflation and a major recession–is still present.

This means that QE is unlikely to do anything to boost the American economy.  At the same time it is already sharply increasing international tensions in a way that poses a real risk of trade, currency, and investment protectionism.

All of this also injects a tremendous amount of uncertainty into the economy.  This uncertainty makes decision making harder–and investment/resource allocation mistakes more likely.  I once quoted Sherwin Rosen’s bracing remark in his Econ 300 class in Chicago in ‘82 or ‘83: “The problem with inflation is that it f*cks up relative prices.”  Well, even if QE doesn’t spark measured inflation, it almost certainly will–and arguably already is–f*cking up relative prices.  That’s not good.  And just the uncertainty itself is a drag on the economy, as decision makers decide that procrastination is the better part of valor.

You don’t have to go all Austrian to have serious concerns that continued monetary stimuli can distort price signals, leading to perverse resource allocations, and economic problems down the road when these misallocations become manifest.

In brief: I see a lot of icebergs out there, but Captain Ben has just ordered all ahead full.  I hope there are enough lifeboats.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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